Real Estate Investments: Trends & Valuation Techniques
Edoardo Fusco CIIA, CAIA
A.R.E.A – Analytical Real Estate Advisory
Is Real Estate an alternative asset class?
The main types of alternative asset classes include:
•Hedge Funds
•Commodities & Managed Futures
•Private Equity
•Credit Derivatives & Structured Products
•Real Estate (RE)
However, it is debatable whether real estate is an alternative asset class for the following reasons:
• Historically, real estate is one of the most “ancient” asset class even in comparison to equities and fixed income securities, which became in the last 50 years traditional investments for retail and
institutional investors.
• There is a wide literature on real estate valuation based on extensive real estate track record and returns. • Real estate is a fundamental and not an alternative asset class.
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Real Estate: Private and Public 1/2
The following properties of real estate make investment in and valuation of this asset class difficult:
•Heterogeneity: Every real estate investment is unique. Areas of differentiation include geography, property type and occupancy rate. As a result of this heterogeneity, an individual property may underperform or outperform its benchmark.
•Indivisibility: Unlike traditional asset classes, direct investments cannot easily be divided and sold to multiple investors. Lack of divisibility means a single investment may be a large part of the investor’s portfolio.
• Liquidity: Largely due to the first two characteristics, direct real estate is also very illiquid. Property sales take an extended period of time to complete and sellers may include significant closing costs. If a quick sale is necessary, the property sale price will need to be significantly discounted.
These limits on direct investments pushed investors to search more diversified, liquid and transparent real estate investments. As a result of that, public real estate vehicles came out.
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Real Estate: Private and Public 2/2
These are the main types of public and private real estate investments:
•Private Real Estate Equity: consists of direct ownership in real estate properties. Advantages of this market segment include investment control, ability to choose individual investments, larger scale investments and tax timing benefits.
9Residential real estate
9Commercial real estate
9Farmland
9Lands with natural resources
•Public Real Estate Equity: consists of stocks for real estate companies and real estate investment trust. Advantages of public commercial equity investments include investor accessibility, lower costs, higher liquidity, objective analysis, corporate governance structure and continuous pricing when the market is open.
9Equity REIT
9 Mortgage REIT
9 Hybrid REIT
•Private Real Estate Debt: includes commingled real estate funds, loans and commercial mortgages.
•Public Real Estate Debt: Commercial Mortgage‐Backed Securities (CMBS) are combined into one fund. This fund is then divided into tranches that have different claims on cash flows.
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Public Real Estate. REIT (Real Estate Investment Trust) 1/2 USA 1960: The Congress approves the Real Estate Investment Trust Act. The act allows to establish Special Purpose Companies, which are corporate tax exempt, subject to the following prescriptions:
• Tax Structure:
Income distribution:
9 75% or more of a REIT gross income must be derived from real estate. 9 90% or more of a REIT taxable income must be distributed via dividends.
9Il 95% or more of taxable income must be derived from dividends, interest and security sales.
9 75% or more of a REIT must be held in real estate, cash, governments securities or temporary investments.
•Corporate Governance:
9 REIT’s must be corporation.
9 At least one trustee or director must manage the REIT.
9 The rule 5/50 prevents five or fewer investors from owning more than 50% of REIT shares.
9 There must be at least 100 owners in the REIT.
9 Owners must be able to transfer REIT shares.
9 The REIT must not be an insurance or a financial firm.
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Public Real Estate. REIT (Real Estate Investment Trust) 2/2* Advantages: • Corporate taxation: REIT’s do not pay corporate taxes, but instead pass all income and capital gains through to shareholders who pay taxes according to their personal tax rate. REIT’s avoid double taxation.
• Liquidity: REIT shareholders are able to trade their shares on stock exchange (e.g. NYSE, AMEX, NASDAQ) and make leveraged purchases through a brokerage margin account.
• Asset Allocation: investors can adjust their strategic allocation by adding real estate to a traditional portfolio or can adjust their tactical allocation by changing their exposure to certain real estate sectors.
• Professional management: REIT managers posses skills such as evaluating, acquiring, managing, financing, and developing real estate properties that investors do not have. • Governance: Independent board of directors protect REIT shareholder interest by monitoring managers.
