Background of Real Estate as an Investment Asset
This article provides a broad perspective regarding the fundamental attributes of real estate, being a widely accepted asset class that serves a role within investment portfolios. Real estate is a diverse asset class with multiple factors influencing value and a unique set of characteristics compared to other asset classes. The intent is to highlight certain considerations in planning a real estate investment, inclusive of the transaction and subsequent holding period.
Real estate is an asset we are all familiar with as users, as we are tangibly aware of the places we call home and work. We live in apartments and condominiums, single-family homes, and shared communities. We work in grocery stores, shopping malls, storefronts that line our streets, and office buildings of various configurations that define our neighbourhoods and skylines.
There are other classes of real estate that we access indirectly. These are the warehouses where our products are sorted and stored before being shipped to local stores or our homes. It is the farms that produce food for the community, the airports and train stations that are part of our journey across the globe, along with the medical centres and firehalls that provide essential services. Behind every space you encounter, directly or indirectly, exists an investment in real estate supporting the activity.
So, for the balance of this article let us think about real estate as an investment asset as opposed to the function that operates from the physical premises. There are differences in the investment risk and investment return profiles for each major investment asset class.
The benefits derived from aggregating a diverse investment portfolio is a fundamental principle of modern portfolio theory. We can infer from empirical data that real estate fulfils an important role within an investment portfolio. Major Canadian pension funds, such as Canada Pension Plan Investments and Caisse de Dépôts et Placement du Québec currently allocate approximately 9% and 10%, respectively, of their investment portfolio to real estate, while other institutional investors have higher portfolio allocations toward 15%.
Real Estate Asset Diversity
It is tempting to generalize all real estate into a single category, as all assets share certain traits. In practice real estate is diverse and there is value in appreciating variances along the asset class, geography, and development cycle dimensions.
The four traditional asset classes include Residential, Office, Retail, Industrial, with a fifth catch-all category referred to as Specialty. The Specialty assets refer to real estate designed for specific purposes, such as student housing, long-term care housing, data centres, hospitality, entertainment, or agriculture.
Each asset class is unique in both the revenue and cost profiles owing to differences in lease terms of its tenant base, along with the capital improvements and services required to operate such assets. For example, many shopping centres contain an anchor tenant that may benefit from a discounted rent structure as a trade-off for drawing traffic into the area. That shopping centre may contain shared space, amenities, and landscaped features that enhance the centre’s attractiveness and shopping experience. There are costs incurred, and ultimately shared, between the landlord and tenants for those features. In contrast, an industrial building suited purely for production activity has differing attributes. Such tenants generally seek predictable rental rates over long-term leases to protect their investment in specialized equipment and to ensure operational efficiency. In this scenario, durable buildings, materials, and low operational maintenance is preferred.
There are also significant differences in the location of an asset. Real estate development tends to lag economic cycles and the preferences of its occupants. It takes careful planning and time to construct new buildings and, as such, they reflect the physical environment, people, and economic environment that surrounds it. So, an investment in real estate represents an investment in the underlying economic attributes of the geography considering prospects for population growth, employment, and natural resources. That’s a contributing factor to explaining the clustered vintages of skylines in cities associated with energy production. They grew in stages in periods of rising energy prices, while cities associated with industrialization grew dramatically in a single prolonged period through the industrial revolution.
Real estate assets follow a continuum of value-add activities with each stage marked by a physical change or entitlement change, with the latter referring the regulatory ability to physically alter the property. From an investment perspective, the earlier stages generally demand higher returns, as they are associated with riskier activities, being defined as readiness for the asset to generate a stable income. The land speculation phase includes acquiring land intended for redevelopment yet without the entitlements to perform such conversion. This is followed by the development stage whereby the project plan is created and refined, concurrent with activities to gain the development entitlements. The next two stages, being sales/leasing and construction, are often conducted in overlapping fashion and mark the transition from planning to reality. With preceding activities complete, the asset generates revenue through leasing space or by selling the building or units of the building.
