Real Estate Investing - Real Value


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A discussion on why real estate ia a \'real\' store of value and why it is a good time to invest.

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Real Estate Investing - Real Value

  1. 1. Real Value_Apr09:Purpose_July06 4/21/09 4:48 PM Page 32 cover story may 2009 By Ahsan Ali Real Value Is Real Estate Investment Still a Wise Choice? 32
  2. 2. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 33 As a rule of thumb, if price growth is outstripping rental growth by 25% over a 12- month period, do not buy! With the global markets in a tailspin, investment appetite has vanished. The impact is much more profound for the supposed culprit – real estate. The “real” in real estate is up for debate. But despite everything, real estate is still a viable investment. 33
  3. 3. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 34 cover story may 2009 The Basics minimum investment horizons mean that this asset Real estate has been an established investment class class should be selected with care. since the earliest historical records. Real estate own- The conversion of real estate to cash is usually not a Like all other investments, real ership initially was the domain of royalty and the simple process and can take between weeks and estate is all about wealthy, before land reforms, urbanization and indus- months. Real estate investment trusts (REITs) are timing. trialization, and implementation of legal systems securities on pools of real estate which are designed evolved this into a viable investment. to reduce the illiquidity by enabling investors to opt in Real estate is generally classified into residential or opt out at any given point in time. Even then, (apartments, villas, houses, townhouses, condomini- because of the underlying factors, this ability is limit- ums etc,), commercial (office buildings, retail space, ed. etc.), industrial (factory premises, warehouses etc.) Real estate requires regular maintenance and and land (developed and undeveloped). upkeep. This can be quite time consuming and prob- The investment returns on real estate can be com- lematic and can impact the investor’s cash flows. pared to a traditional bond. The range of the return varies from: Intrinsic Value • Conservative returns: Coupon (rental) with capital Unlike stocks and bonds, real estate has an “intrin- (value) net of transaction cost. sic” and “affinity” value. A holding period in excess of • Moderate returns: Coupon (rental) with capital 25 years demonstrates that the intrinsic value of the (value) net of transaction cost, plus capital gain equal property persists even when the depreciation is to prevailing deposit rates/inflation. 100%, i.e., terminal value of land, listing as heritage • Aggressive returns: Coupon (rental) with capital site, etc. Some properties have emotional appeal (value) net of transaction cost, plus capital gain based on previous ownership, aspirational value, exceeding prevailing deposit rates/inflation. location or other characteristics. The value of real estate compared to its rental yield Information pools on real estate tend to be localized is effectively the equivalent of the price-to-earnings by neighborhood. This is crucial; as an asset class, valuation methodology for stocks. It is important to this means that homogenous analysis is not possible, understand and quantify the return element for real as the investment returns can vary between two estate, as this should drive buy/sell decisions for the streets in the same neighborhood. The level of infor- investors. mation expertise to generate excess return only Price and rentals mechanics are driven by realistic exists with the local real estate agent. demand and supply mechanics. Short-term aberra- tions tend smooth themselves out within a short peri- When to Buy and Sell od. In the long run, location, amenities, community, Like all other investments, real estate is all about tim- access, safety, recreational areas and other related ing. The distinct disadvantage stems from the fact items drive the demand for any locality. that real estate is the most affordable (lax credit Legislation, social security, employment creation and terms) at the worst possible time to buy. So how do tax incentives are just some variables impacting real you identify the right timing? By monitoring the fol- estate. Government policies have a tangible and lowing three things: direct influence on this investment class. 1. House Price to Rental Index Disadvantages Common sense dictates that housing prices and The real estate market is prone to distortion from rentals should rise more or less in unison. An speculative influences. The availability of credit for excess demand for housing raises rentals, in turn large segments of society tends to mushroom raising house prices. This gives builders incentive demand and induce speculative transactions for to construct additional housing, inducing new resi- short-term gain. Excess liquidity from REITs, funds dents to move to these projects, thus stabilizing and other instruments tend to “crowd” investment in prices and rentals. The rental and pricing differenti- attractive areas, creating artificial demand and dis- ation then happens because of location, communi- torting prices. ty, established amenities, etc. Even then, the high- Real estate is not a “liquid investment.” Always er-priced real estate attracts a higher rental rate, so assume a minimum of medium term (in excess of five as a ratio (house price/rental), an equilibrium point years). Real estate can be a store of value, but the is reached. 34
