Welcome to Finance and Fury. In today’s episode, we will be going through how to reduce the barriers to entry to real estate investments, as well as where real estate assets fit into an investment strategy

  1. Australian’s love property – It is one of the more popular investments that people wish to purchase – its popular probably due to being a part of our everyday lives
    1. Most people have at least a working knowledge of how property operates – unlike shares
    2. Plus, since lending regulations were changed in the early 90s and the interest rate has been trending downwards – people have only seen property go up for the past 30 years
  2. But investing in real estate can be very challenging, particularly due to the high barrier to entry to getting a home deposit and getting funding through a bank/meeting lending capacity – as you need income to service the investment loan on top of any personal mortgage that you might have

In this episode we will be looking at how to get around these major issues – that is by using Real Estate Investment Trusts (REITs) – as a way to gain exposure to real estate investments and compare this to direct property ownership – go through the pros and cons and look at these types of investments in an investment allocation/strategy and where they can fit in – This episode is not advice in any way shape of form – it is general information only – please take your own situation into account and seek advice before making any decisions

To start off – There are a number of methods to obtain exposure to real estate as an investment – the main three ways are direct, unlisted and then listed ownership

  1. Direct ownership: This is what most people think of when they think about an investment property – Where you own the interest in a real property directly – or through an entity like a company or trust
    1. Owning a property directly is generally thought to be an illiquid or lumpy asset but it does have a historically lower correlation to the share market
  2. Unlisted – Managed fund ownership: Where someone own units in an entity that owns one property or a number of properties.
    1. History suggests these pooled funds occasionally have liquidity issues in times of market stress when all investors seek to cash out at the same time.
    2. In the GFC – redemption from these unlisted funds meant that you weren’t selling your assets to others on the secondary market – but directly back to the manager – if the underlying asset is illiquid and takes a while to sell – there is not enough cash to meet the redemptions – almost like a bank run but on a property trust – this means the properties need to be fire sold at a loss
      1. Plus – when you have leverage/debt – on these, a 20% loss in capital value could spell 100% loss in your investment
    3. Listed ownership: Through a vehicle known as real estate investment trusts (REITs) – These are market listed forms of investment in a portfolio of different real estate assets across different sectors
      1. are traded in the secondary market, i.e. the share market – like an ETF of property – Investment through REITs tends to be highly liquid but due to their trading on the secondary market – correlates strongly with the share market’s known volatility.

Where does property sit inside of an investment strategy – why does anyone invest in property?

  1. The idea of property is to gain capital growth, positive cashflow once the debts are repaid and provide diversification to your portfolio to reduce your risks
    1. This all comes down to getting the correct asset allocation – which is part of an investment strategy that aims to balance your risk and reward relationship – the main goal being to maximise the risk-adjusted returns of a portfolio
    2. It is widely known that real estate returns tend to display a low correlation with stock market returns. Hence, adding real estate to a portfolio can help reduce total portfolio risk, thus potentially enhancing its risk-adjusted returns
    3. But it can come with its own risks
  2. The major downside with property investments come in the form of liquidity – hard to sell quickly if you need cash, high barrier to entry – upfront deposit requirement, stamp duty and time to look for the right property, ongoing hassle – dealing with tenants or paying someone to do this for you, lack of diversification – one large capital outlay for one property
  3. The role of REITs is to help reduce these downsides – however it has its own downsides which we will go through later
    1. Barriers to entry – Plus many investors do not have time to manage a direct real estate portfolio
      1. Upfront costs are a major barrier to entry – First you need a deposit or some equity to be able to purchase a property – where the market is currently at, you may be looking at a minimum of around $50k, but probably closer to $100k to avoid LMI
        1. You also have stamp duty costs, which can range from state to state, but this can be another $15k at the bottom end
      2. Time to manage the property yourself and the hassle is another barrier to entry – of course you can pay someone else, but you still need to cover the costs of things that break, plus the costs to cover management at around 8% of the rent – which is a few more thousand –
  • Ongoing costs – Rates, insurances, BC depending on the type of property
  1. Liquidity – Many investors might not have the liquidity to meet the loan repayment obligations where debt is required to purchase the real estate portfolio
    1. If you want to buy property quickly, that is normally not an option for direct property – Or if you need your cash back quickly, it can be hard to sell at the right price quickly
  2. Lack of Diversification – REIT investors can also target specific real estate segments. The REIT sector encompasses a lot of subsectors such as commercial, residential, office, industrial, retail and infrastructure. This means several properties in different geographies and different segments can be diversified.
    1. The REIT enables immediate diversification across potentially hundreds of properties and sectors across one or multiple jurisdictions.
    2. You can access international commercial real estate as an example – which would be almost impossible for an Aus resident to do on their own due to residency and lending requirements that OS countries have

Within these REITs – you can typically access a range of different types of investments  