Valuation of Real Estate as an Investment Asset
The value of a real estate asset is the quotient of its expected stabilized cash flows and market driven yield.
Real estate investment returns are comprised of income returns, capital returns, or both. Income returns are generated through cash flow productivity that is referred to as net operating income (NOI). Enhancement or increase of NOI may occur from leasing vacant space or re-leasing occupied space at a premium rate. Alternatively, it may be generated from a more efficient operating cost structure.
Capital returns are generated by a change in asset valuation, whereby under stabilized conditions, the value equation is calculated by dividing the asset’s NOI by its capitalization rate. The capitalization rate (a.k.a. cap rate) is a market-driven metric based upon the nature and location of the asset. It represents the yield an asset may be transacted at, under prevailing market conditions and normal transaction conditions.
On the numerator portion of the value equation, capital returns may be realized through pro-active activities, such as reformatting space, adding density, or replacing a tenant base. These activities enhance NOI by adding leasable space or increasing the lease rate from existing space. Alternatively, gaining development entitlement on underutilized lands may increase value by enhancing the asset’s future potential cash flow.
On the denominator portion of the value equation, capital returns may also be realized passively through the influence of uncontrollable market forces that impact the prevailing cap rate. Should a particular asset class or geographic market be in favour, the market price an investor will pay for the yield generated from the asset may compress, thus increasing the value of the asset.
As described, we can draw parallels between the investment performance of a real estate asset and a share of a publicly listed company. Firstly, total real estate investment returns, composed of income and capital, may be thought of similarly to total returns generated by dividends and change in price of a public stock. Secondly, we can loosely partition real estate capital returns generated through value-enhancing activities being parallel to alpha (excess return), while capital return fluctuations generated through cap rate movement being parallel to beta (market return). Thirdly, the value of a real estate asset or public security may decline resulting in erosion of capital accompanied by a decline in re-occurring income.
Investment performance may be augmented through financial leverage—that is, borrowing funds against the value of the real estate asset. Positive leverage, the amplification of investment returns, occurs when cash flows per unit of imbedded equity increases with the application of debt. If an asset is valued at $100 and it generates $7 per annum, the unlevered investment yield is 7% calculated by dividing the unlevered cash flows by total value. Should one borrow $50 against the value of the asset and pay 5% to borrow such funds, the levered yield can be enhanced to 9%. Under this scenario the cash flows become $4.5 ($7 unlevered cash flow less $2.5 for interest payment) divided by $50 ($100 asset value less $50 borrowed).
Applying financial leverage should be considered with caution, as the same mechanism will dampen returns upon the cost of borrowing exceeding that of the asset’s unlevered yield. Furthermore, leverage is debt extended for a specific term and it’s an obligation of the borrower retire or refinance that financial commitment. The refinancing event may occur upon unfavorable market conditions characterized by higher borrowing costs or limited availability of debt capital.
Attributes of Real Estate as an Investment Asset
It is useful to explore the role of real estate within an investment portfolio by understanding the specific investment attributes and risk-return spectrum of real estate assets. By nature, real estate is a durable good that is physical in nature and has utility. It cannot be moved or divided. It is capital intensive to acquire or develop, with the financial obligation expended upfront, and requires capital re-investment through its holding period to maintain its productivity. Operationally, real estate requires funding to operate and requires managerial attention.
On the surface, this does not sound like a compelling investment case considering the alternative of purchasing a public security that is liquid, has relatively low transaction costs, and no follow-on capital requirement. Notwithstanding, the benefits of owning direct real estate are numerous and they generally fall into the categories of investment diversification, optionality, utility, and store of value.
The mere introduction of real estate assets enhances investment diversification and provides a relatively predictable stream of cash flows. The cash flows are viewed as inflation protected, especially over the medium to long-term, as rental rates may be periodically reset to reflect new market conditions.
Although the direct ownership of real estate requires managerial attention, there is a benefit to operating the asset. If you are a user of space, owning the premises means one can operate a business without being subjected to fixed leasing costs. Ownership enhances control of the space, and in turn reduces business risk knowing the premises will be available for continual operation.
