After purchasing a residential home many investors allocate investment capital to real estate in varying degrees, relative to their overall total net worth. Return on capital comes from rental income and capital appreciation. This places real estate, in terms of risk and return, between higher equity risk and the lower risk of debt. The real estate market is cyclical, driven by supply and demand. High quality holdings produce significant levels of current cash flow, generated by long-term lease arrangements with clients. Without lease arrangements in place, ownership becomes purely speculative. Real estate is notoriously illiquid. You cannot sell a wing of a villa or the bedroom of an apartment.
The management and administration costs for personal or corporate ownership can be high and it may be difficult to find trustworthy competent managers. Furthermore, income returns on real estate depend on rental yields, which also impact on capital value. These can fluctuate widely if local conditions vary. These factors together with taxation can considerably reduce the overall return on capital. Careful family succession planning is essential with holdings of Real Estate. It may be more difficult to obtain probate or enforce succession rights in respect of a real estate investment held in certain countries which have different inheritance regimes.
Supply and demand in real estate follows the interest rate cycle. Developers build aggressively when access to cheap money is readily available and regulations and planning constraints relaxed, giving rise to overcapacity. In a buoyant economy, businesses expand and create a demand for factory and office space. Consumer spending increases demand for retail space. An investment in the Vanguard US REITs (Real Estate Investment Trust) Index in 2009 would have seen an annual return of 12.78% p.a. more than doubling your capital.
Prudent investors, aware of the risks associated with owning bricks and mortar, take advantage of a large number of publicly and privately held investment vehicles. Unlike direct ownership, the intrinsic value of the REIT comes from dividends, as well as incremental earnings growth of the underlying companies.
A REIT, unlike a typical corporate entity, pays no income tax as long as it distributes at least 90% of its taxable income and generates at least 75% of that income from rents, mortgages and sales of property. REITs serve as a pass-through structure in which income passes through the property without being taxed, to the holders of the security who take responsibility for the tax liability if any.
With its inflation-sensitive nature, real estate provides a powerful diversification to investor portfolios. Careful investors pay close attention to fee arrangements in private partnerships and management fees, maintenance costs when considering private ownership. Ownership of REITs offers investors a low cost, liquid, tax efficient exposure into all sectors of the commercial and residential real estate market increasing the odds of a successful investment outcome. Sensible investors avoid the murky world of private real estate partnerships and participate in the brighter transparent world of publicly traded securities, balancing this carefully with the ownership of illiquid bricks and mortar within their investment portfolios.
Jeremy Blatch TEP