Real Estate Investments

CFA Level 1 - Alternative Investments

What is Real Estate?

• It is a tangible asset.
• It is an immovable asset. Each real estate asset is a unique investment because of the property and buildings that can be built on it.
• Real estate can be very illiquid if the land and buildings are purchased outright. On the other hand, investors can enjoy higher liquidity if the same asset (either land or buildings) is purchased through a fund or some other vehicle.
• It can be divided among a pool of investors, and can be categorized by the way the property is used by the owners or tenants.
• Can be owned in various forms such as public, private or financed through equity of debt.

Forms of Real Estate Investments

1. Free and Clear Equity - A free and clear equity investment confers full ownership for an indefinite period of time. The investor gets all ownership rights. It is an outright purchase of the asset with no encumbrances.
2. Leverage Equity - Leverage equity has same ownership rights as free and clear equity but is subject to debt (promissory note) or a pledge (mortgage) to hand over those rights if payments and terms of the debt are not met.
3. Mortgages- Mortgages are debt investments in which the mortgage holder receives a stream of payments like a bondholder (principal and interest). Mortgage holders are a type of real estate investor because they are entitled to take possession of the real estate asset if the mortgagee defaults. Mortgages can include a clause for early prepayment, which impacts the investor's payment flows. Investors diversify their real estate portfolios by purchasing mortgages that vary in terms of region, duration of the mortgage and type of property (commercial, residential, etc.)
4. Aggregation Vehicles - Aggregation vehicles pool investors' funds together, giving them broader and deeper access to the real estate market.

These include:

• Real estate limited partnerships

allow groups of investors to participate in the real estate market with liability limited to the amount of their original investment. Management of the property is left to experts in the field. Like other limited partnerships, a real estate limited partnership is owned by one or more general partners who handle the organization's operations, and by one or more limited partners who participate financially but have no say in the management and operation of the partnership. For limited partners, the risk of loss is limited to their investment. Often, these partnerships are put together to build shopping centers or low-income housing. The appeal to investors is the special tax deductions they hold for developers and that are passed through to the investors. Unfortunately, most individual investors aren't in high enough income brackets to take full advantage of the deductions.

Limited partnerships can be purchased through stockbrokers. Because they are laden with high sales commissions and management fees, investment income - and therefore total return - is reduced accordingly. Limited partnerships are not liquid - selling a partnership interest in a timely fashion is often difficult. A five- to 20-year investment horizon is not uncommon. In many cases, the only option for cashing-out and liquidating the partnership interest is liquidation of the partnership itself.   In the past, real estate limited partnerships lost substantial amounts of money for a variety of reasons, including the impact of changes in federal income tax legislation.

• Commingled funds are pools of money made up of contributions from a number of different pension plans or other funds. The money is managed by a professional money manager, be it a bank, insurance company, or independent investment counselor. The fund contributes money to the pool, and it is mingled together - or "commingled" - with the assets of the manager's other clients. When these pools consist entirely of pension money, the commingled funds are tax exempt. Investors take profits on a pro rata basis according to the amount they invested in the fund. They can be open or closed end funds.
• REITs (Real Estate Investment Trusts) are a well-known type of closed end fund that buys, develops, manages and sells real estate assets. REITs allow participants to invest in a professionally-managed portfolio of real estate properties. They distribute or "pass-through" the majority of their cash flows to investors. Most REIT revenues come principally from the rental income their properties generate. In fact, most are actually restricted to generating only property rental income.  Since REITs are traded on the major exchanges, they are more liquid than limited partnerships and even compared to traditional private real estate ownership.

Equity REITS invest in and own properties (and are therefore responsible for the equity or value of their real estate assets). Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or purchase existing mortgages (or mortgage-backed securities). Most of their revenue comes from interest earned on the mortgage loans. Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages.

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