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Real Estate

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Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC

Background

     Real estate has provided returns competitive with stocks and bonds in the long term. The primary reasons to invest in real estate are high returns and low correlations with other major asset classes which can make real estate a valuable diversifier. Investors can also diversify within real estate by location, economic region and property type. Characteristics of real estate include (1) high transactions costs, (2) lack of publicly available, audited information (3) large transaction size (4) uniqueness of each property (5) complexity of possible transactions and (6) varying state and federal laws.

     Despite its drawbacks, there are compelling reasons to include real estate as a significant component in a diversified portfolio. Real estate's low correlation and typically high dividends can provide a valuable cushion during bear markets. Some advisors recommend allocating 10% or more of a portfolio to Real Estate.

     There are several ways for institutional investors to invest in real estate, but the primary option for individual investors is to buy shares in a Real Estate Investment Trust (REIT). REITs are sometimes referred to as the "mutual funds of real estate." REIT.com has this table of Historical REIT Industry Market Capitalization: 1972-2009 which shows the growth (and recent contraction) of REIT valuations.

     REITs are technically treated as corporations for tax purposes, however, the income is taxed only at the shareholder level if certain requirements are satisfied. REIT requirements include: management by a board of directors; shares must be fully transferable; must have a minimum of 100 shareholders; at least 75 percent of income must come from real estate; and must pay dividends of at least 90% of the REIT's taxable income. Another potential advantage of REITS is that part of the dividend is treated as return of capital on your tax software. This can dramatically lower the tax bite on dividends.

     Historically, REIT returns have been volatile. For example Vanguard's VNQ REIT ETF had gains of 33% in 2006 and 30% in 2009, but lost 16% and 37% in 2007 and 2008. Ishares IFGL (an international REIT fund) debuted a few years ago and promptly lost 52% in 2008, but gained 42% in 2009. In 1974-75 REIT prices were more than cut in half and following the tax reform act of 1986, REITs lost roughly one third of their value (1987-91). Another concern with REITs is that historical correlations with small stocks have been high which lessens the diversification benefits of investing in real estate.

     Sources of historical information for real estate include REITs, Commingled Real Estate Funds (CREFs) and other data. REIT returns are typically measured by the Morgan Stanley REIT index. Problems with CREFs include illiquidity and value being determined by real estate appraisals. Data based on appraisals suffer from "smoothing" in the appraisal process which seems to reduce the volatility. This problem is magnified by the fact that returns from CREFs and REITs have historically not been as highly correlated as expected.

     There are three primary approaches used in valuing or appraising real estate.

  1. The Cost Approach, which generally works well for estimating the value of new buildings, involves estimating the cost to build an identical property taking into account land prices, labor, construction materials and developers profit.
  2. The Comparative Sales Approach involves estimating a property's value by comparing it to similar properties recently sold. The problem with this approach is that all properties are unique and adjustments must be made to account for differences in the properties being compared.
  3. The Income Approach involves estimating a properties value by calculating the present value of future income. The formula for market value equals annual net operating income (NOI) divided by a market capitalization rate that must be estimated and is determined by market factors. Funds from operations (FFO) - a commonly used term - are funds available for distribution to shareholders = net income plus depreciation less principal payments.

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