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 Private real estate investments often hold the greatest appeal for investors with long-term investment horizons and the ability to accept relatively lower liquidity. Pension funds, sovereign wealth funds, insurance companies, and high-net-worth individuals have been among the largest investors in private real estate. Securitized real estate ownership—shares of publicly traded, pooled real estate investments, such as real estate operating companies (REOCs), real estate investment trusts (REITs), and mortgage-backed securities (MBS)—has historically provided smaller investors with ready access to the asset class because of low share prices and the benefits of higher liquidity and professional management. Institutional investors also pursue securitized real estate when the market capitalization of the vehicles can accommodate large investor demand. In fact, institutional ownership of US REITs has increased from 6% in 1990 to 65% in 2015, according to a 2019 research paper (Huerta, Ngo, and Pyles 2019).

 Regardless of vehicle type, the risk profile of the underlying investment can vary significantly. High-quality properties in leading markets with long-term leases and low leverage have a conservative risk profile, as do those mortgages that represent only slightly more than half of the asset’s value. Older properties with short-term leases in suburban markets with ample room for new development and higher leverage constitute higher-risk properties. Below-investment-grade, non-rated, and mezzanine debt similarly carries higher risk. Development property is often considered the riskiest because of long lead times and the dependence on contractors, suppliers, regulators, and future tenants for success.

 Section A presents real estate as an asset class, delves into its role in portfolios, and contrasts the different characteristics of the major property types. Sections B and C explore private and public investing, respectively, with particular attention to valuation. Investment valuation and performance can be analyzed at the property and vehicle level. The end of the reading returns to the role of real estate in the portfolio and discusses whether investors’ goals are best served by choosing private or public real estate vehicles.

  Learning Outcomes The member should be able to: compare the characteristics, classifications, principal risks, and basic forms of public and private real estate investments; explain portfolio roles and economic value determinants of real estate investments; discuss commercial property types, including their distinctive investment characteristics; explain the due diligence process for both private and public equity real estate investments; discuss real estate investment indexes, including their construction and potential biases; discuss the income, cost, and sales comparison approaches to valuing real estate properties;

  compare the direct capitalization and discounted cash flow valuation methods; estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods; calculate the value of a property using the direct capitalization and discounted cash flow valuation methods; calculate and interpret financial ratios used to analyze and evaluate private real estate investments; discuss types of REITs; justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income; describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation; calculate and interpret the value of a REIT share using the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches; and explain advantages and disadvantages of investing in real estate through publicly traded securities compared to private vehicles.

 Real estate property is an asset class that plays a significant role in many investment portfolios and is an attractive source of current income. Investor allocations to public and private real estate have increased significantly over the last 20 years. Because of the unique characteristics of real estate property, real estate investments tend to behave differently from other asset classes—such as stocks, bonds, and commodities—and thus have different risks and diversification benefits. Private real estate investments are further differentiated because the investments are not publicly traded and require analytic techniques different from those of publicly traded assets. Because of the lack of transactions, the appraisal process is required to value real estate property. Many of the indexes and benchmarks used for private real estate also rely on appraisals, and because of this characteristic, they behave differently from indexes for publicly traded equities, such as the S&P 500, MSCI Europe, FTSE Asia Pacific, and many other regional and global indexes.

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 General Characteristics of Real Estate Real estate investments make up a significant portion of the portfolios of many investors. Real estate investments can occur in four basic forms: private equity (direct ownership), publicly traded equity (indirect ownership claim), private debt (direct mortgage lending), and publicly traded debt (securitized mortgages). Each of the basic forms of real estate investment has its own risks, expected returns, regulations, legal structures, and market structures. Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk. The returns to equity real estate investors have two components: an income stream and capital appreciation. Many motivations exist for investing in real estate income property. The key ones are current income, price appreciation, inflation hedge, diversification, and tax benefits. Adding equity real estate investments to a traditional portfolio will potentially have diversification benefits because of the less-than-perfect correlation of equity real estate returns with returns to stocks and bonds. If the income stream can be adjusted for inflation and real estate prices increase with inflation, then equity real estate investments may provide an inflation hedge. Debt investors in real estate expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate. Thus, debt investments in real estate are similar to other fixed-income investments, such as bonds. Regardless of the form of real estate investment, the value of the underlying real estate property can affect the performance of the investment. Location is a critical factor in determining the value of a real estate property. Real estate property has some unique characteristics compared with other investment asset classes. These characteristics include heterogeneity and fixed location, high unit value, management intensiveness, high transaction costs, depreciation, sensitivity to the credit market, illiquidity, and difficulty of value and price determination.

