Real Estate — Grand Galley Capital

How to invest in Real Estate?

Exposure to real estate as a class of asset is possible through private or public investments. Another major classification is investment in equity or debt (former means owning all or part of the asset, and later means you lend money to someone who owns the asset as the asset being collateral).
If we combine these two categorizations (Private vs. Public and Equity vs. Debt), we will have four possible combinations:
Private Equity, Private Debt, Public Equity, Public Debt

Private real estate:
Direct ownership of an investment property or a piece of land is a well-known method of real estate investment.
Alternatively, you can allow an investment management firm (“Manager”) to help you with investing. You should be an accredited investor to qualify for this. In this indirect private real estate investment, the Manager forms a fund, which is a legal entity, most commonly a limited partnership (“LP”). By contributing cash to the fund, you will become a limited partner in this LP, and in exchange for your cash, you will receive units of the LP. The Manager usually has an affiliated management corporation that acts as the general partner of the LP (or “GP”). The Manager has experience and knowledge in the real estate space. In addition, you benefit from the pooling effect (similar to Mutual Funds), allowing investors to get exposure to larger assets that they could not afford on their own otherwise. In exchange for the investment services provided, the Manager charges two fees: management fee and performance fee (or “carried interest”). The most common fee structure is 2/20, meaning that the fund gets charged 2% on total assets under management annually, plus 20% of the fund’s residual cash (i.e. any cash remaining at the end of the fund’s life, when all expenses are paid, investors’ initial outlays are returned, and the compounded interest owed to investors is paid. Investors are entitled to the remaining 80% of the residual cash.)

Investment in private debt simply means that you lend money under certain terms and conditions (for example, 4% interest rate, payable monthly, and the loan matures in 5 years). In some jurisdictions, the rules and regulations allow for setting up mortgage companies (sometimes called Mortgage Investment Corporation or MIC) rather easily.

Public real estate
To get exposure to real estate through public vehicles, you can buy shares of REITs, REOCs, or ETFs that hold these shares.
REIT or Real Estate Investment Trust is a good investment for those who are looking interested in receiving regular dividends, since REIT’s are required to distribute 90% of their taxble income to investors. This means that they can’t re-invest and there is not much exponential growth as you see with stocks like Amazon. That being said, since REITs issue shares that are traded on stock markets, they are impacted by ups and downs of the market. So, if suddenly market participants feel like land value is go up 3x for some unknown reason, the price of REITs that own land might go up 3 times and even 10 times (because of mania). But this scenario is unlikely. The most likely scenario is slow growth and steady dividends.
In most jurisdictions, REITs (public or private) have tax advantages. But this advantage comes with some conditions. One of the conditions, as mentioned above, is the distribution of excess cash. There are other requirements such as the type of investments (a certain percentage must be in real estate) and the number of investors.
REOC or Real Estate Operating Company do not have the restrictions of REITs, but at the same time, they don’t have the tax advantages. REOCs are. not as popular as REITs.

As of June 2022, there were 211 REITs included in the ‘FTSE Nareit All REIT index’ (which keeps track of all public REITs), with a market cap of $1.5 trillion. Just to give you an idea of the growth in this sector, in 2000, there were 189 REITs (market cap: $138 billion), in 2010, 153 REITs (market cap: $389 billion), in 2015, 233 REITS (market cap: $938 billion), and in 2020, 223 REITs (market cap of $1.25 trillion).

As illustrated in the table and chart below, REITs have been growing at an accelerating pace in the past 10 years. One of the reasons for the attention to REITs is historically low interest rates after the 2008 financial crisis which forced large institutions to look for returns outside of the bond market. Recently, the rates have been rising, but this is combined with high inflation. Higher rates have historically put downward pressure on real estate, with an opposite effect induced by inflation. In an environment where signals are mixed, the best approach is owning the best-in-class assets, which is true about real estate as well. Whether it’s public or private, look for quality.

