Real Estate: Buying an investment property?

Traditionally, real estate investment has been considered a safe and profitable alternative. For many, it is a way to finance retirement due to its supposedly stable cash flows, in addition to the appreciation that is expected. However, this is not necessarily true.

In this piece, we will review some relevant considerations before deciding on real estate investment. We will start with the most traditional ones: diversification, liquidity, and financing; and we will end with others that are more specific, such as its risk hedging capacity, value creation, or as collateral for additional financing.

Diversification

Diversification is the most prominent issue when it comes to this type of investment. Many individuals participate in the real estate market directly through the purchase of a property. In such cases, the investor's equity ends up very concentrated in a single asset, exposing them to idiosyncratic risks that could be eliminated through diversification. In contrast, a diversified alternative to access the real estate market is through real estate mutual funds or through REITs, both of which also have the advantage of requiring lower minimums than those necessary to buy a home (so that the rest could be invested in diversified alternatives that consider other asset classes).

However, not all real estate funds are the same and they also carry risk. Moreover, some funds are also highly concentrated in certain types of properties, which limits diversification. This happens, for instance, with funds that diversify within a city, but not across cities. In that case, an alternative is to invest in foreign real estate funds.

Diversification, in any case, does not completely eliminate risk. The relevant question for the investor is whether they can bear those risks, avoiding at the same time those that can be eliminated through diversification. In the case of real estate investment, one of the important risks is the high correlation that these assets have with the economic cycle. Both the tolerance and capacity to assume risk should be evaluated in this regard.

Liquidity

In alternative assets in general, and in real estate in particular, illiquidity is an aspect that should concern investors. For example, during recessions, homeowners are reluctant to sell their homes at prices they consider low, even if they need cash or have other reasons to sell. Crucially, this also makes it harder to observe the market price at such a time. Many of these assets can be as volatile as stocks, but the lack of liquidity dampens reported volatility: the price seems to move less than it has actually varied. The same is observed in the United States now that interest rates have risen, as those who have secured a low-rate mortgage are not willing to move to a new home financed at higher rates, preventing us from observing more transactions, which would provide more information about the market price. Some managers can benefit from this dampened volatility: prices could appear higher than they actually are, meaning reported results will look better than they actually are.

Illiquidity is a problem and reflects part of the risky nature of these assets. That is why in finance we talk about a liquidity premium (which is actually a premium demanded by investors due to the illiquidity of a given asset). Other risks are given by falling rents or misse drent payments. These risks are much higher for those who decide to invest in the sector by buying only one or two properties, while they are lower (but still not zero) for those who invest through funds.

Funding

In addition, those who want to invest in a particular real estate asset must consider how to finance their strategy. Many do so through a mortgage loan. In some cases, more than one, in order to buy more than one property. Financing any investment with debt (leverage) has a multiplying effect on returns, so it is a widely used alternative to achieve higher profitability. But, just as higher returns can be obtained, the risks of greater losses are also amplified.

Hedging

Another relevant dimension that investors should consider is the degree of hedging provided by the real estate sector.

Hedging #1: Inflation

It is common to hear that real assets are a good hedge against inflation (just like, for example, commodities). However, two relevant points must be considered.

First, the cash flows generated by a real estate asset are not necessarily protected against inflation (although some leases may be indexed to inflation). A contract that is adjusted every six months or a year already suffers from a lag with respect to inflation. Additionally, there may be potential costs associated with renegotiating rents (for example, higher tenant turnover).

Second, there are other alternatives to hedge against inflation: stocks, inflation-protected bonds, and commodities that, together, may be more appropriate for many investors.

Hedging #2: Rent Risk

When it comes to real estate assets purchased for personal use, such as a house or an office, it is important to evaluate whether renting offers a better alternative. Buying, as already mentioned, entails a high concentration of assets, but it also provides a benefit of hedging against the volatility of the rental market. In the case of purchases financed with mortgage loans, the monthly payment is many times fixed (although in many countries variable rates are the norm). Of course, if rents fall, the tenant stands to benefit, while the buyer does not.

Other costs and benefits

Finally, as with any investment, it is also important to understand the tax implications, which will depend on the particular type of real estate and its geographical location. For example, mortgage interest payments and sales of certain properties have tax benefits in some jurisdictions. In addition, real estate assets can be used as collateral to access financing for other purposes (they are mortgaged to reduce creditor risk), especially in contexts where creditors have little protection. In developed markets such as the United States, it is very common to receive cash from a loan where a real estate asset is mortgaged (equity release). There are even reverse mortgages, where elderly people receive monthly cash flows leaving property as collateral, basically transforming home equity into cash income.

Final Considerations for Retail Investors

Before buying a property strictly for investment purposes, individual investors should ask themselves if they want to incur the risks that such an investment entails. Firstly, there is very little diversification achieved. By buying one or two properties, in many cases located in the same city where the investor resides, the investor is exposed to the economic cycle of the same country and region they reside in and, furthermore, they will see their returns severely affected if just one of their properties loses value or fails to produce the expected cash flows (if the rental price drops or the tenant defaults). In a diversified portfolio, if a stock fails to pay the expected dividend or a company fails to pay the coupons of a bond, the impact on the investor's wealth will be much smaller, as it is highly probable that other holdings in the portfolio will buffer or even offset that particular loss. Moreover, a property can be an illiquid asset, especially during periods of low economic growth. That is, if an investor needs to access cash, a portfolio of publicly traded stocks and fixed income instruments would allow for much quicker access to liquidity. Some of these problems will persist even if the properties purchased are overseas or if the investment is made through funds that are highly concentrated (i.e., they do not offer adequate diversification, or penalize withdrawals).

It is recommended that investors analyze their particular circumstances with their financial advisor, evaluating the potential returns and risks of each alternative, taking into account their individual risk tolerance and capacity.