If you are solely a real estate investor, opportunity exists to generate value in enhancing the revenue profile through tenant and lease optimization activities. Tangibly, this includes physically improving the asset, or soliciting a complimentary and appealing tenant base which may induce demand from prospective tenants who will pay a premium to be part of the node. Cost control and expense efficiency, especially realized from scale across multiple assets, enhances asset-level cash flow and NOI.
Ultimately real estate has a practical and utilitarian element as it houses us and the economy. We require a place to live and conduct economically productive activities.
In every-day language, having access to real estate is a need. Economists call this inelastic demand, whereby demand for utility of an asset does not change with adjustments in price.
The amenities and adornments of such space beyond providing basic security and sanitary needs are aspirational. We prefer to live in places with in-suite laundry facilities and air conditioning. We prefer to provide employees places of employment that are welcoming and accessible by multiple modes of transit. Economists call this elastic demand, whereby demand for enhanced attributes of an asset changes with adjustments to price.
Store of Value
The implication of its utility, along with its elastic and inelastic attributes, is that real estate possesses a two-pronged demand characteristic driven both by necessity and lifestyle enhancement. In part owing to this demand characteristic, real estate asset values remain relatively stable and are not directly linked to daily fluctuations in the broader equity markets.
Amidst challenged economic periods, when real estate values fall, the demand inelasticity for the asset tends to support a valuation floor. If anything, variability in cash flows (and in-turn asset value) tends to lag structural changes in broader macro-economic conditions as revenue and cost structures are generally fixed for periods through contractual obligations of both tenants and service providers.
From centuries of observation, one’s expenditure on real estate reaches well beyond the bare necessities and features as a primary budgetary item. So, in stable and expansionary economic periods, demand elasticity supports asset value growth as users re-allocate discretionary and excess funds towards better serving accommodation.
Considering the attributes of real estate, institutional investors and private families alike utilize the asset class as a store of value. In translating cash into equity capital within a durable and useful asset, investors diversify their investment portfolio, while seeking value stability and yield on their investment.
Real estate is often utilized as a mechanism for estate and tax planning, and multi-generational wealth transfer. In conveying the physical asset, both the equity within the asset and the income being generated from the asset are transferred to a beneficiary. Considering real estate is a tangible asset and subject to contractual rights and obligations, inherent wealth can be transferred in a manner planned and contemplated by the benefactor.
In accessing real estate through our daily routines, we possess an innate understanding of its physical characteristics. That perspective is derived from a user’s standpoint, where in this article we add perspective from the investment standpoint in exploring the attributes of real estate as an investment asset.
The items presented are broad and intended to only orient one’s thoughts in contemplating real estate as an investment asset. There are layers of complexity and interrelations that require further consideration. Under best practices, real estate investment allocation should be made within the context of an investor’s overall portfolio scale, profile, and objectives. One should exercise caution in considering leverage or utilizing real estate for estate planning services and engage professionals with specialized expertise to undertake such activity and highlight inherent risk. Care should be taken to consider additional matters including ownership and governance, tax efficiency, family dynamics, and other investment considerations.
Real estate can meaningly contribute to the measured performance of one’s investment portfolio, yet let’s remember that tangible real estate assets also provide intangible benefits that have endured through every technological revolution inclusive of today’s digital and information age.
About the Author
An accomplished real estate professional, Gavin Reiff is a core member of Richter’s Real Estate Advisory group. Gavin understands the risks and issues that can arise in today’s competitive and evolving real estate environment and uses his valuable insights to ensure his clients are prepared to make favourable decisions. Gavin has worked in both institutional, private equity, and public market environments. He has extensive investment transaction and investment management experience as a principal investor and a joint venture partner. Gavin is a member of advisory boards for real estate investment funds and regularly contributes to industry publications, and is also a member of the Jewish Foundation’s Professional Advisory Committee.