Introduction
In the current investment industry, real estate is considered as one of the most viable investment. Real estate investment offers a lot of benefits to the investor and is considered to have a very bright future.
Basically, real estate is defined as “any interest on land”. The interest can either be a leasehold interest or an ownership interest. In the case of ownership interest, the owner or investor has full land ownership rights and, at the same time, assumes the responsibilities and risks associated with the ownership. The ownership rights include the legal use and transfer of title of the land or property; the responsibilities include payment of property taxes; and the risks include losses due to natural calamities. On the other hand, a leasehold interest exists when the landowner accepts to pass on some of the rights to a tenant at a fee, usually called the rent (Woychuk, 2011).
A real estate investor is one who purchases the ownership interests and then earns a return on the investment through issuing the leasehold interests to the tenants, who pay rent in exchange.
The type of real estate market is very crucial to the investor as it directly determines the level of exposure, which in turn determines the level of returns and the risks involved. These markets are: the private real estate market, and the public real estate market. In the private market, an investor can purchase direct interest in various real estate properties. The investor then owns and can operate the real estate properties either individually or through an agent called the property manager. In the public real estate market, an investor participates by purchasing a share in the publicly traded companies (real estate companies), like the Real Estate Investment Trust. In this case, the investor’s (shareholder’s) exposure to the market is quite indirect as the real estate company owns and manages the properties on behalf of the investors or shareholders. The investor then receives the dividend instead of the rent paid by the tenants.
Investment types
In real estate market, one can invest in either equity or debt. An equity investor is basically the property owner. When the value of the property increases, the rent goes up and the investor benefits more. On the other hand, the risks are much more. A real estate debt investor is one who lends funds to the owners or purchasers of real estate. Such an investor receives periodic interest and security charge in mortgage form. Real estate debt investment is similar to that of bonds.
In order to choose the best investment type, one must consider his/her return expectations and the risk tolerance. Equity investment is riskier; however, the rewards are vast.
Features of the Real Estate Investment
Unlike other investments, real estate has both bond-like (regular and steady income) and stock-like (fluctuation in value) components. The income received is dictated by the rent paid by the tenants and the operating costs. The higher the rent, the higher the income received. It is therefore important to ensure that the property is fully occupied. This depends on the demand and supply. When the market is weak, i.e. poor demand or oversupply, the owner must lower the rent in order to keep the building fully occupied; unlike in strong markets. This lowers the income.
The common features of real estate are highlighted hereunder (Woychuk, 2011):
Tangibility - Just as the name suggests, real estate is real. One can visit, see, and touch the property. The owner can therefore control the property physically, unlike the stocks and bonds. Because of the tangibility, real estate requires proper management. The complaints of the tenants needs to be addressed and the building must be renovated.
Low liquidity - The liquidity of real estate is very low. It is difficult to sell real estate since private brokerage is a must.
Maturity is not fixed - Real estate equity does not mature like the bonds which have fixed maturity dates. The owner can therefore buy the property, work on it, and dispose it off as appropriate. An exception is the fixed-term debt.
High costs – It is very costly to purchase and sell real estate. The purchase requires various costs such as agent commissions, fees for lawyers and engineers, among other costs, which in turn raises the purchase price. Brokerage fee is also required when selling the property so that it can be better exposed to the market. Due to these high costs, speculative trading is uncommon and the holding periods are longer as compared to stocks.
Location dependency – Location directly determines the profitability of the real estate investment. A given piece of real estate performs differently across the regions, countries, cities, or within the cities. When investing, regional differences should be considered as it impacts directly on the returns.
Market inefficiency – Real estate market is characterized by irregularity of information among the participants. Those with expertise, resources, or special information, stand the best chance of making greater profits. Information is the king in real estate markets. The reverse is true for public stock markets where information is very efficient and symmetrical.
Advantages and disadvantages of real estate
Real estate is considered as one of the most viable investments due to the following benefits:
Inflation does not affect the real estate returns. The returns are directly dictated by the rents paid by the tenants. Most leases provide for rent increase in case of inflation. Besides, when the lease period expires or the tenant renewed, rents are increased. In a nutshell, returns from real estate increases faster with the inflation, making the investor to maintain the real returns.
Real estate investment greatly enhances yield. For a given level of risk, the real estate investment returns are high. Besides, an investor can maintain a given level of returns and at the same time reduce the risks.
