What is Real Estate?
Real estate is a tangible asset, made up of land and anything attached to the land space, i.e. the buildings and any natural resources within the land space (natural resources refer to uncultivated flora and fauna, farmed crops, livestock and also mineral deposits). Real estate is commonly subdivided into 3 categories:
Residential real estate includes undeveloped land and housing complexes, which may be either owner occupied or rental properties.
Commercial real estate includes non residential structures, such as office buildings, warehouses and retail buildings. Apartment buildings (despite being residential) are also often considered commercial as they are owned to produce income.
Industrial real estate includes manufacturing buildings and property, such as warehouses.
In the past 50 years, investments in real estate have averaged returns of 11%, much higher than the average of other asset classes. With the exception of a national recession, real estate investments are considered to be a profitable and steady investment, with low risk due to the low market volatility (which occurs due to the long amount of time it takes to liquidate a property asset). Real estate investments generate a passive income through a steady cash flow, which likely increase over time due to capital appreciation (increase in the property’s value). Real estate investments also offer portfolio diversification as real estate has low correlation with other asset classes, allowing for diversified assets with a higher return per unit of risk. Investors also have potential for tax benefits as tax can be deducted for the reasonable costs of owning, operating and managing a property. Other reasons for investing in real estate include the building of one’s net worth and wealth, the use of real estate as a hedge against inflation (in an expanding economy), and the increase of return through use of debt (real estate leverage).
It is important to prepare and research before planning to invest in property; while real estate investments can produce greater returns comparatively to other investment options, there are inevitable risks associated with it (entry and exit costs are expensive, rental income is not guaranteed and property value can fluctuate undesirably and illiquid/difficult to convert to cash).
Ways to invest in Real Estate
Retail investors can gain exposure to real estate through the following investment vehicles:
Real Estate Investment Trust
A REIT (Real Estate Investment Trust) is a company that owns and typically operates income-producing real estate or related assets. They provide a way for individual investors to earn a share of income generated through commercial real estate ownership without owning a property themselves. The two main types of REITs are equity and mortgage REITs. Equity REITs own and operate properties to generate revenue primarily through rental income. Mortgage REITs on the other hand on the other hand focus on interest income derived from mortgages and mortgage-backed securities.
Mortgage-Backed Security ETF
Mortgage-backed security (MBS) ETFs are another way to invest in real estate. A MBS is an investment collateralized by a pool of home loans bought from banks. Investors in MBS receive periodic payments similar to bond coupon payments. MBS ETFs give investors access to the domestic mortgage-backed bond market including those issued by government-sponsored corporations like Fannie Mae and Freddie Mac.
Real Estate Investment Group
Real estate investment groups (REIGs) buy, renovate, sell, finance, manage or lease property in search of profits. They differ from REITs in that they do not have specific limitations on business structure or ways in which real estate investments are carried out. REIGs are an entity with multiple partners or shareholders. Multiple sources of capital investments provide a greater pool of capital and greater diversification benefits.
The Federal National Mortgage Association, more commonly known as Fannie Mae, is a corporation that enables investors to invest in the mortgage market through Mortgage Backed Securities (MBS). “What exactly are Mortgage Backed Securities and why would investors choose to invest in these financial instruments?” you might ask. Well simply put, Mortgage Backed Securities are basically coupon paying bonds. Mortgages are contracts between a bank and a borrower that entitles the bank to receive periodic payments of the principal (amount lent) and interest over a long duration of time (usually over 20 years). All seems well, the borrower gets to buy a house, the bank earns interest payment. Except, the bank has to keep the mortgage in its books for the duration of the loan, which ties up capital and resources. So the bank plays it smart and decides to sell the mortgage as a Mortgage Backed Security to investors, essentially acting as a middleman between the borrower and investor. This way, the bank will simply earn money through fees associated with setting up the mortgage and the investor is entitled to all the interest payment.
Due to regulations, Mortgage Backed Securities can only be issued to the market by Government Sponsored Enterprises (GSE) such as Fannie Mae. These corporations ensure that the securities are appropriately bundled and the risk level is appropriately classified, the latter being one of the prime factors behind the GFC due to negligence. Those who invest in Mortgage Backed Securities issued by Fannie Mae receive timely interest and principal payments. As these payments are both timely and guaranteed, Fannie Mae will charge a fee.