By Louis Portail and Victor Yan
If you have not already, we recommend reading ‘What is Investing’, ‘Introduction to Stocks’ and ‘Introduction to Bonds’ first.
In this edition of UNIT’s Intro to Investing series, we cover the basics of property investment and ownership. Although stocks and bonds may be more familiar to you, property ownership and investment are omnipresent; for every house, apartment, office block and shopping centre, there is an owner and therefore an investor.
The result is that property represents roughly 60 percent of total global assets. Further, it should be safe to assume that all our readers are familiar with home ownership, given residential property accounts for 75 percent of the total value of global property. However, there are a number of less well-known types of property investments that make up the rest of global property assets. In this article, we aim to shed some light on them, property investing as a whole, and the benefits and risks associated with this asset class.
What is Property?
For the purpose of this article, we will refer to property and real estate interchangeably.
Real estate is an investment in property or physical land containing buildings, structures or natural resources.
Property or real estate can be segmented into three broad categories: residential, commercial and industrial, consisting of housing and apartments, shopping centres and offices, and factories, warehouses and storage, respectively.
While most people may think the stock market is the biggest investment market in Australia, the residential property market dwarfs all other forms of investment, including Australian superannuation. The market value of residential property in Australia is a whopping $5.5 Trillion, compared to the $1.6 Trillion stock market.
The residential property market is so substantial because it is largely considered a safe and proven way to grow wealth, beyond providing the obvious benefit of shelter and a home. However, before looking at the historical performance of property, and the risks associated with property investment, we must first consider the ways an investor can add property to their portfolio.
What are the ways I can add property to my portfolio?
Property can be owned and invested in through various means.
Investors can purchase the physical asset directly either outright or financed with a mortgage. The investor is responsible for the maintenance, rental agreements and tax liabilities associated with ownership of the property. Residential property makes up the majority of direct property investment. The main considerations for direct property investment are the capital requirements, the liquidity constraints associated with the asset itself, and the substantial transaction costs.
REITs and MBS Instruments
With that said, to those who want to gain exposure into the property market but avoid barriers to entry such as high costs or bureaucracy of buying or mortgaging property, there are financial instruments designed and available for that specific purpose. The most noteworthy to be mentioned are Real Estate Investment Trusts (REITs), which not only give the investor exposure to property, but act as an excellent diversification option in an overall portfolio with 2 main paths of generating return through:
- Generation of dividend income
- Capital appreciation
Historically speaking, REITS are one of the best-performing asset classes available. For example, the FTSE NAREIT Index is the most common gauge of the U.S. real estate market (think of it like the S&P 500, but for real estate). Between 1990 and 2010, the index’s average annual return was 9.9%.
Here, REITS are companies that own and operate a portfolio of properties, and generate income for their investors dependent on their designated REIT type:
- Equity REITs operate like a landlord. Owning the underlying real estate, these REITS provide upkeep of and reinvest in the property, while collecting rent checks from their tenants. These payments are pooled and then distributed out to investors in the form of dividends.
Equity REITs can choose to focus their property ownership broadly, or on a particular segment. Below illustrates the returns on following REIT sectors:
Generally speaking, equity REITs provide more stability in income due to their revenue generation via rent collection and capital appreciation. As property tends to rise over time, so will the expectation of rent payments associated with these properties.
Due to more certainty and easier forecast in future rent payments, equity REITs typically display relatively low-risk characteristics in the REIT universe. Yet, risks typically reside in potential cyclical shocks towards the property market in the short-run (eg. a recession), as well as property-supply dynamics (for example, the oversupply of property can lower rental incomes)
- Mortgage REITs (or mREITs) do not own the underlying property, but instead invest in mortgage and debt instruments as their source of revenue generation. In this sense, mREITs operate more akin to a bank loan, where income is earned from receiving interest payments on their investments, and then REIT profits paid to investors as dividends (hence, mREITs tend to perform well during times of high interest rates).
