Everyone likes to own a piece of land they can call their own. This can be as shelter or as increasingly the case is turning out to be as a worthwhile investment. Real estate would include homes, offices, retail spaces, parking lots, apartments, warehouses, etc. It is a tangible, immovable asset. Insurance and pension funds invest in real estate for a good rate of return. Mortgage-backed securities are real estate investment instruments. Countries too are investing in real estate. For example, China is purchasing condominiums, warehouses and retail spaces in America, quite aggressively.
There are different forms of Real Estate Investment:
- Free and clear equity
- Leveraged equity
- Aggregation Vehicles
In the Free and Clear Equity form of real estate the owner obtains property rights for an indefinite time period. He can choose to rent or lease the property to a tenant. He can also resell the property to another party. This is also called fee simple.
Leveraged Equity is when the owner takes a pledge (mortgage) and a debt (promissory note) to relinquish ownership rights if the loan payments are made. Simply put a person investing in a piece of property takes a loan and offers the bought property as security to the agency he has taken the loan from. In the event of a default, the owner hands over his rights to the loan giver (usually a bank or housing finance agency). Leveraged equity therefore has two parts: equity ownership and debt. The mortgage loan therefore is made of the debt and the pledge.
Mortgages are also an investment vehicle by themselves. This happens in the form of mortgage-backed securities, the debt instruments that aid in real estate investing. In this format of investment, banks issue securities, in which a group of mortgages are clubbed together. Investors who buy these securities avail returns periodically, not unlike revenue streams from a bond. The components of this payment are net interest, net of mortgage servicing fees and a schedule of repayment of principal. If a debtor makes some early repayments on the loan, the debt holder also receives excess principal repayments called mortgage prepayments. This introduces some uncertainty in terms of the amount and timing of the cash flows.
In the Aggregate Vehicles form of real estate investment, investors invest with limited liability. It provides collective access to the investment. This is usually done through Real Estate Limited Partnerships (RELP). Limited liability means these partners are not involved in the management of the real estate, and only put in an initial investment. Capital is raised from a group of institutional investors brought together by an intermediary and are known as Comingled Funds. Payouts are made in the same proportion as the investment by each investor. These funds can be close or open ended.
Close ended funds have fixed closing dates. Post fund initiation, no new investors are allowed into the fund. No further reinvestments take place even as sales occur.
Open ended funds accept new investors and reinvestments even after fund initiation. These funds tend to review and change their portfolio over time.
Real Estate Investment Trusts (REITS) are a kind of close ended investment company. Their shares are traded in the market and they invest exclusively in the real estate segment. They are liquid investments but their share price can trade at a discount or at a premium to the Net Asset Value (NAV) of the properties in their portfolio. Unlike comingled funds, here capital is raised from individual investors. Since these companies invest in a wide variety of real estate, investors’ portfolios are diversified too.
REITS that invest in mortgages behave like an investment in a bond. There are equity REITS that invest in residential and commercial real estate using leverage and in this sense behave like a leveraged equity real estate.