Disadvantages:
• Systematic Risk: Being listed on public stock exchange increases REIT systematic risk and therefore reduces the diversification benefits from adding REIT’s to a portfolio as REIT’s are not pure real estate investment. REIT’s have market capitalization similar to and are significantly correlated with small and middle‐capitalization stocks, which tend to be more volatile.
• Individual taxation: Because of their pass‐through status, REIT dividends are not eligible for qualified tax rate. Instead they pay taxed according to ordinary tax rate, which is problematic for investors in high tax brackets.
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REIT – Valuation Methods
These are the fundamental approaches for REIT’s valuation:
• NAV (Net Asset Value) approach 9 Advantages: it allows to detect potential misprincings, in case the REIT’s market capitalization is more or less than its NAV.
9Disadvantages: it does not take in consideration value creation as a result of active management.
• DCF (Discounted Cash Flow) approach
9Funds from Operations (FFO): Net Income + D&A – property sales profits
9Adjusted Funds from Operations (AFFO): FFO – capital expenditures
9AFFO yield: 1) P/AFFO = (n. of shares*price)/AFFO 2) AFFO yield = 1/(P/AFFO)
9Conclusion: if AFFO yield > implicit yield derived from market prices, the REIT is undervalued (and vice versa)
• DDM (Dividend Discount Model) approach – Gordon Model (1962)
9Fundamental Value calculation: D1/(k‐g) where: k is the cost of capital – according to CAPM or internal methods
g=(1‐payout)*ROE
D1=D0*(1+g) 7
REIT – Valuation Methods (DCF) example
DCF Example ‐ Calculating FFO and AFFO of Company A
Share Price = $40
Earning per Share = $4
Outstanding Shares = 600,000
Net Income = $2,450,000
Depreciation = $2,000,000
Property sale profits = $1,500,000
Recurring Capex = $450,000
(1) Given these informations, calculate:
(a) Funds from Operations (FFO)
(b) Adjusted Funds from Operations (AFFO)
(c) AFFO Yield
(2) Determine if company A is fairly value according to market capitalization yield of 8%:
Answer:
(1) Given these informations, calculate:
(a) FOF = 2,450,000 + 2,000,000 ‐ 1,500,000 = 2,950,000
(b) AFFO = 2,950,000 ‐ 450,000 = 2,500,000
(c) P/AFFO = (500,000 x $40)/2,500,000 = 8
(d) AFFO Yield = 1/(P/AFFO) = 1/8 = 12,5%
Company A's AFFO yield is higher than the market capitalization yield, which means that Company A is undervalued
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REIT – Valuation Methods (DDM) example
DDM Example ‐ Valuing a REIT
Share Price = $6
Dividends per Share = $4,50
Return on Equity = 13%
Risk Free Rate = 2%
Market risk premium = 8%
Beta = 1,2
Dividend payout rate = $4,50/$6 = 75%
Retention Rate = 1 ‐ 75% = 25%
Sustainable Growth Rate = 5% x 13% = 0,65%
Discount Rate = 2% + (1,2 x 8%) = 11,6%
V = $4,50 x (1 + 0,65%) / (11,6% ‐ 0,65%) = $41,36
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Private Real Estate. The NCREIF
The NCREIF (National Council Real Estate Investment Fiduciaries) is the most representative data source on real estate investments in the USA.
• Not‐for‐Profit Association founded in 1982, it provides the most relevant indexes on USA real estate markets.
• NCREIF Property Index (NPI) is the most well known index and it shows US national quarterly real estate returns based on appraisal data on core properties.
• NPI presents the returns on domestic unleveraged, institutional grade real estate investments .
Property Type
Office
Apartment
Retail
Industrial
Hotel
NPI Weight
36,6%
24,1%
22,1%
15,3%
2,0%
• NCREIF produces indices for different regions and different real estate assets as well as indices (total return, capital return, income return). Valuation Methods
• Comparable Sales Method: Sales of similar properties are analyzed to determine a price per square foot, which is adjusted to reflect the characteristics of the subject property and the multiplied by the square footage of the subject property to determine the appraised value. The drawbacks are that infrequent transactions may inhibit the appraisal and adjusting the prices per square foot is difficult and subjective. • DCF method: It captures specificity of the single property type but is exposed to input errors.
