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.


<ul><li> 1. Real Value_Apr09:Purpose_July06 4/21/094:48 PM Page 32cover story may 2009 Ahsan AliReal ValueIs Real Estate Investment Still a Wise Choice? 32 </li></ul> <p> 2. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 33As a rule ofthumb, if price growth is outstripping rental growth by25% 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. Real Value_Apr09:Purpose_July064/21/094:50 PMPage 34cover storymay 2009 Basics minimum investment horizons mean that this assetReal 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, realership initially was the domain of royalty and the simple process and can take between weeks and estate is all aboutwealthy, before land reforms, urbanization and indus-months. Real estate investment trusts (REITs) aretiming. trialization, and implementation of legal systemssecurities on pools of real estate which are designedevolved this into a viable investment. to reduce the illiquidity by enabling investors to opt inReal 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 andand 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 investors cash flows.pared to a traditional bond. The range of the returnvaries 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 isto 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 yieldInformation pools on real estate tend to be localizedis 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 realas the investment returns can vary between twoestate, as this should drive buy/sell decisions for thestreets in the same neighborhood. The level of infor-investors. mation expertise to generate excess return onlyPrice and rentals mechanics are driven by realisticexists 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 Sellod. 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 factitems drive the demand for any locality. that real estate is the most affordable (lax creditLegislation, social security, employment creation andterms) at the worst possible time to buy. So how dotax incentives are just some variables impacting realyou identify the right timing? By monitoring the fol-estate. Government policies have a tangible andlowing three things:direct influence on this investment class. 1. House Price to Rental IndexDisadvantagesCommon sense dictates that housing prices andThe real estate market is prone to distortion from rentals should rise more or less in unison. Anspeculative influences. The availability of credit for excess demand for housing raises rentals, in turnlarge segments of society tends to mushroomraising house prices. This gives builders incentivedemand and induce speculative transactions for to construct additional housing, inducing new resi-short-term gain. Excess liquidity from REITs, fundsdents to move to these projects, thus stabilizingand other instruments tend to crowd investment inprices 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, soassume a minimum of medium term (in excess of five as a ratio (house price/rental), an equilibrium pointyears). Real estate can be a store of value, but the is reached. 34 4. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PMPage 35 Median US Home Price Relative to Owners Rent Source: National Association of Realtors, U.S. Department of LaborAs the graph points out, any disturbance from theAs 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 2007globally. The important thing to realize when a trend until now. is forming. Source: IPD, NCREIF 35 5. Real Value_Apr09:Purpose_July064/21/094:50 PM Page 36cover story may 2006, end real estate returns (local currency 3. Mortgage Data as a Predictornominal returns) were dipping in most countries. AsMortgage delinquencies, or the inability of customersis evident, real estate returns tend to move in ato repay their mortgage installments on time, is aband with very few outliers (in this graph, Southleading indicator of things to come. If the level ofAfrica). 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 increasingexposure to real estate.Mortgage Default RatesSource: Freddie Mac, March 27, 2008 Decades of credit behavior show that a mortgagesionary phase should not be how much return can beloan is the last commitment that a borrower renegesgenerated, but rather, how long investment can beon. 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 consumerhas no other option, mortgages.To summarize the price/earnings indexes, trendsand mortgage data highlight the key characteristicsof real estate drivers, such as speculative influences,Recessiondemand-supply imbalances, excess liquidity, lax cred-provides thesavvy investorit rules, potential defaults, employment outlook, con- with greatsumer confidence, etc. When viewed together, theyopportunities, asprovide a very good macro insight on whether to buy,long as thesell or stay put. investmentobjectives are clear.Recessionary InvestmentRecession provides the savvy investor with greatopportunities, as long as the investment objectivesare clear. The key question for the investor in a reces- 36 6. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PM Page 38cover story may 2009 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 declinea six-year holding period can be almost 36%. Theduring banking crises has been 35.5% and recov-important point is the realization of the holdingery has taken an average of six years. What is period.important to note is that aside from the notableexception of Japan, in all other countries, houseWhy Real Estate Even Now?prices actually clawed back the loss in value andAs mentioned earlier, real estate is a tangible storeposted significant gains even beyond that. For the of value. This commonsensical view is borne out bykeen real estate investor, the average return over an empirical study conducted by MIT. 38 7. Real Value_Apr09:Purpose_July06 4/21/09 4:50 PMPage 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 406Ahsan 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 realNoor Islamic Bank in estate over a longer investment horizon is a viableThinking Things Outthe 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, a1. 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 onprogram management thing else. When the world is going one way, realthe 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 theduring economic downturns. Institute of Business4. The ability to prudently leverage to obtain the Administration, Karachi University, as well anbest results.MS in FinancialWith a well thought-out approach, real estate will Economics from theremain 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 </p>