Real Estate Finance- Introduction

Real estate refers to all tangible and immovable property that an individual owns. It includes
land and any constructions made on it such as buildings, warehouse or other
infrastructure.

Real estate offers investors long-term stable income, some protection from inflation and
generally low correlations with stocks and bonds. High-quality, well-managed properties
with low leverage are generally expected to provide higher returns than high-grade
corporate debt (although with higher risk) and lower returns and risk than equity.

Real estate investment can be an effective means of diversification in many balanced

investment portfolios. Investors can choose to have the equity, or ownership, position in
properties, or they may prefer to have exposure to real estate debt as a lender or owner of
mortgage-backed securities.

Investment comparison between Private and Public Real Estate

Factors to Consider Private Real Estate Securitized Real Estate1
Suitable for Long-term investors Investors seeking liquidity and
with lower liquidity professional management with lower
needs. minimum investment requirements.
Typical investors/ Pension funds, • Real estate operating companies
Investment Options sovereign wealth funds, (REOCs)
insurance companies, • Real estate investment trusts
high-net-worth (REITs)
individuals. • Mortgage-backed securities (MBS)
Large investors also utilize
securitized real estate, especially
when dealing with large capital
demands.
Benefits Potentially higher Liquidity, diversification, professional
returns, direct control management.
over investments.
Drawbacks Lower liquidity, higher Potentially lower returns than direct
minimum investment, real estate, less control over

1 Indirectly invest in real estate through publicly traded financial instruments instead of directly purchasing
properties. It essentially involves pooling income-generating real estate assets and dividing ownership into
shares sold to investors. This allows for greater accessibility and liquidity compared to direct ownership.

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 requires in-depth investments.
market knowledge and
active management.

Characteristics of real estate

Features Description
Unique Asset No two real estate properties are the same. Whereas all bonds of a
particular issue are identical, as are stocks of a particular type in a
& Fixed
specific company, no two properties are the same. Buildings differ in
Location
use, size, location, age, type of construction, quality, and tenant and
leasing arrangements. Even identically constructed buildings with the
same tenants and leases will be at different locations.

High Unit The price of a unit of real estate property is high compared with the
Value price of a single stock or bond.
The unit value to purchase one private real estate property is large
compared to a single share of stock or a bond. The amount required to
make an investment in private real estate limits the number of
potential investors and the ability to construct a diversified real estate
portfolio.

Management Owning real estate requires maintenance, contracting, and collecting

Intensive rent. Owning a stock or bond does not require such efforts.

A private real estate equity investor or direct owner of real estate has
responsibility for management of the real estate, including maintaining
the properties, negotiating leases, and collecting rents. This active
management, whether carried out by the owner or by hired property
managers, creates additional costs when projecting returns.

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High Buying/selling real estate is costly in time and money with multiple
Transaction parties involved. Trading in stocks/bonds is much more
Costs straightforward.
Buying and selling real estate is also costly and time consuming
because others—such as brokers, appraisers, lawyers, lenders, and
construction professionals—are likely to be involved in the process
until a transaction is completed.

Depreciation Real estate investments are directly subject to depreciation as buildings

are subject to “wear and tear”.
Buildings depreciate as a result of use and the passage of time. A
building’s value may also change as the desirability of its location and
its design changes from the perspective of end users.

Illiquidity Real estate investments require time to sell, and the bid/ask spread is
much wider than that for stocks and bonds.
Real estate properties are relatively illiquid. They may take a
significant amount of time to market and to sell at a price that is close
to the owner’s perceived fair market value. The initial spread between
bid and asked prices is generally wide.

Need for debt Real estate investments typically require debt capital.
capital Real estate values are sensitive to the cost and availability of debt
capital because of the large amounts required to purchase and develop
real estate properties. The ability to access funds and the cost of funds
in the credit markets are important.

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 Price Real estate prices are typically determined by appraisals and estimates
Determination rather than by market transactions readily visible in the market as
each property is unique.
As a result of the wide differences in the characteristics of real estate
properties and the low volume of transactions, estimates of value or
appraisals rather than transaction prices are usually necessary to
assess changes in value or expected selling price over time. The limited
number of participants in the market for a property, combined with
the importance of local knowledge, makes it harder to know the
market value of a property.

Definition of Real estate investments

Real Estate investment refers to the investment of funds made by individuals or institutions
on real estate (land/building) that results in ownership. This investment could be made
either directly or indirectly and is known as equity investing.

Moreover, real estate investment also includes lending against real estate property. This is
known as debt investing. For example, banks providing mortgage loans or investors
purchasing Mortgage-backed securities.

To summarize, real estate investment refers to direct or indirect purchase of land/building

and/or providing loans to others to fund such purchase of land/building.

Rationale for investing in real estate

From a financial perspective, investment in real estate is motivated by the following
factors:

• Potential for competitive long term total returns driven by both income generation
and capital appreciation

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 • Real estate can be used by the investors to protect themselves from adverse cash
flow effects of economic shocks. This is achieved by leasing out real estates at fixed
rates for multiple years.
• Likelihood that less-than-perfect correlation with other asset classes may provide
diversification benefits
• Real estates can provide inflation hedge if rents can be adjusted quickly for inflation

From a non-financial perspective, investment in real estate is due to the desire to get access
to the various property rights of ownership (i.e right to possess, use, improve, extract,
dispose property)

Forms/Types of real estate investment

• Real estate investments can be categorized based on two dimensions; debt or equity
based (source of financing) and private or public market (nature of transaction;
direct or indirect).
• The classification is as follows:
Types Debt Equity
Private Mortgages Direct ownership of real estate; can be
Construction Lending through sole ownership, joint ventures etc.

