By Ian Woychuk, CFA
The most basic definition real estate is "an interest in land". Broadening that definition somewhat, the word "interest" can mean either an ownership interest (also known as a fee-simple interest) or a leasehold interest. In an ownership interest, the investor is entitled to the full rights of ownership of the land (for example, to legally use and transfer the title of the land/property), and must also assume the risks and responsibilities of a landowner (for example, any losses as a result of natural disasters and the obligation to pay property taxes). On the other side of the relationship, a leasehold interest only exists when a landowner agrees to pass some of his rights on to a tenant in exchange for a payment of rent. If you rent an apartment, you have a leasehold interest in real estate. If you own a home, you have an ownership interest in that home. Some jurisdictions recognize other interests beyond these two, such as a life estate, but those interests are less common in the investment arena.
As a real estate investor, you will most likely be purchasing ownership interests and then earning a return on that investment by issuing leasehold interests to tenants, who will in turn pay rent. It is also not uncommon for an investor to acquire a long-term leasehold interest in land, which then has a building constructed upon it. At the end of the land lease, the land and building become the property of the original land-owner.
Private Versus Public Markets
When you are planning your real estate investments, one of your first tasks is to decide what kind of exposure to the real estate market is appropriate for your situation. Different exposures produce varying levels of risk and return. Your choice will also influence the means by which you will acquire the real estate.
The first type of market you could participate in is the private market. In the private market, you would be purchasing a direct interest in one or more real estate properties. You would own and operate the piece of real estate yourself (or through a property manager), and you would receive the rent payments and value changes from that investment. For example, if you were to purchase an industrial building that was leased to one or more tenants who pay you rent, you would be participating in the private real estate market. You could also participate in this market by purchasing properties with any number of partners - this is known as a pool or syndicate.
Alternatively, you could choose to invest in the public real estate market. You would be participating in the public market if you purchased a share or unit in a publicly traded real estate company, such as a real estate investment trust (REIT). If you buy a real estate security, you are investing in a company that owns real estate and manages it on behalf of the shareholders/unit-holders of the company. As a result, your exposure to the real estate market is more indirect. A real estate security usually pays a dividend or distribution in order to send the rent payments that it receives from tenants to its shareholders/unit-holders. Any price appreciation or depreciation in the assets owned by the company is reflected in its share or unit price.
(We will discuss REIT investments and their characteristics in greater detail in Chapter 6.)
Equity and Debt Investments
In addition to choosing your market, you need to choose whether to invest in debt or equity.
When you invest in debt, you are lending funds to an owner or purchaser of real estate. You receive periodic interest payments from the owner and a security charge against the property in the form of a mortgage. At the end of the mortgage term, you get back the balance of your mortgage principal. This type of real estate investing is quite like that of bonds. (To read more about mortgages, see Shopping for a Mortgage, Understanding the Mortgage Payment Structure and Paying Off Your Mortgage.)
An equity investment, on the other hand, represents a residual interest in the property. When you are an equity investor, you are essentially the owner of the property. You stand to gain a lot when the property value increases or if you are able to get more rent for your building. However, if things should go wrong (for example, all your tenants vacate and you can't make your mortgage payment) then the mortgagee, who has a priority interest in your property, may foreclose and you must forfeit your equity position to satisfy their security. In that sense, the risks of an equity position in real estate is much like that of owning stock.
The choice of whether you want to invest in equity or debt will depend upon your risk tolerance and your return expectations. The riskier choice is investing in equity, but you can also make a lot more money! As the greater the risk, the greater the reward. (To find out where your risk tolerance lies, see Determining Risk And The Risk Pyramid.)
The Investment Selection Matrix
Now, let's put it all together.
Once you select your market and decide whether debt or equity investing is appropriate, it becomes apparent what type of security to buy or investment to make. Take a look at the following diagram:
If you choose quadrant A, Public Equity, you should purchase real estate securities such as standard equity REITs or publicly traded real estate operating companies.
If you select quadrant B, Private Equity, you should buy direct, ownership interests in real estate properties.
If you choose quadrant C, Public Debt, you would purchase a mortgage REIT, a mortgage-backed securities (MBS) or (Commercial Mortgage-Backed Securities (CMBS).
If quadrant D, Private Debt, is most appropriate, then you would lend money to purchasers of real estate, thereby investing in mortgages.
(We will expand our discussion of some of these investment structures in Chapter 6.)
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