While most of the mortgage securities that REITs buy are federally backed, mREITs are still exposed to greater credit risk relative to their equity counterparts (especially if invested into riskier mortgage instruments). Following risk/return rationale, mREITs usually command a higher return on dividends than equity REITs.
- Hybrid REITs are a combination of both equity and mortgage REITs. This can be a good way of risk diversification between the systematic risks existent in each REIT instrument. Of course, hybrid REITs are not created equal, and can differ depending on their equity/mortgage allocations towards the overall portfolio, as well as the individual properties and debt-instruments targeted respectively.
The overall attractiveness of REITs comes with two major advantages, one being that you gain exposure to a range of properties and thus can diversify within the property asset class (much like owning an equity ETF), second being that you sidestep the requirement for knowledge in managing property as the REIT functions as a middle man for your investment.
REITs aside, one can also look towards mortgage backed securities (MBS). While they have garnered a bad reputation from their contribution towards the 2008 GFC, when designed right they are still a viable investment option. Here, MBS’s groups together a pool of mortgage payments and sells shares of the pool to prospective investors. Here, MBS’s are divided into different “tranches” describing their risk/return profile suitable to the investor’s risk tolerance, where a AAA tranche is deemed the safest but offers relatively lower expected return and C tranche the most risky but also higher expected return. This could be seen similarly in practice to credit ratings, discussed in ‘Intro to Bonds’.
Property Investment Returns
Property provides returns via two ways: capital gains and rental income. For owner-occupiers of residential property, investors will see returns through the growth in the asset’s price. For investors, they will see returns through both rental income and capital growth.
As mentioned before, property is commonly perceived to be safer than stocks but provide greater returns than bonds. This perception is built on the assumption that the demand for property, particularly residential property, is constantly growing, while the supply of property is limited. This places property investments, generally, between stocks and bonds on the risk-return curve
Risks Associated with Property Investments
As always, past performance does not indicate future performance. And like all asset classes, there are substantial risks associated with real estate investment. These risks have the potential to affect both the market value of the property and the rental income received, compounding the risk of losses.
The current (2020) Coronavirus situation demonstrates a number of risks faced by property investors. The most salient is the lack of rental income received by tenants, across both residential and commercial property. If tenants simply cannot afford to pay rent, landlords may have no choice but to extend rental holidays or in extreme circumstances, rental forgiveness. Further, the consequence of a global pandemic is the sudden drop-off in immigration. Given much of the demand for residential property is supported by inorganic population growth via immigration, a reduction in immigration puts downward pressure on both the market value of residential property, as well as rental yields.
Further risks involve over-development which leads to oversupply, typically in the residential property market. This can also lead to reductions in property value and rental yields. Increases in interest rates raise the cost of borrowing and make it more difficult for investors and mortgagees to pay the interest on their home loans. For property investors, this additional cost can be greater than the rental income and therefore force the sale of the property, putting downward pressure on property prices. Finally, regulatory changes such as the possible elimination of negative gearing, a major talking point during the last election, may make property investing un-viable or unattractive for many individuals, suppressing property demand and hence prices.
Ultimately, while the limited supply of property, particularly residential property, implies that prices will always grow, there are a number of major risk factors for short and medium-term property prices.
While we hope that this introduction to property investing provides a fresh take on the options with financial investing, there is still much to extend upon the basics mentioned in this piece. As such, at UNIT we intend to follow up with a sequel piece to property investing regarding a decision everyone has to make at some point in their lives: “Should I buy or mortgage my home?”
In addition, look forward to our next piece where, with what we’ve learned in our previous three pieces, we cover ‘How to Invest’.
So, what can you do now to learn more about investing?
This semester, UNIT is publishing an article for beginners interested in investing every fortnight.
Other Related UNIT Articles:
Take a look at other articles in our series:
- ‘What is Investing’
- ‘Introduction to Stocks’
- ‘Introduction to Bonds’
- ‘How to Invest’
- ‘Introduction to Portfolio Allocation’
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.