Reading 79

Real estate can provide income in the form of rent, as well as the potential for price appreciation. Investment in real estate can be made directly in properties or indirectly through limited partnerships and publicly traded securities. The types of real estate discussed include single-family residential and commercial. The four largest subcategories of commercial real estate are:

• Office buildings
• Shopping
• Industrial / warehouse / distribution
• Rental residential (single-family detached and multifamily apartment)

Real estate investment can be described in terms of a quadrant (see Figure 79.1). The first (vertical) dimension differentiates between public and private real estate; the second (horizontal) dimension distinguishes between debt and equity investments.

Private market. Ownership usually involves direct investment, such as purchasing property or lending money to a purchaser. Direct investments can be solely owned or indirectly owned through partnerships, where the general partner (GP) provides property management services and limited partners (LPs) are investors (e.g., pension plans).

Public market. Ownership involves securities that serve as claims on the underlying assets, rather than direct investment. Examples include shares of real estate investment trusts (REITs), equity in real estate companies, ETFs, residential mortgage-backed securities (MBSs), commercial mortgage-backed securities (CMBSs), mortgage REITs, and mortgage ETFs.

An equity investor has an ownership interest in real estate or in securities of an entity that owns real estate. Equity investors control decisions such as borrowing, property management, and the exit strategy.

A debt investor is a lender that owns a mortgage or mortgage-backed securities. The mortgage is collateralized (secured) by the underlying real estate. The lender has a higher priority claim than the equity investor on default. Because debt must be repaid first, the value of the equity investor's interest equals the property value less the value of outstanding debt.

Each form has its own risk, expected returns, regulations, legal issues, and market structure. Private real estate investments tend to be larger than public investments because real estate is indivisible and illiquid. Public real estate investments are liquid and let investors divide ownership without dividing the property — so they enable diversification across many properties. Private direct investment requires property management expertise on the part of the owner; publicly traded securities and private limited partnerships are professionally managed.

Direct Real Estate Investment involves purchasing and financing a real estate investment.

Benefits of direct investment:

• Control. The owner decides what to buy, how to finance it, what improvements to make, which tenants to target, and when to sell.
• Diversification. Real estate returns are less than perfectly correlated with stocks and bonds, so adding private real estate can reduce portfolio risk.
• Tax benefits. Deductions for noncash depreciation (even though properties typically appreciate) and interest expense.

Drawbacks:

• Illiquidity and price opacity
• Complexity of managing property
• Need for specialized knowledge of current market conditions
• High initial investment / capital required
• Concentration risk if a portfolio holds only one or a few properties

Indirect Real Estate Investment. Indirect investments can be made through limited partnerships, joint ventures, or publicly traded securities. REITs are a popular form of investment for income-producing real estate as they are exempt from double taxation. REITs are exchange-traded and therefore (unlike mutual funds) do not face redemption / liquidation risk. REITs are run by managers with the specialized knowledge needed to invest in properties successfully. REITs report GAAP metrics such as earnings per share (EPS); some also provide non-GAAP metrics such as net asset value.

Types of REITs:

• Equity REITs — invest in real estate directly or via partnerships
• Mortgage REITs — lend money for real estate or invest in MBSs / CMBSs
• Hybrid REITs — invest in both real estate and mortgages

REIT investment strategies (by risk, low → high):

• Core — invest in high-quality commercial and residential properties that deliver stable returns. Typically open-end structures with indefinite lives, allowing investors to invest or redeem at any time (similar to open-end mutual funds).
• Core-plus — accept slightly more risk than core by undertaking modest development and redevelopment.
• Value-add — undertake development and redevelopment on a somewhat larger scale than core-plus.
• Opportunistic — pursue large-scale redevelopment and repurposing of assets, invest in distressed properties, or speculate on upturns in real estate markets.

Riskier strategies (core-plus, value-add, opportunistic) are most often structured as closed-end funds with finite lives.

Among real estate investments, first mortgages or investment-grade CMBSs are the least risky and behave similarly to bonds. Core strategies are the next-least risky and also have bond-like characteristics, since they receive stable rental income from many lessors (a diversified income pool). Value-add and opportunistic strategies are the most risky and are more equity-like in their risk-and-return characteristics.

Because REITs invest in many properties, they provide diversification benefits in addition to the liquidity of a publicly traded security. However, the correlation of REIT returns with equity returns is higher than that for direct real estate investment, and correlations increase during steep market downturns. Even so, real estate investments improve the risk–return profile of a portfolio relative to one comprising only traditional asset classes.

Infrastructure investments include:

• Transportation assets — roads, airports, ports, railways
• Utility assets — gas distribution, electric generation and distribution, waste disposal and treatment
• Information and communication technology — telecom towers, cable systems
• Social infrastructure — prisons, schools, health care facilities

Ways to invest:

• Construct the assets and either sell or lease them to the government, or operate them directly
• Buy existing assets from a government and lease them back or operate them
• Invest through a public–private partnership

Cash flows generated from infrastructure investments include:

• Availability payments for making the infrastructure available
• Usage-based payments such as highway tolls
• Take-or-pay arrangements requiring the buyer to pay a minimum purchase price for an agreed-upon volume

Investments in infrastructure assets that are to be constructed are referred to as greenfield investments. Greenfield investments typically follow a life cycle known as build-operate-transfer (BOT):

1. Cash outflows during the building phase
2. Increasing cash inflows as the private investor begins operating the facility
3. Transfer of the facility to a government entity or third party

Investments to expand or privatize an existing infrastructure asset are known as brownfield investments. An example is a sale-leaseback arrangement whereby the asset is purchased from the government and leased back to it. Investments in fully operational facilities that do not need any further development are called secondary-stage investments.

Infrastructure assets typically have a long life and are quite large in cost and scale, so direct investment has low liquidity. More liquid investments backed by infrastructure assets are available through ETFs, mutual funds, private equity funds, or master limited partnerships (MLPs). Publicly traded vehicles for infrastructure investing are a small part of the overall universe and are relatively concentrated in a few categories of assets. Debt issued to fund infrastructure can be privately placed or publicly traded.

In general, brownfield investments provide stable cash flows and relatively high current yields, but offer little potential for growth. Secondary-stage brownfield investments (e.g., existing toll roads and hospitals) are the least risky and offer the lowest return. Greenfield investments (e.g., new toll roads, renewable energy facilities) are subject to more uncertainty and may provide relatively lower yields in the near term, but offer greater growth potential. Infrastructure projects that rely on revenues from uncertain future demand tend to be the riskiest.

Because of long-term contracts and barriers to entry, cash flows from equity investment in infrastructure are stable and have low correlation with public equities. Infrastructure debt also tends to be safer and less affected by economic cycles. Greenfield investments in developing economies, while risky, have generated attractive long-term returns as they benefit from increasing per-capita incomes and wealth.

Investing in infrastructure assets can provide diversification benefits, but investors should be aware that these investments are often subject to:

• Regulatory risk
• Risk from financial leverage
• Cash flows that may be less than expected
• Construction risk (for projects that involve building infrastructure)
• Operational risk (when assets are operated by a private owner)

Infrastructure investments tend to be most suitable for long-term institutional investors such as pension plans, life insurance companies, and sovereign wealth funds.