What good is real estate?
Photo: Joao Pacheco. Source: Picjumbo
I don’t mean as a place to live. Everyone needs four walls and a roof. I’m talking about real estate as an investment.
Lots of people consider investing in real estate. By this they usually mean private real estate—buying a small apartment or office building and renting out the space. There may be a lot of specific, local demand for living and working space: college students cycling through; young couples relocating to an area; small businesses starting out; and so on. But there’s also a lot of specific risk that goes along with local real estate—the local economy, local zoning laws, local property managers. And individual properties aren’t very liquid. The easiest way to invest in real estate is through a fund or real estate investment trust (REIT), which may have certain tax advantages.
Along with stocks and bonds, real estate is a major asset class. It’s estimated that the total value of commercial property in the United States is around $10 trillion. In a sense, income property is a kind of hybrid security. The lease income that comes from tenants is like a portfolio of short-term bonds, and the property owner holds a call option on the residual equity—benefitting from growth.
So a property’s value is determined by its rental income after all expenses, along with its growth prospects. That income can be compared with bond income. Real estate values are closely linked to interest rates and the economy. Rental income may go up with inflation, but if the economy weakens, that income can fall as well—as rents and occupancy fall. Returns are made up of income returns and price changes, just like stocks and bonds. Because of its nature, real estate returns can be uncorrelated with those of other asset classes.
Real estate can provide a diversified source of return for many investors. But it’s important to think clearly. All property is local, and local conditions will dominate any local investment. But diversified funds like REITs can enhance a portfolio.
Douglas R. Tengdin, CFA
Chief Investment Officer