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Private Real Estate. NPI limitations and potential adjustments
NPI is an Appraisal Based index, which presents substantial limitations:
• Lagging Values: Changes in the NPI value lag changes in the value of the underlying property market.
• Low volatility: Artificially low volatility causes risk‐adjusted performance measures to be inflated and leads to excessive real estate allocations in portfolio.
• Low correlation: Artificially low correlations with other asset classes overstate the potential diversification effects of real estate and lead to excessive real estate allocations in portfolio.
These limitations create a divergence between REIT’s returns and NPI returns (smoothing effect). In order to better reflect the price trends of the underlying property market, four methods of unsmoothing the NPI can be used.
•Use current transactions: The index is recalculated using only properties that were actually sold in the most recent quarter. The drawback of this approach is the small sample size of recent transactions.
• Use revalued properties : The index is recalculated using only properties that were revalued due to significant event (e.g. macroeconomic conditions, renovation, etc.) The drawback again is the small sample size of properties that experience significant events.
• Hedonic Price Index: A model is used to attribute the total price changes from actual transactions to the characteristics of the properties. The model then simulates prices changes for non‐transacted properties based on their similarities to the characteristics of the transacted properties. The index is then recalculated.
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Real Estate Investment Style: Core, Value‐Added e Opportunistic The NCREIF has identified three distinct real estate investment styles:
• Core Investments: These include office, retail, apartments and industrial real estate properties. Of the real estate styles, core investments have the highest liquidity the lowest leverage and tend to be more developed. Core properties are held for long time periods and returns are dependent on cash flows rather than price appreciation. • Value‐Added Investments: These include resorts, hotels, hospitals, assisted living facilities, outlet mails and low income residential properties. Value‐added investments can also be core properties that are not fully leased or need a strategy drift. Properties in this category require special expertise to manage, reposition, renovate or redevelop. Value‐added properties use more leverage than core properties. Returns stem from cash flows and a significant amount of price appreciation. • Opportunistic Investments: These include properties that require significant development or a turnaround. These properties have high risk and return expectations and are generally held for a 3‐5 year time horizon. Returns are generated by primarily by price appreciation, which comes with significant rollover risk. Opportunistic managers trade rather than operate properties and therefore pursue dramatic value enhancing strategies (i.e. development of raw land, redevelopment of dilapidated properties, etc.). Private Equity Real Estate (PERE) funds have become a common way for investors to gain exposure to opportunistic real estate, especially when real estate is located in a foreign nation.
In the reality, any single investment may have characteristics taken from each real estate style.
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Investment Styles: Core
Core Investments
Definition
Property Type
Time Horizon
Occupancy Rate
Investments Turnover
Financial Leverage
Market
Investment Control
Expected Return
Expected Volatilty
Return vs Benchmark
Large percentage of returns from cash flows with low volatility
Retail, offices, apartments and industrial
Long
High
Low
Low
Local investors mainly
Direct
9‐10%
10‐11%
0% vs NPI
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Investment Styles: Value ‐ Added
Value‐Added Investments
Definition
Property Type
Time Horizon
Occupancy Rate
Investments Turnover
Financial Leverage
Market
Investment Control
Expected Return
Expected Volatilty
Return vs Benchmark
Non‐core assets with a significant portion of returns from price appreciation with moderate volatility
Hotels, hospitals and commercial centers
Medium
Moderate
Moderate
Moderate
Local and international. Up and coming institutional investors
Moderate with preferred liquidation positions
10‐13%
10‐13%
NPI + 200 bps
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Investment Styles: Opportunistic
Opportunistic Investments
Definition
Returns primarily from price appreciation with high volatility due to leverage, development risk and leasing risk
Property Type
Time Horizon
Occupancy Rate
Investments Turnover
Financial Leverage
Market
Investment Control
Expected Return
Expected Volatilty
Return vs Benchmark
Nontraditional properties (e.g. speculative development and raw land)
Short
Low
High
High
International investors. Private Equity Real Estate
Minimal control with unsecured positions
>13%
>13%
NPI + 500 or more bps
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Private Equity Real Estate (PERE)
These are some of the main properties within Private Equity Real Estate Funds:
• PERE funds have grown rapidly in the past decade, although recently invested funds ahve dropped significantly.