The performance or the value of a real estate property can be easily influenced by the owner, unlike other investments. Because it is tangible, the owner can improve the quality and value of the property through such activities as repainting, replacing leaky roofs, replacing tenants with more quality ones, etc. in a nutshell, the investor has the powers to control the performance of the investment.
Real estate investment puts the investor at higher positions of accessing more credit.
The major disadvantages of real estate investment are highlighted hereunder.
Real estate is a very costly investment. Buying real estate requires substantial amount of money, which makes most investors resort to loans from lending institutions. The transaction costs are also high. Operating real estate is also costly as it requires regular maintenance due to its tangibility. The investment also requires management. The property must be managed on its day-to-day operation and also in the long term. This comes at a cost as it requires both time and resources. Insurance and taxes can also be very expensive.
Generally, real estate is difficult to acquire. Building a real estate that is meaningful and well diversified is quite challenging.
Lack of proper measurement of performance – It is generally difficult and challenging to measure the performance of real estate. Also, measuring the market risk is difficult as compared to the stock market.
The US Housing Market and the House Prices
According to the FHFA (Federal Housing Finance Agency), the housing market drifts lower as the house prices fall. Housing prices fell by 7.22%, seasonally adjusted, in 2011, and in 2010, it fell by 7.42%. Despite these depressed prices, the rental market keeps expanding. By 2011 November, the confidence of homebuilders was, an 18 months high, as recorded by the HMI (Wells Fargo Housing Market Index) / NAHB). In the third quarter of 2011, the levels of home owners remained high, though the number of those who owe multiple homes decreased. The US Federal Reserve Board indicates that in the second quarter of 2011, there was a drop in mortgage delinquency rate to 10.53% from the previous year’s 11.17% (The global property guide, 2011).
The house prices, however, have not bottomed out. There are high expectations that the housing market shall decline due to large inventory of homes whose mortgages are felonious (Freddie Mac. 2011). In September 2011, 313,000 new single family houses units were sold. This was a decrease of 0.9% as compared to the previous year. The average prices were also down 20.02% from 2007 according to FHFA.
Currently, most people believe that house prices are very low and most houses are undervalued. According to Zillow Inc. (2011), the home prices are to low, down from the fair value, and the undervalued markets are: Fort Myers in Florida (undervalued at 13%), Modesto in California (undervalued at 18%), and Detroit (undervalued at 25%).
The Foreclosures
In the third quarter of 2011, mortgage delinquency rate fell to 7.99% from 8.44% in 2010. The decline in the foreclosures and delinquencies is said to have helped the market since most of the delinquencies end in forfeiture. Reduction of delinquencies, therefore, reduces the houses supply from the foreclosures. It is however not clear whether the drop in the foreclosures indicates a market recovery.
Real Estate and the Economy
The housing market has poor outcome majorly due to economic reasons such as high unemployment rates and higher house inventories in combination with foreclosures and the unemployment, which together push down the house prices.
In order to save the falling housing market, government agencies continue to pump out more and more housing loans. In 2011 October, a mortgage relief plan (Home Affordable Refinance Program - HARP) that attempts to rejuvenate the housing sector and stimulates the economy, was announced.
In 2011, the economic growth was 1.5%, a reduction from the 2010’s 3% growth. In October, the unemployment rate was still high at 9%, same as in 2009. By the end of 2011, inflation was at 3%, higher than the 2010’s 1.65%. These were the major challenges facing the real estate market which led to the low house prices.
The real estate sector and the performance of the economy are directly related. When the sector performs poorly, as it is now, the economic growth must also be low. The sector creates employment opportunities to various individuals and, when it performs poorly, the income decreases and most people are rendered jobless.
Reference
Freddie Mac. (2011). Housing and Economic Information in Your State. Retrieved 16 Feb. 2012 from http://www.freddiemac.com/
The global property guide. (2011). House prices in US - how low can they fall? Retrieved 17 Feb. 2012 from http://www.globalpropertyguide.com/North-America/United-States/Price-History
Woychuk, I. (2011). Exploring Real Estate Investments. Retrieved 16 Feb. 2012 from http://www.investopedia.com/university/real_estate/real_estate4.asp#axzz1mQjmLSyq
Zillow Inc. (2011). Real Estate Market Reports. Retrieved 17 Feb. 2012 from http://www.zillow.com/local-info/
