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THE BIGGER PICTURE

The appeals and pitfalls of owning real estate for investors

Our first purchase of real estate is usually motivated out of desire to have somewhere to live. As we accumulate capital, so we turn our attention to owning property as an investment. Why? Bricks and mortar as well as land are a real, tangible asset. A legal title is conveyed to guarantee ownership. The investable world of real estate exposes investors to the benefits and risks of owning land, commercial office properties, apartment complexes, villas, industrial warehouse facilities and retail establishments.

Real estate assets combine characteristics of fixed income investments (bonds) and equities (shares). Fixed income is just that, a contractual obligation to deliver a fixed sum for a specified time. Leasable real estate properties exhibit bond-like qualities. It is important, however, that investors differentiate between such 'core' real estate holdings and more risky 'non-core' real estate. Non-core properties without tenants or with short-term leases exhibit mainly equity-like qualities. Investment in raw land, ground-up development activity and hotel operations fall outside the definition of core real estate, because the investments rely substantially on operating expertise to produce cash flows.

Real estate risks generally fall between those associated with bonds and equities. Due to bond-like rental streams and equity-like residual values, real estate investors should be expecting results somewhere between those of the bond market and stock market. Ibbotson Associates data for the past 78 years to 2014 indicates that stocks returned 10.4% annually and government bonds 5.4%. This suggests that real estate investors can expect a return around 7.9% pa (2.5% above bonds).

The strong relationship between replacement cost and market value leads to one of real estate's most attractive attributes: a high correlation with inflation. Since the labour materials used to build real estate assets rise in line with inflation, the replacement cost of real estate tracks inflation closely.

Let us remember, however, that in its purest form real estate is actually illiquid. Sensible investors recognising this will also hold a portfolio of marketable securities, providing both diversification and liquidity. Although exceptions do exist for individual investors, publicly traded real estate securities generally provide reasonably low cost exposure to high quality pools of real estate assets. Unfortunately, with few exceptions, the privately offered shares in private partnerships provide exposure to real estate at such an obscenely high cost, that they wipe out any individual investor's chance of earning fair returns.

Finally, many investors in real estate benefit from an unusual investment vehicle, the Real Estate Investment Trust (REIT). The REIT, unlike any other legal entity, does not pay income taxes as long as it distributes 90% of its taxable income and generates at least 75% of that income from rents, mortgages and sales.

With its inflation-sensitive nature, real estate provides a powerful diversification to portfolios. Sensible investors, however, pay close attention to fee arrangements and measure their options against a benchmark of passively managed, publicly traded REIT funds.

The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.