There are no official data on the market size in terms of AuM.
• PERE funds are primary used to pursue value‐added and opportunistic real estate investments as they started as a diversification strategy. Core real estate constitutes a small portion of PERE investments.
• PERE funds are sometimes used to invest in foreign countries (from a perspective of a US or EU based investor). Many foreign transactions, especially in Europe, involve government or corporate owned real estate assets that are in need of repositioning or development.
• Traditionally they present a complex capital structure and a higher level of risk, relatiev to core and value‐added real estate, resulting from leverage, zone risk and public policy risk, development risk, currency, tenant and property turnaround risk.
• Valuation of PERE properties is difficult due to lack of disclosure requirements. Another complication in the valuation is the fact that many properties are purchased and valued substantially below their true potential. Also, during real estate market downturns, property transact less often and sellers may maintain unreasonable high asking prices. Thus, valuations based on recent transactions are unreflective of the market environment.
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Private Real Estate – valuation methods*
Valuation methods are those which are traditionally adopted in corporate finance analysis:
• Income Valuation Approach
NOI/(1+k) + NOI(1+k)^2 + NOI(1+k)^3….NOI/(1+k)^i + NSP/(1+k)^i
dove: NOI (Net Operating Income); k (discount rate); NSP (Net Sale Proceeds)
NOI (Potential Gross Income) ‐ Vacancy Losses* ‐ Operating Expenses
9 Advantages and drawbacks: it allows to value real estate properties based on cash flows generation but it does not consider those which can be valued only when they are sold.
• Comparable Sales Price Approach
9 uses recent transaction values of similar properties and then adjust these values based on an any differences between the properties (e.g. property size, property age or location).
• Profit Approach
9 is used for properties whose primary value is driven not by the property itself, but by the business that is located there. In these case, the business itself is valued based on projected profits.
•Cost Approach
9 four steps: undertake the free and empty land valuation; estimates of cost of production; depreciations (time, economic, functional, etc.), site value creation. Total Value = (Production Cost – Depreciation) + Site Value. *Potential Gross Income*Vacancy Loss Rate
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Private Real Estate – Valuation Methods (Income Valuation Approach) example
Income Approach to real estate valuation
AAA Mall is a recently completed mall that contains 80 store units. Each of these units has a yearly lease payment of $90,000. Based on comparable
properties, a vacancy loss rate of 7% is expected over the life of the lease. Operating expenses are 20% of effective gross income.
(1) Given these informations, calculate:
(a) Calculate net operating income for AAA Mall for year 1
(b) Calculate an appropriate discount rate for AAA Mall, given that the risk‐free rate is 2%, liquidity premium is 3% and the risk premium is 6% (c) Assuming a NOI growth rate of 3% for year 2 and the net selling proceeds of $40 million in year 2, determine the value of AAA Mall using income approach
Answer:
Potential gross income = 90,000 x 80 = 7,200,000
Vacancy losses = 7% x 7,200,000 = 504,000
effective gross income = 7,200,000 ‐ 504,000 = 6,696,000
operating expenses = 20% x 6,696,000 = 1,339,200
Net Operating Income = 6,696,000 ‐ 1,339,200 = 5,356,800
K = 2% + 3% + 6% = 11%
V= 5,356,800 /(1 + 11%) + 5,517,504 / (1 + 11%)^2 + 40,000,000 / (1 + 11%)^2 = 52,958,227
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Real Estate Development
Real Estate development is different from an investment in stand‐alone real estate properties in two key ways:
• In the development, a new real estate asset is created
• There is significant uncertainty associated with development, because is a complex process. The stages of the real estate development process include:
9 Acquiring the land or the site of the development project.
9 Forecasting the revenues, costs and profitability of a planned project.
9 Designing the building. This step may include hiring architects, builders, and so on. 9 Securing approval through government building permits and public support of the project.