 There are many different types of real estate properties in which to invest. The main commercial (income-producing) real estate property types are office, industrial and warehouse, retail, and multi-family. Other types of commercial properties are typically classified by their specific use. Certain risk factors are common to commercial property, but each property type is likely to have a different susceptibility to these factors. The key risk factors that can affect commercial real estate include business conditions, lead time for new development, excess supply, cost and availability of capital, unexpected inflation, demographics, lack of liquidity, environmental issues, availability of information, management expertise, and leverage. Location, lease structures, and economic factors—such as economic growth, population growth, employment growth, and consumer spending—affect the value of each property type. An understanding of the lease structure is important when analyzing a real estate investment. Appraisals estimate the value of real estate income property. Definitions of value include market value, investment value, value in use, and mortgage lending value. Due diligence investigates factors that might affect the value of a property prior to making or closing on an investment. These factors include leases and lease history, operating expenses, environmental issues, structural integrity, lien/proof of ownership, property tax history, and compliance with relevant laws and regulations.

 Appraisal-based and transaction-based indexes are used to track the performance of private real estate. Appraisal-based indexes tend to lag transaction-based indexes and appear to have lower volatility and lower correlation with other asset classes than transaction-based indexes. Private Equity Real Estate Generally, three different approaches are used by appraisers to estimate value: income, cost, and sales comparison. The income approach includes direct capitalization and discounted cash flow methods. Both methods focus on net operating income as an input to the value of a property and indirectly or directly factor in expected growth. The cost approach estimates the value of a property based on adjusted replacement cost. This approach is typically used for unusual properties for which market comparables are difficult to obtain. The sales comparison approach estimates the value of a property based on what price comparable properties are selling for in the current market. When debt financing is used to purchase a property, additional ratios and returns calculated and interpreted by debt and equity investors include the loan-to-value ratio, the debt service coverage ratio, and leveraged and unleveraged internal rates of return. Publicly Traded Real Estate Securities The principal types of publicly traded real estate securities available globally are real estate investment trusts, real estate operating companies, and residential and commercial mortgage-backed securities. Publicly traded equity real estate securities offer investors participation in the returns from investment real estate with the advantages of superior liquidity; greater potential for diversification by property, geography, and property type; access to a larger range of properties; the benefit of management services; limited liability; protection accorded by corporate governance, disclosure, and other securities regulations; and in the case of REITs, exemption from corporate income taxation within the REIT if prescribed requirements are met.

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 Disadvantages include the costs of maintaining a publicly traded corporate structure and complying with regulatory filings, pricing determined by the stock market and returns that can be volatile, the potential for structural conflicts of interest, and tax differences compared with direct ownership of property that can be disadvantageous under some circumstances. Compared with other publicly traded shares, REITs offer higher-than-average yields and greater stability of income and returns. They are amenable to a net asset value approach to valuation because of the existence of active private markets for their real estate assets. Compared with REOCs, REITs offer higher yields and income tax exemptions but have less operating flexibility to invest in a broad range of real estate activities and less potential for growth from reinvesting their operating cash flows because of their high income-to-payout ratios. In assessing the investment merits of REITs, investors analyze the effects of trends in general economic activity, retail sales, job creation, population growth, and new supply and demand for specific types of space. They also pay particular attention to occupancies, leasing activity, rental rates, remaining lease terms, in-place rents compared with market rents, costs to maintain space and re-lease space, tenants’ financial health and tenant concentration in the portfolio, financial leverage, debt maturities and costs, and the quality of management and governance. Analysts make adjustments to the historical cost-based financial statements of REITs and REOCs to obtain better measures of current income and net worth. The three principal figures they calculate and use are (1) funds from operations or accounting net earnings, excluding depreciation, deferred tax charges, and gains or losses on sales of property and debt restructuring; (2) adjusted funds from operations, or funds from operations adjusted to remove straight-line rent and to provide for maintenance-type capital expenditures and leasing costs, including leasing agents’ commissions and tenants’ improvement allowances; and (3) net asset value or the difference between a real estate company’s asset and liability ranking prior to shareholders’ equity, all valued at market values instead of accounting book values.