  4. 4. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 35 Median US Home Price Relative to Owner’s Rent Source: National Association of Realtors, U.S. Department of Labor As the graph points out, any disturbance from the As a rule of thumb, if price growth is outstripping rental point of equilibrium has to be either due to excep- growth by 25% over a 12-month period, do not buy! tional demand (population displacement, natural dis- asters, massive surge in population due to emigra- 2. Global Trends tion, etc.) or is pure speculation. The consequences Real estate markets tend to exhibit similar trends are quite evident, as seen in the decline from 2007 globally. The important thing to realize when a trend until now. is forming. Source: IPD, NCREIF 35
  5. 5. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 36 cover story may 2009 By 2006, end real estate returns (local currency 3. Mortgage Data as a Predictor nominal returns) were dipping in most countries. As Mortgage delinquencies, or the inability of customers is evident, real estate returns tend to move in a to repay their mortgage installments on time, is a “band” with very few outliers (in this graph, South leading indicator of things to come. If the level of Africa). Looking at the trend in this graph, most of the delinquencies is shooting up, it is inevitable that fore- returns seem to have either plateaued or declined in closures and auctions will follow. the last period. Not a good indicator for increasing exposure to real estate. Mortgage Default Rates Source: Freddie Mac, March 27, 2008 Decades of credit behavior show that a mortgage sionary phase should not be how much return can be loan is the last commitment that a borrower reneges generated, but rather, how long investment can be on. The pyramid of default usually starts from unse- held before divestment. cured debt (credit cards, store cards, personal loans, etc.) to vehicle loans and finally, when the consumer has no other option, mortgages. To summarize the price/earnings indexes, trends and mortgage data highlight the key characteristics of real estate drivers, such as speculative influences, Recession demand-supply imbalances, excess liquidity, lax cred- provides the savvy investor it rules, potential defaults, employment outlook, con- with great sumer confidence, etc. When viewed together, they opportunities, as provide a very good macro insight on whether to buy, long as the sell or stay put. investment objectives are clear. Recessionary Investment Recession provides the savvy investor with great opportunities, as long as the investment objectives are clear. The key question for the investor in a reces- 36
  6. 6. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 38 cover story may 2009 Past and Ongoing Real House Price Cycles and Banking Crises: Peak-to-trough Price Declines (left panel) and Years Duration of Downturn (right panel) As the graph shows, the average price decline a six-year holding period can be almost 36%. The during banking crises has been 35.5% and recov- important point is the realization of the holding ery has taken an average of six years. What is period. important to note is that aside from the notable exception of Japan, in all other countries, house Why Real Estate Even Now? prices actually clawed back the loss in value and As mentioned earlier, real estate is a “tangible” store posted significant gains even beyond that. For the of value. This commonsensical view is borne out by keen real estate investor, the average return over an empirical study conducted by MIT. 38
  7. 7. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 39 The returns generated on purchase and subse- quent sales of homes in the U.S. were measured over a 27-year period. The graph above depicts 406 investment periods; for example, a property bought in 1983 and sold in 1986 generated an average return of 11.6%. The astonishing fact that emerges is that in only 11 (2.7%) of the 406 Ahsan Ali is head of investment periods were the returns actually neg- Wealth Management and SME Banking for ative! This once again points out the fact that real Noor Islamic Bank in estate over a longer investment horizon is a viable Thinking Things Out the UAE. An avid investment alternative. The major keys to real estate investing include: supporter of CSR and development initiatives, With the global equity markets in disarray, a 1. Clarity of investment objectives (rental yield, he is involved in strong point for real estate is the negative corre- investment horizon, capital appreciation, etc.). mentoring, training and lation between real estate and pretty much every- 2. A good sense of timing for the investment on program management thing else. When the world is going one way, real the basis of available macro research. with various public- private partnerships. He estate should go the other way. 3. The ability to take an educated contrarian view holds an MBA from the during economic downturns. Institute of Business 4. The ability to prudently leverage to obtain the Administration, Karachi University, as well an best results. MS in Financial With a well thought-out approach, real estate will Economics from the remain a wise investment alternative. School of Oriental and African Studies, London. Ali is a CFA Charter Holder, an FRM certified risk manager and a member of the Securities and Investment Institute (SII), UK. 39