9 Raising capital to finance the project.
9 Building the structure.
9 Leasing and/or managing the property.
9 Selling the property.
There is an inverse relationship between cumulative investment, project risk and the stages of the project. Once the construction begins, uncertainty falls. At that point the developer has a better understanding of the time line for completion the project, which reduces uncertainty with respect to revenue and expense projections. Profitability, both forecasted and realized, varies across different types of development projects as well as different developers.
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Feasibility Studies: Residential and Retail
These are some of the key factors in feasibility studies for residential and retail real estate investments:
• Residential
9 Local market housing trends: if the properties are expected to be sold (i.e. one time sale) to owners/occupiers, local prices and timing are critical.
9 Psychological and demographic trends: Age, wealth, specific interest, expectations of high‐end services such as security features et cetera must be considered.
9 Quality of local school districts: This is related to demographic trends as well. Downtown loft buyers may care less about school districts than suburban home buyers.
9 Commuting trends: It is important to assess public transportation options available to residents and the distance/time involved to commute to the local business district.
9 Mortgage financing issues and trends: For example, a developer who proposed a project in late 2008 would have been faced serious issues due to the restrictions on mortgage financing. •Retail
9 Location: The target market may have easy access to the development. It also must be an enticing property to attract customers. The developer must assess whether local business are similar to or quite different from the proposed retail development. The so called “catchments area” is also fundamental in order to assess which customers or visitors are attracted.
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Ratio Analysis for Real Estate Loans
These are some of the key financial indicators in order to analyze borrowers solvability and default risk in commercial mortgages.
•Loan‐to‐Value Ratio (LTV): It is the remaining balance of the loan divided by the (market) value of the property (Loan/Market Value Property).
The LTV is comparable to long term debt‐to‐assets ratio used in corporate finance to indicate the capital structure (percentage of debt and equity) of the firm. The initial LTV ratio is determined by the risk of the property and the investor’s credit worthiness.
At the purchase of the property, the typical LTV for a commercial mortgage is 75% or lower. It is important to note that the LTV usually varies over time as the property ages and the owner makes payment on the loan. •Interest Coverage Ratio: calculated as the property’s net operating income (NOI) divided by the amount of annual interest payable is equivalent to the interest coverage ratio used in corporate finance.
Generally, a high interest coverage ratio indicates less risk to the lender because net operating income can drop significantly before the borrower will experience difficulty making interest payments. A typical required interest coverage ratio for a commercial mortgage is 1.2 or greater (Net Operating Income/Annual Interest Payment).
•Debt Service Coverage Ratio (DSCR): is calculated as the property’s NOI divided by the total loan payment, including interest and principal (Net Operating Income/Total Loan Payment).
• Fixed Charge Ratio : it is yet another way of measuring the ability of the borrower to meet their financial obligations (Net Operating Income/All Fixed Payment).
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Real Estate Development – Valuation Methods (DCF)
As we all know, Discounted cash flow (DCF) is the most common valuation method used to estimate the attractiveness of projects.
It uses future free cash flow projections and discount them, at the investor’s rate of return, to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the investment is profitable. The advantage of this method is that is consistent with respect to the time value of money. The DCF method states cash flow on comparable basis by discounting and comparing cash flows in the same time period. However, there are some drawbacks:
• Input estimates: Estimating cash flows, especially in a pure speculative developments, is difficult. Both costs and potential revenues are uncertain. The longer term of the project, the more difficult is to estimate accurate cash flows.
• Mutually exclusive projects: when choosing between mutually exclusive projects it may not be appropriate to use the same discount rate for both projects because of the riskiness of the two projects may be different.
• Short term projects: NPV ignores the lifetime of the projects and may not appropriately value short term projects. This is because the short term project allows for the ability to pursue new projects sooner.
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Real Estate Development – Valuation Methods (IRR)
The Internal Rate of Return (IRR) Method is one the most common valuation techniques in order to assess the return on investment.
It is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. Everything else equal, the project with the highest IRR is the most profitable.