 REITs and some REOCs generally return a significant portion of their income to their investors and, as a result, tend to pay high dividends. Thus, dividend discount or discounted cash flow models for valuation are also applicable. These valuation approaches are applied in the same manner as they are for shares in other industries. Usually, investors use two- or three-step dividend discount models with near-term, intermediate-term, and/or long-term growth assumptions. In discounted cash flow models, investors often use intermediate-term cash flow projections and a terminal value based on historical cash flow multiples. IAS 40 Investment Property applies to the accounting for property (land and/or buildings) held to earn rentals or for capital appreciation (or both). Investment properties are initially measured at cost and, with some exceptions. may be subsequently measured using a cost model or fair value model, with changes in the fair value under the fair value model being recognised in profit or loss. IAS 40 was reissued in December 2003 and applies to annual periods beginning on or after 1 January 200

 History of IAS 40 Date Development Comments October 1984 Exposure Draft E26 Accounting for Investments published March 1986 IAS 25 Accounting for Investments issued Operative for financial statements covering periods beginning on or after 1 January 1987 July 1999 Exposure Draft E64 Investment Property published Comment deadline 31 October 1999 April 2000 IAS 40 Investment Property (2000) issued (Supersedes IAS 25 with respect to investment property) Operative for annual financial statements covering periods beginning on or after 1 January 2001 May 2002 Exposure Draft Improvements to International Accounting Standards (2000) published Comment deadline 16 September 2002 18 December 2003 IAS 40 Investment Property (2003) issued Effective for annual periods beginning on or after 1 January 2005 22 May 2008 Amended by Annual Improvements to IFRSs 2007 (include property under construction or development for future use within scope) Effective for annual periods beginning on or after 1 January 2009 12 December 2013 Amended by Annual Improvements to IFRSs 2011–2013 Cycle (interrelationship between IFRS 3 and IAS 40) Effective for annual periods beginning on or after 1 July 2014 8 December 2016 Amended by Transfers of Investment Property (Amendments to IAS 40) Effective for annual periods beginning on or after 1 July 2018

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 Related Interpretations None Amendments under consideration by the IASB None Summary of IAS 40 Definition of investment property Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both. [IAS 40.5] Examples of investment property: [IAS 40.8] land held for long-term capital appreciation land held for a currently undetermined future use

 building leased out under an operating lease vacant building held to be leased out under an operating lease property that is being constructed or developed for future use as investment property The following are not investment property and, therefore, are outside the scope of IAS 40: [IAS 40.5 and 40.9] property held for use in the production or supply of goods or services or for administrative purposes property held for sale in the ordinary course of business or in the process of construction of development for such sale (IAS 2 Inventories) property being constructed or developed on behalf of third parties (IAS 11 Construction Contracts) owner-occupied property (IAS 16 Property, Plant and Equipment), including property held for future use as owner-occupied property, property held for future development and subsequent use as owner-occupied property, property occupied by employees and owner-occupied property awaiting disposal property leased to another entity under a finance lease In May 2008, as part of its Annual improvements project, the IASB expanded the scope of IAS 40 to include property under construction or development for future use as an investment property. Such property previously fell within the scope of IAS 1 Other classification issues

