In general, real estate refers to buildable lands and buildings, including residential homes, raw land and income-producing properties (such as warehouses, office and apartment buildings). Real estate is a type of tangible assets, which are investment assets that can be seen and touched. In contrast, financial assets are only recorded as pieces of paper.

There are plenty of ways to invest in real estate without owning, financing, and operating physical properties.

Overview of the Real Estate Market

Characteristics of real estate as an investable asset class:

• Properties are immovable and basically indivisible so they are illiquid.
• Every property is unique, primarily because no two properties can share the same location. In addition, terms and conditions of transactions may differ significantly. Therefore, properties are only approximately comparable to other properties.
• There is no national, or international, auction market for properties. Therefore it is difficult to assess the market value of a given property.
• Transaction costs and management fees for real estate investments are high.
• Real estate markets suffer inefficiencies because of the nature of real estate itself and because information is not freely available.

Forms of Real Estate Ownership

They may be classified along two dimensions, debt or equity based, and in private or public markets. There are many variations within the basic forms.

Direct ownership refers to full ownership rights for an indefinite period of time, giving the owner the right, for example, to lease the property to tenants and resell the property at will. Owners can borrow money. Leveraged ownership refers to the same ownership rights but subject to debt (such as a promissory note) and/or a pledge (mortgage) to hand over real estate ownership rights if the loan terms are not met. The benefits of of direct ownership are control, and tax benefits.

Mortgages represent a type of debt investment as a mortgage provides the investor a stream of bondlike payments. This is a form of real estate investment as the creditor may end up with owning the property being mortgaged. To diversify risks a typical investor often invests in securities issued against a pool of mortgages.

Aggregation vehicles aggregate investors and serve the purpose of giving investors collective access to real estate investments.

Real Estate Partnerships (RELPs). A RELP is a professionally managed real estate syndicate that invests in various types of real estate. The purpose of the RELP varies from raw land speculation to investments in income producing properties. Managers assume the role of general partner with unlimited liability, while other investors are treated like limited partners with limited liability.

Real Estate Investment Trusts (REITs). A REIT is a type of closed-end investment company that sells shares to investors and invests the proceeds in various types of real estate and real estate mortgages.

• It allows small investors to receive both the capital appreciation and the income returns without the headache of property management.
• Its shares are traded on a stock market.
• It provides a tax shelter.
• It also has strong restriction on the use, and distribution of funds.

Investment Categories

Residential properties: an individual or a family purchases a home. In most cases a financial institution makes a direct debt investment in the home by offering a mortgage. The largest sector of the real estate market by value and size is the residential real estate.

Commercial real estate: a direct equity and/or debt investment is made into a property which is then managed to generate economic benefit to the parties. It includes office building, shopping centers, and warehouses.

REIT investing: mortgage REITs invest in mortgages and equity REITs invest in commercial and residential properties.

Mortgage-backed securities (MBS): securitization of mortgages. MBS maybe issued privately or publicly.

Risk and Return Characteristics

There are different types of indices: appraisal indices, repeat sales indices and REIT indices. They are constructed differently and have their own limitations such as sample selection biases and understated volatility. They are not necessarily representative of the entire real estate universe due to different geographic concentrations, property types, and asset quality. The low volatility and low correlation with other asset classes may result from these limitations.

Real estate investing can be lucrative, but it's important to understand the risks. Key risks include bad locations, negative cash flow, high vacancies, and problem tenants. Other risks to consider are the lack of liquidity, hidden structural problems, and the unpredictable nature of the real estate market. Leverage also magnifies the effects of both gains and losses for both equity and debt investors.

Diversification Benefits

Due to real estate's moderate correlation with other asset classes, it has been demonstrated to reduce portfolio risk. However, during steep market downturns the correlations between equity REIT and other asset classes can be high.

Valuation

This last section was in previous years' required readings but not in this year's. It is presented here for reference purpose only.

There are three commonly used approaches to real estate market value:

The comparison sales approach uses as the basic input the sales prices of properties (benchmark value) that are similar to the subject property. The price must be adjusted to reflect its superiority or inferiority to comparable properties. This approach can give a good feel for the market.

The income approach calculates a property's value as the present value of all its future income. It assumes that the annual net operating income (NOI) of a property can be maintained at a constant level forever (that is, NOI is a perpetuity). The most popular income approach is called direct capitalization:

Net operating income (NOI) equals the amount left after subtracting vacancy and collection losses and property operating expenses from an income property's gross potential rental income.

The market capitalization rate is obtained by looking at recent market sales figures to determine the rate of return required by investors.

The discounted cash flow approach is a variation of the income approach.

The cost approach is based on the idea that an investor should not pay more for a property than it would cost to rebuild it at today's prices. It generally works well for new or relatively new buildings. Most experts use it as a check against a price estimate. Limitations:

• An appraisal of the land value is not always an easy task.
• The market value of an existing property could differ significantly from its construction cost.

An income-based or asset-based approach can be used to value a REIT.