The very basics of real estate investment

  • 2002-10-10
  • Ieva Kvedaraviciene

When times are tough on the international financial markets and investors look around for other things to invest in, it is not just gold which catches their eyes.

Real estate too is often seen as a safe bet. Hence investors of all types are allocating increasing parts of their investment resources to real estate funds.

Funds such as the United States' REIT (Real Estate Investment Trusts), Germany's Immobilienfunds and many other real estate investors are currently seeing enormous influxes of capital.

Investors have as their ultimate goal the maximization of expected return for a given amount of risk or the minimization of the investment risk for a given level of expected return. Investment return can be earned in several different ways: investing in business, securities or bonds, holding a bank deposit or acquiring real estate.

Time periods vary from short to long term depending on the type of investment and investors profile.

Usually, real estate investments are long term but this also depends on the type of real property and the nature of the investor.

Real estate can be broadly classified as residential (family houses, single apartments), commercial (offices, shops, etc.), industrial (manufacturing facilities, warehouses), or agricultural (farmland, forestry).

Usually it is institutions which invest in commercial and industrial property, whereas individuals usually limit themselves to residential ownership, but both types of investment bring benefits.

Increases in the value of an asset over its purchase price benefit the owner when it comes to selling the property, but money is also to be made during ownership in the form of rents and other income.

The main benefits of owning real estate are:

Security: Land is virtually indestructible and buildings normally have a long life if maintained in a satisfactory condition. Physical risks such as fire or floods can be insured against.

Real estate cannot be substituted for anything else - everybody has to live or work somewhere.

An inflation hedge: It has often been said that real estate as a hedge against inflation is superior to other investments, although short-term fluctuations in capital values can be severe, due to the forces of demand and supply.

Rental income is one of the principal benefits for many types of project. With a full repairing lease tenants are responsible for building maintenance and insurance.

Appreciation: When a property changes in value some of the change may be due to inflation while some may result from changes in supply and demand in the real estate market. Changes in the value due to inflation do not affect the wealth of the investor, but changes in the relative value of real estate are relevant.

These relative price changes may occur for a variety of reasons including growth of companies utilizing the property, specific improvements on the land, a lack of supply of other objects of investment and shifts in the tastes and preferences of tenants.

The ability to control one's investment: Rather than having a passive investment where managerial decisions are made for the investor, such as an investment in stocks or bonds in a publicly traded companies, some investors want to manage their own investments directly. They want to be able to develop, modify, manage or change their real estate.

Finally, financial leverage is traditionally considered to be one of the principal benefits of investing in real estate.

Taking into account these benefits of investing in real estate, the main factors influencing real estate investments are:

Economic trends: Economic growth determines demand for real estate and determines the availability of financing.

Demographic factors and company growth and size. Growth in population and companies are a key determiner of the long-term value of real estate investments.

Supply factors: All investment markets are closely related to each other so a fall in one market can prompt a rise in another.

In general as a real estate market matures it becomes more institutionally driven.

As regards the Baltic real estate markets, foreign investors are realizing higher yields than in Western countries and with relatively low risk.

But real institutional investors are currently not investing in the Baltics as they are considered illiquid and the general investment objects too small.

The main type of new investors in the new future are therefore going to be smaller real estate trusts and individuals, and they will continue to demand higher yields than institutional ones.