 Property held under an operating lease. A property interest that is held by a lessee under an operating lease may be classified and accounted for as investment property provided that: [IAS 40.6] the rest of the definition of investment property is met the operating lease is accounted for as if it were a finance lease in accordance with IAS 17 Leases the lessee uses the fair value model set out in this Standard for the asset recognised An entity may make the foregoing classification on a property-by-property basis. Partial own use. If the owner uses part of the property for its own use, and part to earn rentals or for capital appreciation, and the portions can be sold or leased out separately, they are accounted for separately. Therefore the part that is rented out is investment property. If the portions cannot be sold or leased out separately, the property is investment property only if the owner-occupied portion is insignificant. [IAS 40.10] Ancillary services. If the entity provides ancillary services to the occupants of a property held by the entity, the appropriateness of classification as investment property is determined by the significance of the services provided. If those services are a relatively insignificant component of the arrangement as a whole (for instance, the building owner supplies security and maintenance services to the lessees), then the entity may treat the property as investment property. Where the services provided are more significant (such as in the case of an owner-managed hotel), the property should be classified as owner-occupied. [IAS 40.13]

  Rental Properties Owning rental properties can be a great opportunity for individuals who have do-it-yourself (DIY) renovation skills and the patience to manage tenants. However, this strategy does require substantial capital to finance upfront maintenance costs and to cover vacant months. Pros Provides regular income and properties can appreciate Maximizes capital through leverage Many tax-deductible associated expenses Cons Managing tenants can be tedious Potentially damage property from tenants Reduced income from potential vacancies \

  According to U.S. Census Bureau data, the sales prices of new homes (a rough indicator for real estate values) consistently increased in value from the 1960s to 2007, before dipping during the financial crisis. 1 Subsequently, sales prices resumed their ascent, even surpassing pre-crisis levels. 2 3 The long-term effects of the coronavirus pandemic on real estate values remain to be seen. Sales prices of new homes chart Source: Survey of Construction, U.S. Census Bureau Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

  4 Real Estate Investment Groups (REIGs) Real estate investment groups (REIGs) are ideal for people who want to own rental real estate without the hassles of running it. Investing in REIGs requires a capital cushion and access to financing. REIGs are like small mutual funds that invest in rental properties. 5 In a typical real estate investment group, a company buys or builds a set of apartment blocks or condos, then allows investors to purchase them through the company, thereby joining the group.

  A single investor can own one or multiple units of self-contained living space, but the company operating the investment group collectively manages all of the units, handling maintenance, advertising vacancies, and interviewing tenants. In exchange for conducting these management tasks, the company takes a percentage of the monthly rent. A standard real estate investment group lease is in the investor’s name, and all of the units pool a portion of the rent to guard against occasional vacancies. To this end, you'll receive some income even if your unit is empty. As long as the vacancy rate for the pooled units doesn’t spike too high, there should be enough to cover costs. Pros More hands-off than owning rentals Provides income and appreciation Cons Vacancy risks Fees similar to those associated with mutual funds

  Susceptible to unscrupulous managers House Flipping House flipping is for people with significant experience in real estate valuation, marketing, and renovation. House flipping requires capital and the ability to do, or oversee, repairs as needed. This is the proverbial "wild side" of real estate investing. Just as day trading is different from buy-and-hold investors, real estate flippers are distinct from buy-and-rent landlords. Case in point—real estate flippers often look to profitably sell the undervalued properties they buy in less than six months. Pure property flippers often don't invest in improving properties. Therefore, the investment must already have the intrinsic value needed to turn a profit without any alterations, or they'll eliminate the property from contention. Flippers who are unable to swiftly unload a property may find themselves in trouble because they typically don’t keep enough uncommitted cash on hand to pay the mortgage on a property over the long term. This can lead to continued, snowballing losses.

