With real estate being a part of the capital allocation decisions of both institution and retail investors, there has been increasing development in real estate funds. Due to the capital intensity of real estate investing, its requirement for active management and the rise in global real estate opportunities, institutions are gradually moving to real estate funds of funds to allow for appropriate asset management.
The same is true for retail investors, who now have a much larger selection of real estate mutual funds, allowing for efficient capital allocation and diversification. Like any other investment sector, real estate has its benefits and its disadvantages. However, real estate should be considered for most investment portfolios, and real estate investment trusts (REITs) and real estate mutual funds may be the best methods to fill that allocation.
Real Estate for Institutional Investors
Real estate investment has long been dominated by large investors, such as pension funds, insurance companies and other large financial institutions. Thanks to the globalization of real estate investing and new offshore opportunities, both of which allow for greater diversification and return potential, there is an increasing trend toward finding a permanent place for real estate in institutional portfolio allocations.
The permanent allocation of real estate capital comes with some hurdles. First and foremost, it is capital intensive. Unlike stocks that can be purchased in small increments, commercial real estate investments require relatively large sums, and direct investment often results in lumpy portfolios and inordinate risks in either location or by property type. Real estate also requires active management, which is labor intensive. Managing a real estate allocation requires significant resources relative to traditional investments. As a result of these issues, institutions tend to gravitate toward real estate funds and funds of funds, in order to increase management efficiency and capital distribution. The same advantages that institutions gain from real estate funds can be achieved by retail investors through REITs, REIT exchange-traded funds (ETFs) and real estate mutual funds.
The following are several ways that retail investors can access the return potential of real estate and obtain exposure to the asset class.
This strategy relates to investors directly selecting specific properties. The great advantage in this strategy is control. Direct ownership in property allows for the development and execution of strategy and direct influence over return. However, direct investment makes it very difficult to create a well diversified real estate portfolio. The real estate allocation for most retail investors is not large enough to purchase enough properties to diversify and will increase exposure to local property market and property type risks.
Real Estate Investment Trusts (REIT)
REIT shares are private and public equity stock in companies structured as trusts that invest in real estate, mortgages or other real estate collateralized investments. REITs typically own and operate real estate properties. These may include multifamily residential properties, grocery-anchored shopping centers, local retail properties and strip centers, malls, commercial office space and hotels.
Real estate investment trusts are run by a board of directors that conducts investment management decisions on behalf of the trust. REITs pay little or no federal income tax as long as they distribute 90% of taxable income as dividends to shareholders. Even though the tax advantage increases after-tax cash flows, the inability for REITs to retain cash can significantly hamper growth and long-term appreciation. Apart from the tax advantage, REITS provide many of the same advantages and disadvantages as equities.
Because REIT managers provide the strategic vision and make the investment and property decisions, they reduce management issues for investors. For retail investors, the greatest disadvantage is the difficulty in investing in them with limited capital and the significant amount of asset-specific knowledge and analysis required in selecting them and forecasting their performance.
REIT investments have a much higher correlation to the overall stock market than direct real estate investments, which leads some to downplay their diversification abilities. Volatility in the REIT market has also been higher than direct real estate. Explanations for this is due to the influence of macroeconomic forces on REIT values and the fact that REIT stocks are continuously valued, while direct real estate is influenced more by local property markets and is valued using the appraisal method, which tends to smooth investment returns
Real Estate Mutual Funds
Real estate mutual funds invest primarily in REIT stocks and real estate operating companies. They provide the ability to gain diversified exposure to real estate with a relatively small amount of capital. Depending on their strategy and diversification goals, they provide investors with much broader asset selection than can be achieved in buying REIT stocks alone and also provide the flexibility of easily moving from one fund into another. Flexibility is also advantageous to the mutual fund investor due to the comparative ease in acquiring and disposing of assets on a systematic and regulated exchange, as opposed to direct investing which is arduous and expensive. More speculative investors can tactically overweight certain property or regional exposures to maximize return.
Creating an exposure to a broad base of mutual funds can also reduce transaction costs and commission relative to buying individual REIT stocks. Another significant advantage to retail investors is the analytical and research information provided by the funds on acquired assets and management's perspective on the viability and performance of specific real estate investments and as an asset class.
Real estate funds allow investors who do not have the desire, knowledge or capital to buy land or property on their own to participate in the income and long-term growth potential of real estate. Although real estate mutual funds bring liquidity to a traditionally illiquid asset class, naysayers on the use of these funds believe they are not akin to direct investment in real estate.
Many retail investors who have not considered real estate allocations for their investment portfolios fail to realize that they may already be investing in real estate by owning a home. Not only do they already have real estate exposure, most are also taking additional financial risk by having a home mortgage. For the most part, this exposure has been beneficial and has helped many people amass the capital required for retirement.
The Bottom Line
Although retail investors can and should take into account home ownership when conducting their portfolio allocations, additional, more liquid investments in real estate might also be considered. For those with the requisite trading skills and capital, REIT investing provides access to some of the benefits of real estate investing without the need for direct ownership. For others considering a smaller allocation or for those that do not want to be saddled by asset selection but require maximum diversification, real estate mutual funds would be an appropriate choice.
More From Investopedia
- Moving Up: Dream House Or Money Pit?
- 5 Mistakes That Make House Flipping A Flop
- 10 Habits Of Successful Real Estate Investors
- Real Estate
- real estate investing
- real estate investment trusts
- real estate
- mutual funds