Public Mortgage-backed securities Shares in real estate corporations

(MBS) Collateralized Mortgage Shares of Real Estate Investment Trusts
Obligations (CMO) (REIT’s)

The categorization of real estate investment into the four quadrants helps investors
identify the forms that best fit their objectives. For example, some investors may prefer to
own and manage real estate. Other investors may prefer the greater liquidity and
professional management associated with purchasing publicly traded REITs. Other
investors may prefer mortgage lending because it involves less risk than equity investment

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or unsecured lending; the mortgage lender has a priority claim on the real estate used as
collateral for the mortgage. Still other investors may want to create a portfolio of investors.

Each quadrant offers differences in risk and expected return, including the impact of taxes
on the return. So, investors should explore the risk and return characteristics of each
quadrant as part of their investment decisions.

Types of Investors:
1. Private Investors: They can directly buy property (ownership) or use special
vehicles (partnerships).
▪ Models include:
- Direct Ownership: Individual or joint ownership with full liability.
- Syndications: Partnerships with general partners (active management) and limited
partners (passive investors).
▪ Typical limited partners:
- Insurance companies, pension funds, high-net-worth individuals, etc.

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 2. Public Investors: They can invest in listed entities that own real estate (indirect
investments).
▪ Benefits: Liquidity; Access to professional management; Portfolio diversification; Low
minimum investment.
▪ Common Investment options:
- Stocks: Publicly traded companies owning real estate.
- REITs: Real Estate Investment Trusts, required to distribute income.
- Mortgage-backed Securities (MBS): Own rights to cash flow from mortgage pools.
- Investment Vehicles:

Basics of Indirect Forms of Investment:

1. Real Estate Operating Companies (REOCs):
• Taxable corporations owning and managing commercial real estate.
• Less restricted than REITs.
• Can develop and own property.
2. Real Estate Investment Trusts (REITs):
• Must primarily own and operate rental properties and mortgages.
• Required to distribute almost all earnings to avoid corporate tax.
• Diversified real estate exposure with income potential.
3. Mortgage-backed Securities (MBS):
• Publicly traded, indirect investments in mortgage pools.
• Offer cash flow based on underlying mortgages backed by real estate.
• Restrictions on eligibility and minimum investment size.
Debt vs. Equity Investment:
▪ Equity investors expect higher returns than debt investors but take on more risk.
▪ Debt investors are paid first from cash flows and property sales before equity
investors.
▪ As leverage (debt) increases, risk increases for both debt and equity investors,
potentially increasing their return expectations.
▪ Equity investors face the additional risk that their expected higher returns may not
materialize.
Returns for Debt Investors in Real Estate:
▪ Debt investors receive returns from promised cash flows, not property appreciation.

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 ▪ Debt investments in real estate are similar to fixed-income investments like bonds.
Returns for Equity Investors in Real Estate:
▪ Equity investors earn income from renting properties and potential capital
appreciation from property value increases.
▪ Adding equity real estate to a portfolio can potentially benefit diversification if its
returns are not perfectly correlated with stocks and bonds.
Factors to Remember in Real Estate
• Real estate investments can occur in four basic forms: private equity (direct
ownership), publicly traded equity (indirect ownership claim), private debt (direct
mortgage lending), and publicly traded debt (securitized mortgages).
• Many motivations exist for investing in real estate income property. The key ones
are current income, price appreciation, inflation hedge, diversification, and tax
benefits.
• Adding equity real estate investments to a traditional portfolio will potentially have
diversification benefits because of the less-than-perfect correlation of equity real
estate returns with returns to stocks and bonds.
• If the income stream can be adjusted for inflation and real estate prices increase
with inflation, then equity real estate investments may provide an inflation hedge.
• Debt investors in real estate expect to receive their return from promised cash flows
and typically do not participate in any appreciation in value of the underlying real
estate. Thus, debt investments in real estate are similar to other fixed-income
investments, such as bonds.
• Regardless of the form of real estate investment, the value of the underlying real
estate property can affect the performance of the investment with location being a
critical factor in determining the value of a real estate property.
• Real estate property has some unique characteristics compared with other
investment asset classes. These characteristics include heterogeneity and fixed
location, high unit value, management intensiveness, high transaction costs,
depreciation, sensitivity to the credit market, illiquidity, and difficulty of value and
price determination.

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• There are many different types of real estate properties in which to invest. The main
commercial (income-producing) real estate property types are office, industrial and
warehouse, retail, and multi-family. Other types of commercial properties are
typically classified by their specific use.
• Certain risk factors are common to commercial property, but each property type is
likely to have a different susceptibility to these factors. The key risk factors that can
affect commercial real estate include business conditions, lead time for new
development, excess supply, cost and availability of capital, unexpected inflation,
demographics, lack of liquidity, environmental issues, availability of information,
management expertise, and leverage.
• Location, lease structures, and economic factors—such as economic growth,
population growth, employment growth, and consumer spending—affect the value of
each property type.