  There is another kind of flipper who makes money by buying reasonably priced properties and adding value by renovating them. This can be a longer-term investment, wherein investors can only afford to take on one or two properties at a time. Pros Ties up capital for a shorter time period Can offer quick returns Cons Requires a deeper market knowledge Hot markets cooling unexpectedly Real Estate Investment Trusts (REITs) A real estate investment trust (REIT) is best for investors who want portfolio exposure to real estate without a traditional real estate transaction. A REIT is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major exchanges, like any other stock. 6 A corporation must payout 90% of its taxable profits in the form of dividends in order to maintain its REIT status. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed on its profits and then have to decide whether or not to distribute its after-tax profits as dividends. 7 Like regular dividend-paying stocks, REITs are a solid investment for stock market investors who desire regular income. In comparison to the aforementioned types of real estate investment, REITs afford investors entry into nonresidential investments, such as malls or office buildings, that are generally not feasible for individual investors to purchase directly. More importantly, REITs are highly liquid because they are exchange-traded trusts. In other words, you won’t need a real estate agent and a title transfer to help you cash out your investment. In practice, REITs are a more formalized version of a real estate investment group.

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 Finally, when looking at REITs, investors should distinguish between equity REITs that own buildings and mortgage REITs that provide financing for real estate and dabble in mortgage-backed securities (MBS). Both offer exposure to real estate, but the nature of the exposure is different. An equity REIT is more traditional in that it represents ownership in real estate, whereas the mortgage REITs focus on the income from real estate mortgage financing. Pros Essentially dividend-paying stocks Core holdings tend to be long-term, cash-producing leases Cons Leverage associated with traditional rental real estate does not apply Online Real Estate Platforms Real estate investing platforms are for those who want to join others in investing in a bigger commercial or residential deal. The investment is made via online real estate platforms, which are also known as real estate crowdfunding. This still requires investing capital, although less than what's required to purchase properties outright.

 Online platforms connect investors who are looking to finance projects with real estate developers. In some cases, you can diversify your investments with not much money. Pros Can invest in single projects or portfolio of projects Geographic diversification Cons Tend to be illiquid with lockup periods Management fees Why Should I Add Real Estate to My Portfolio?

 Real estate is a distinct asset class that many experts agree should be a part of a well-diversified portfolio. This is because real estate does not usually closely correlate with stocks, bonds, or commodities. Real estate investments can also produce income from rents or mortgage payments in addition to the potential for capital gains. What Is Direct vs. Indirect Real Estate Investing? Direct real estate investments involve actually owning and managing properties. Indirect real estate involves investing in pooled vehicles that own and manage properties, such as REITs or real estate crowdfunding. Is Real Estate Crowdfunding Risky? Compared to other forms of real estate investing, crowdfunding can be somewhat riskier. This is often because crowdfunding for real estate is relatively new. Moreover, some of the projects available may appear on crowdfunding sites because they were unable to source financing from more traditional means. Finally, many real estate crowdfunding platforms require investors' money to be locked up for a period of several years, making it somewhat illiquid. Still, the top platforms boast annualized returns of between 2% and 20%, according to research.

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  The Bottom Line Whether real estate investors use their properties to generate rental income or to bide their time until the perfect selling opportunity arises, it's possible to build out a robust investment program by paying a relatively small part of a property's total value upfront. And as with any investment, there is profit and potential within real estate, whether the overall market is up or down. When you think about real estate investing, the first thing that probably comes to mind is your home. Of course, real estate investors have lots of other options when it comes to choosing investments, and they're not all physical properties. Real estate has become a popular investment vehicle over the last 50 years or so. Here's a look at some of the leading options for individual investors, along with the reasons to invest. KEY TAKEAWAYS Real estate is considered to be its own asset class and one that should be at least a part of a well-diversified portfolio.

  One of the key ways investors can make money in real estate is to become a landlord of a rental property. Flippers try to buy undervalued real estate, fix it up, and sell it for a profit. Real estate investment trusts (REITs) provide indirect real estate exposure without the need to own, operate, or finance properties. Historical Prices Real estate has long been considered a sound investment, and for good reason. Before 2007, historical housing data made it seem like prices could continue to climb indefinitely. With few exceptions, the average sale price of homes in the U.S. increased each year between 1963 and 2007—the start of the Great Recession. Home prices did take a small hit at the onset of the COVID-19 pandemic in the Spring of 2020. However, as vaccines were rolled out and pandemic concerns waned, home prices accelerated to reach all-time highs by 202 This chart from the Federal Reserve Bank of St. Louis shows average sales prices between 1963 and Q1 2022 (the most recent data available). The areas that are shaded in light grey indicate U.S. recessions. The most significant downturn in the real estate market before the COVID-19 pandemic coincided with the Great Recession. The long-term results of the coronavirus crisis have yet to be seen. Rental Properties If you invest in rental properties, you become a landlord—so you need to consider if you'll be comfortable in that role. As the landlord, you'll be responsible for things like paying the mortgage, property taxes, and insurance, maintaining the property, finding tenants, and dealing with any problems.