Even IRR has its limitations: • Multiple IRRs: When the signs (i.e. positive or negative) of the cash flows change more than once, the IRR approach can result in multiple IRRs. In phase development projects, this is a common occurrence. Also, projects where clean up and restoration is necessary (i.e. mining), we will have negative cash flows in the final year, causing the signs of the cash flows to change more than once.
• Mutually exclusive projects : IRR can lead to an incorrect investment decision when choosing between mutually exclusive projects. This occurs sometimes because IRR ignores the scale of a projects or whether the timing (i.e. early vs late in the project’s life) of the cash flows of the two projects differs significantly.
When choosing between projects, the NPV is the superior method. If two different methods give the same results, NPV is the criterion of choice. If scale is a problem the differential cash flow approach can be used. Under this approach the smaller projects are subtracted from the larger project cash flow and the IRR is recalculated. 23
Real Estate Development Financing
In determine whether to finance a development project, the lenders considers the following factors:
• Financial strength of the borrower: For smaller firms, the past development experience of the borrower is important. For larger development companies, the credit rating of the firm is generally more important. • The speculative nature of the project: Cash flows are more uncertain in speculative developments. The ability to lease the project space is uncertain. Pre‐leasing and pre‐selling reduces uncertainty.
• Terms of the loan agreement: The amount to be borrowed, the collateral and the cross‐collateralization of the loan, loan recourse and the seniority of the debt are all important. Provisions may include profit sharing with the lender and possibly a specified minimum return for the lender.
• Loan‐to‐Value Ratio: Loan to value ratios are generally below 65% for speculative properties and below 75% for pre‐leased properties.
Other risk mitigation actions: Full forward Sale e Full Forward Funding.
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Alternative Real Estate Vehicle
Private Real Estate Investment Vehicle
• Open ‐ End Real Estate Mutual Fund
• Commingled Real Estate Funds
• Limited Partnership
Public Real Estate Investment Vehicle
• Options and Futures on real estate indices
• Exchange‐Traded Funds (ETF’s)
• Real Estate Hedge Funds (Equity & Debt)
• Closed – End Real Estate Mutual Funds
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Open – End Real Estate Funds
Open – End Real Estate Funds raise capital by selling shares to stockholders. They turn invest the capital in real estate assets.
• Advantages
9 Investors gain access to real estate investment with limited amounts of capital, similar to real estate investment trust (REIT’s).
9 Funds generally buy and sell shares to and from investors upon request, allowing investors to enter and exit the fund at will.
9 The investors gains exposure to real estate asset class with more liquidity than is available from the underlying real estate assets.
9 Funds are regulated.
• Disadvantages
9 Funds often reserve the right to defer investor share redemption to avoid liquidity problems, resulting in a potential lack of liquidity for investors This often occurs when a significant percentage of shareholders want to redeem shares at once or the underlying real estate market may be facing liquidity issues.
9 Calculated NAV may trail true market values of the underlying real estate assets. Potential commissions, fees and transaction costs. Tax inefficiency relative to ETF’s.
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Commingled Real Estate Funds
Commingled Real Estate Funds consists of privately placed commingled (i.e. pooled) capital that is invested in real estate. Ownership certificates, which are not exchange traded, represent the investor’s proportional share of ownership in the underlying commercial properties.
• Advantages
9 Access to private real estate assets that the firm or pension fund would otherwise be unable to purchase due to capital constraints. Even if large enough, the investor may prefer commingled funds, because of an unwillingness to take on the unique risks of the underlying properties.
9 Access to fund managers with specific geographic and/or property type expertise.
• Disadvantages
9 The same disadvantages described under open‐end funds. Namely, a lack of liquidity, a loss of direct control and potentially stale real estate valuations.
9 Not available to small individual investors due to significant capital requirements.
9 Investors may not be able to realize reported performance.
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Limited Partnership
Real Estate Limited Partnership combine the benefits of partnership , including tax (i.e. no corporate taxation) and income distribution benefits, with the limited liability feature of a corporate investment. General partners manage the funds while limited partners, typically pension funds, endowments and high net worth individuals, provide the capital. • Advantages
9 Limited liability for limited partners. Limited partners are liable only for the amount invested.
9 The ability to adopt a more aggressive investment style that includes greater leverage (gearing) than other types of real estate funds.