The return as per Nareit index for all equity REITs (^FNER) is approximately 8.9% per year. This includes dividend and capital gain. We ran regression between ^FNER and S&P500 as well as ^FNER and 10 year treasury bill (^TNX). There is a between ^FNER and S&P500 but no meaningful relationship between ^FNER and ^TNX (even though there is a negative relationship between ^TNX and cap rates).
Simply put, if you invest in REITs, you can expect an average of 9%, but the volatility that matches stock market. The benefit of this investment over private investment is that it’s liquid and you can cash out relatively easily.

Graph below shows the correlation between REITs and S&P500. Interesting observation is that the gap between the two charts disappeared after 2020. It could be the new normal, or we might expect a mean reversion in here in which either stocks slip lower or REITs climb higher. Given ^FNER is all equity REITs, the fact that retail and office REITs are still under pressure after COVID is dragging down the whole index.

Position of Real Estate in a Portfolio:

Currently, private real estate is considered an ‘alternative investment’ vehicle (as opposed to investment in stock and bonds which are ‘traditional investment’ vehicles.) There are studies that show there is low correlation between real estate and stock market and conclude that addition of private real estate will add value by ‘diversifying’ the portfolio. We do believe in value that real estate (private or public) adds to a portfolio, but low correlations might not hold under all circumstances, especially during times of distress when investors need money the most. At such times (crisis), all assets move down together, but this does not manifest itself in private real estate because there are very few deals that happen during such time. And because of lack of data points, the numbers from before and after crises are used to extrapolate the values at the time of crisis. This results in numbers that are not as ugly as the stock market, but they don’t represent real transactions. So, if your financial conditions are such that you won’t be put in a position that you have to fire sell your assets, then investing in private real estate is a good option.
Public REITs, on the other hand, have strong correlation with stock markets. So, there is not much diversification benefit. Moreover, to maintain the REIT status and tax advantage, REITs must distribute dividends, so they cannot reinvest the free cash flow in the business. As such, there is no significant growth aspect to it either. The benefits of adding public REITs are: 1) receiving regular dividend payment; 2) no double taxation; 3) liquidity (can buy and sell relatively quick); 4) benefiting from pooling effect and having ownership in assets that otherwise is not possible; 5) doesn’t require large outlay of cash and can be done with small amount; and 6) investors can benefit from the experience professional property managers.
In addition to the above, real estate as a class of asset has been receiving more attention from institutional investors, resulting in higher valuation of the properties, which has worked its way to REIT valuation.

Investment approach:

How do we formulate an appropriate investment strategy? As explained in our post on investment policy, it all depends on personal situation and conditions.
We review two common scenarios down here.

Case 1: An investor who has savings while saving more to purchase a property within one-year timeframe.
The main objective in this case is to purchase a property, which is not only a large investment, but also a highly leveraged one. Preserving the capital for down payment is number one priority. So, if you’re conservative, buying GIC in order to get a slightly improved interest return seems appropriate. If you’d like to take more risk, you can allocated 80/20 to GIC/REIT. Please note that the price of REIT is also impacted by stock market dynamics. So, you it is possible that when you need cash for down payment, the stock markets are down and you have to liquidate your position and crystalize the loss.

Case 2: Investor with long-term outlook and no immediate need for the cash.
Investors want to earn the highest return per unit of risk. Basically, when faced with two investment that have the same return, investors choose the one with lower risk. Obviously, it gets complicated when we unitize risk (as it’s done in professional investment firms).
Before investing in REITs, consider these two points: 1) Are you paying high interest rate on your mortgage. By paying down a portion of your mortgage, you’re in effect earning the interest you’re paying, except that it’s tax-free and risk-free. 2) Given right conditions, buying a property is a good option.
Buying shares of a public REIT is an option. Depending on the underlying investments, REITs are divided into residential, office, retail, datacenter, mixed, etc. After the start of COVID, retail and office REITs have lost value. But data centers, self storage and residential REITs have gained traction.
Another option is buying ETFs. Below are example of a few:
VNQ (Vanguard Real Estate ETF); IYR (iShares US Real Estate ETF); FREL (Fidelity MSCI Real Estate Index ETF); REM (iShares Mortgage Real Estate ETF); SRET (Global X SuperDividend REIT ETF)