  Unless you hire a property manager to handle the details, being a landlord is a hands-on investment. Depending on your situation, taking care of the property and the tenants can be a 24/7 job—and one that's not always pleasant. If you choose your properties and tenants carefully, however, you can lower the risk of having major problems. One way landlords make money is by collecting rent. How much rent you can charge depends on where the rental is located. Still, it can be difficult to determine the best rent because if you charge too much you'll chase tenants away, and if you charge too little you'll leave money on the table. A common strategy is to charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. The other primary way that landlords make money is through appreciation. If your property appreciates in value, you may be able to sell it at a profit (when the time comes) or borrow against the equity to make your next investment. While real estate does tend to appreciate, there are no guarantees.

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  This is particularly true during periods of intense volatility in the real estate market, including most recently throughout the duration of the COVID-19 pandemic. From February 2020 to March 2022, median real estate prices in the U.S. rose by an astonishing 38%. The dramatic growth has left many wondering whether prices are due to crash. Flipping Houses Like the day traders who are leagues away from buy-and-hold investors, real estate flippers are an entirely different breed from buy-and-rent landlords. Flippers buy properties with the intention of holding them for a short period—often no more than three to four months—and quickly selling them for a profit. The are two primary approaches to flipping a property: Repair and update. With this approach, you buy a property that you think will increase in value with certain repairs and updates. Ideally, you complete the work as quickly as possible and then sell at a price that exceeds your total investment (including the renovations). Hold and resell. This type of flipping works differently. Instead of buying a property and fixing it up, you buy in a rapidly rising market, hold for a few months, and then sell at a profit.

  With either type of flipping, you run the risk that you won't be able to unload the property at a price that will turn a profit. This can present a challenge because flippers don’t generally keep enough ready cash to pay mortgages on properties for the long term. Still, flipping can be a lucrative way to invest in real estate if it's done the right way. REITs A real estate investment trust (REIT) is created when a corporation (or trust) is formed to use investors’ money to purchase, operate, and sell income-producing properties. REITs are bought and sold on major exchanges, just like stocks and exchange-traded funds (ETFs). 5 To qualify as a REIT, the entity must pay out 90% of its taxable profits in the form of dividends to shareholders. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed on its profits, thus eating into the returns it could distribute to its shareholders. 5 Much like regular dividend-paying stocks, REITs are appropriate for investors who want regular income, though they offer the opportunity for appreciation, too. REITs invest in a variety of properties such as malls (about a quarter of all REITs specialize in these), healthcare facilities, mortgages, and office buildings. In comparison to other types of real estate investments, REITs have the benefit of being highly liquid.

 Real Estate Investment Groups Real estate investment groups (REIGs) are sort of like small mutual funds for rental properties. If you want to own a rental property but don’t want the hassle of being a landlord, a real estate investment group may be the solution for you. A company will buy or build a set of buildings, often apartments, then allow investors to buy them through the company, thus joining the group. A single investor can own one or multiple units of self-contained living space. But the company that operates the investment group manages all the units and takes care of maintenance, advertising, and finding tenants. In exchange for this management, the company takes a percentage of the monthly rent. There are several versions of investment groups. In the standard version, the lease is in the investor’s name, and all of the units pool a portion of the rent to guard against occasional vacancies. This means you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company that offers it. In theory, it is a safe way to get into real estate investment, but groups may charge the kind of high fees that haunt the mutual fund industry. As with all investments, research is key.