9 Like other types of funds, limited partnership may provide access to fund managers with specific skills and expertise.
9 General partners, called fund sponsor, often contribute capital to the fund.
9 The structure allows for the possibility of special cash distribution to partners.
• Disadvantages
9 Returns vary greatly based on investment style of the fund. The amount of gearing also affect returns.
9 Too much leverage can amplify returns as well as losses. Not available to small investors. Illiquidity.
9 Funds may generate tax liabilities for partners even no cash distributions have been made to cover taxes.
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Options and Futures on real estate indices , ETF’s and Real Estate Hedge Funds
• Options and futures on real estate indices: it allows investors to gain exposure to real estate as an asset class without actually investing in real estate, either directly or indirectly. The payoff of the option or futures contract is linked to a real estate index. For example, in May 2006 the Chicago Mercantile Exchange (CME) began listing housing options and futures based on the S&P/Case Shiller Housing Indices in ten cities including Chicago, Boston, New York, Miami and Washington. • Exchange Traded Funds (ETF’s): these are tradable investment securities that track a particular index. The ETF holds the assets, or a sub‐sample of the assets, included in the index. They trade at approximately the net asset value (NAV) of the underlying assets and are traded on exchanges. ETF’s have gained in popularity because they are relatively low‐cost, tax efficient and provide some of their benefits such as high liquidity, the ability to tale a short position and the prospect of dividend payments. The Dow Jones US Real Estate index is tracked by one such ETF .
• Real Estate Hedge Funds: They represent a niche in hedge fund investing as their traditional trading strategy is hardly adaptable to the illiquid nature of real estate investing. Traditionally, real estate hedge funds operate either on the stock markets, buying real estate stocks, or in the debt market (i.e. CDO’s and CMO’s). 29
Closed‐End Real Estate Mutual Funds
Closed – End Real Estate Funds are exchange traded mutual funds. Unlike open‐end funds, they have a fixed number of shares outstanding. • Shares are offered to the public via an initial public offering (IPO). One key advantage is that the fund does not need to maintain liquidity to redeem shares, as an open‐end fund must do. They are also more liquid for investors, who can simply sell shares in the secondary market. There has been significant growth in closed‐end real estate mutual funds. • Advantages
9 Increased liquidity since they are exchange traded.
9 ETF’s and closed‐end funds can be purchased with margin.
9 Generally investors can take long and short positions.
9 Increased transparency because they are valued in public markets.
9 Regulated.
• For both ETF’s and closed‐end funds, the liquidity advantage is less important to long term investors. Also, it may difficult to obtain access to specific sectors or the real estate market through ETF’s and closed‐end funds. Real estate options and futures are new and complex, making them inappropriate for some investors.
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Real Estate and Asset Allocation
These are some of the most relevant factors of real estate from a macro and a global portfolio perspective:
• Limitation with respect to asset allocation:
9 Real volatility> calculated volatility (smoothing) 9 Large capital requirements
9 Illiquidity
9 Long‐term horizon • Diversification e correlation:
9 Limitations with respect to global exposure diversification
9 Limitations with respect to geographic exposure diversification (i.e. office spaces in financial centers in 2008)
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Real Estate and Inflation hedging*
This graph clearly explains the power of real estate, both private (NPI) and public (REIT’s) to work as inflation hedge. *Inflation Rates measured by US Consumer Price Index (CPI). Data from December 31, 1978 to December 31, 2009
From a general perspective, private real estate investments represent a better inflation hedge solution in a low interest rate environment. 32
Conclusions
According to this general overview, we can draw the following conclusions: • Investors can get exposure to this asset class through a public investments (REIT’s) and private investments (private residential or commercial buildings). • Public investments (REIT’s) are more liquid and diversified. Public investments result less volatile and more decorrelated from traditional asset classes. However, there is a volatility smoothing issues with respect to public investments.
• Since the beginning of the last century, investors asked for extra‐returns through new real estate forms such as Private Equity Real Estate ,in order to capture speculative opportunities mainly in emerging real estate markets.
• Real estate development projects are by definition highly speculative.
• Historically, real estate has revealed to be an excellent inflation hedge solution.
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Q&A
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