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 up to 10% 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). Here is a list of mutual funds that invest in REITs. Several pension funds have announced recently that they will shift assets from private real estate to REITs. REITs are sometimes referred to as the "mutual funds of real estate." The market capitalization of REITs has increased from approximately $10 Billion in 1986 to over $120 Billion. The value of all private equity real estate is in the $4 trillion range. (See 97 REIT Outlook from NAREIT.)
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; must pay dividends on 95% of its taxable income; and, no more than 30% of income can result from property held less than four years. Another potential advantage of REITS is that part of the dividend is treated as return of capital for tax purposes. This can dramatically lower the tax bite on dividends.
Historically, REIT returns have been volatile. For example 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.
(The Vanguard Group has a fund that seeks to track the index.) However, the relatively short existence of REITs and CREFs (the first CREFs were created in the 70's) make comparison to other assets less relevant. 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.
- 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.
- 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.
- 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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