  1. The real estate sector is divided into two main categories — residential and commercial real estate
    1. Most first-time property investors are inclined to invest in residential property – probably because of a familiarity bias – most people have either rented or owned their own home – so have some working knowledge of residential property
    2. Commercial property tends to be an investment that more experienced property investors make – or those that have run a business – either through occupying that business or being familiar with how commercial property operates
  2. Each has their own pros and cons – and it does come down to what you are after from a property investment as to which may best suit your investment needs
    1. In comparing the two, consider the following rules of thumb (at risk of overgeneralising) –
      1. Residential property tends to provide lower yields, higher capital growth, and the expenses are largely borne by the landlord/owner.
      2. commercial property tends to provide higher yields (but potentially more unpredictable yields), lower capital growth rates, and the expenses payable are often part of the negotiation.
        1. Commercial real estate consists of three sectors: retail, office, and industrial. Each of these sectors has their own cycle, representing different risks and rewards for investors.
        2. One of the risks of commercial property is that it is not unusual for a commercial property to be vacant for twelve months or more – Businesses do not move as regularly as a family.

If you don’t already own an investment property – How much to allocate – and to what type of REIT

  1. Whether someone should own REITs as an investment depends on a number of factors – their adversity to risk when measured by volatility is a big one –
    1. But it also depends on how large their allocation is to real estate already is – if you have a large part of your net worth in your primary home and/or investment properties, then perhaps diversifying elsewhere, into shares for instance may be a better option
    2. On the other hand – if you do not own a home or investment property then an allocation to REITs can be an easy way to gain exposure to property price movements
    3. Looking at other studies of allocation – A report called ‘The Diversification Potential of Real Estate’ covered 30 studies on the benefits of adding listed real estate to a portfolio found the median suggested allocation was 15%, with most of the literature concluding the addition of real estate in a mixed-asset portfolio is beneficial with recommended allocations ranging from 10% to 20% – this was found to be beneficial from a risk return point of view – helping to provide some diversification plus provide better risk adjusted returns than just investing solely in shares

Place in the portfolio – aim is to provide diversification and long term growth and income returns

  1. Real estate versus equities studies – when looking at liquid investments, most people have shares/equities – due to familiarity and the reputation shares have to outperform over the long term
    1. there are a number of studies that suggest that REIT returns are closely matched to share market over the long term with less volatility on average
    2. According to an ASX and Russell Investments study for the 20-year period from 1995 to 2015, the average rates of returns for Australian equities and real estate were as follows:
      1. Residential real estate — 10.5% p.a., Australian shares — 8.7% p.a., Listed real estate — 7.7% p.a. (ASX & Russell Investments 2015) – listed real estate took a major hit in the GFC in Australia
      2. In the US – as of First Quarter 2021, the return for the period 1996 to 2021 – Commercial real estate — 10.3% p.a., Residential real estate — 10.3% p.a., S&P 500 stock market index — 9.6% p.a.
  • According to the 2021 Vanguard Index Chart, for the 30-year period from 1992 to 2021, the average rates of return were US shares — 12.3% p.a., International listed real estate — 11.2% p.a., Australian shares — 10.4% p.a., Australian listed real estate — 10.2% p.a. (Vanguard 2021)
  1. So Australian shares have edged out Australian listed real estate – But international listed real estate beat out both – but how does the volatility compare –
    1. the volatility of real estate returns (as measured by the standard deviation) was significantly lower, with the standard deviation of the real estate returns (at 9.98%) substantially lower than that for equities (at 21.94%). This finding appears to contradict one of the basic assumptions of modern asset valuation models: higher risks should come with higher rewards.

Downsides –

  1. Correlated to shares – due to being listed, in market sell off periods, REITs are not immune – the price of these assets tends to drop with share prices – whilst not 100% correlated, it is more correlated than the price of residential or commercial property, which is illiquid and doesn’t move as quickly
  2. Can be volatile due to leverage nature and people panic selling – due to being liquid and listed on a secondary market – if everyone is running for the door, the price can fly out the window –
  3. Don’t get to take advantage of the same gearing – through borrowing on a residential property, you normally have a leveraged effect on returns –
    1. If you borrow $400k to buy a $500k property, you put $100k of equity down – so if the property goes up by 10%, you are up $50k which is a 50% return on your equity – obviously this can work against you, where if the property goes down by 10%, you have lost 50% of your equity – but for a REIT if you invested $100k and the price goes up by 10%, you make $10k – i.e. the 10% – you can access margin loans for an investment in a REIT but I would strongly suggest against it – would introduce double leveraging which only works if markets always go up or it is actively managed
  4. Brokerage
  5. Have underlying management expenses – REITs have operating costs that they charge prior to passing on returns –

Summary –

  1. Real Estate Investment Trusts, or REITs – allows access to property through smaller investments – gets around the hurdles that come with direct property investment
    1. A listed Trust owns a number of properties – Different areas – You pick up a fraction of all them – so you can purchase a small allocation in a number of properties for a few thousand dollars – helps to provide diversification
      1. Don’t have to get your own finances – Or deal with management/finding properties
    2. Downside – Volatile, more correlated to shares than residential property
      1. Don’t get the same leveraged returns as residential property – have underlying costs

Thanks for listening

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