With real estate a firm part of the capital allocation matrix for both institutional and retail investors, real estate funds have been seeing increasing growth recently. Due to the capital-intensive nature of real estate investing, its requirement for active management, as well as the rise in global real estate opportunities, institutions seeking efficient asset management are gradually moving to real estate funds of funds (FOF).
The same is true for retail investors, who now benefit from access to a much larger selection of real estate mutual funds than before, allowing for efficient capital allocation and diversification. Like any other investment sector, real estate has its pros and cons. It should, however, be considered for most investment portfolios, with real estate investment trusts (REITs) and real estate mutual funds seen as possibly the best methods of filling that allocation.
- Retail investors should consider real estate investment trusts (REITs) and real estate mutual funds for their investment portfolios.
- REITs typically own and operate real estate properties such as grocery-anchored shopping centers, malls, commercial office space, and hotels.
- Real estate mutual funds, which invest primarily in REIT stocks and real estate operating companies, can provide diversified exposure to real estate with a relatively small amount of capital.
- Many retail investors don't realize that they may already be investing in real estate by owning a home.
Challenges of Real Estate Investing
Real estate investment has long been dominated by large players: pension funds, insurance companies, and other large financial institutions. Thanks to the globalization of real estate investing and the emergence of new offshore opportunities, both allowing for a greater degree of diversification as well as return potential, there's a trend toward real estate having a permanent place in institutional portfolio allocations.
The permanent allocation of real estate capital comes with certain hurdles. First and foremost, it is capital intensive. Unlike stocks that can be purchased in small increments, commercial real estate investments require relatively large sums, and direct investment often results in lumpy portfolios and inordinate risks in either location or by property type. Real estate also requires active management, which is labor intensive. Compared to managing traditional investments, managing a real estate allocation requires significant resources.
As a result of these issues, aiming to increase management efficiency and capital distribution, institutions tend to gravitate toward real estate funds and funds of funds. These same advantages can be achieved by retail investors through REITs, REIT exchange-traded funds (ETFs), and real estate mutual funds. Here are several ways for retail investors to access the return potential of real estate and obtain exposure to the asset class.
This strategy relates to investors directly selecting specific properties. The great advantage of this strategy is control. Direct ownership of property allows for the development and execution of strategy, as well as direct influence over return. However, direct investment makes it very difficult to create a well-diversified real estate portfolio. For most retail investors, the real estate allocation is not large enough to allow the purchase of enough properties for true diversification; it also increases exposure to the local property market, as well as property-type risks.
Real Estate Investment Trusts (REITs)
REIT shares represent private and public equity stock in companies that are structured as trusts that invest in real estate, mortgages, or other real estate collateralized investments. REITs typically own and operate real estate properties. These may include multifamily residential properties, grocery-anchored shopping centers, local retail properties and strip centers, malls, commercial office space, and hotels.
Real estate investment trusts are run by a board of directors that makes investment management decisions on behalf of the trust. REITs pay little or no federal income tax as long as they distribute 90% of taxable income as dividends to shareholders. Even though the tax advantage increases after-tax cash flows, the inability of REITs to retain cash can significantly hamper growth and long-term appreciation. Apart from the tax advantage, REITs provide many of the same advantages and disadvantages as equities.
REIT managers provide strategic vision and make the investment- and property-related decisions, thus addressing management-related issues for investors. The greatest disadvantages of REITs for retail investors are the difficulty of investing with limited capital and the significant amount of asset-specific knowledge and analysis required to select them and forecast their performance.
REIT investments have a much higher correlation to the overall stock market than do direct real estate investments, which leads some to downplay their diversification characteristics. Volatility in the REIT market has also been higher than in direct real estate. This is due to the influence of macroeconomic forces on REIT values and the fact that REIT stocks are continuously valued, while direct real estate is influenced more by local property markets, and is valued using the appraisal method, which tends to smooth investment returns.
Investors who don't have the desire, knowledge, or capital to buy land or property on their own can participate in the income and long-term growth potential of real estate via real estate funds.
Real Estate Mutual Funds
Real estate mutual funds invest primarily in REIT stocks and real estate operating companies. They provide the ability to gain diversified exposure to real estate using a relatively small amount of capital. Depending on their strategy and diversification goals, they provide investors with a much broader asset selection than can be achieved by buying REIT stocks alone, and also provide the flexibility of easily moving from one fund to another. Flexibility is also advantageous to the mutual fund investor because of the comparative ease in acquiring and disposing of assets on a systematic and regulated exchange, as opposed to direct investing, which is arduous and expensive. More speculative investors can tactically overweight certain property or regional exposure in order to maximize return.
Creating exposure to a broad base of mutual funds can also reduce transaction costs and commissions relative to buying individual REIT stocks. Another significant advantage for retail investors is the analytical and research information provided by the funds on acquired assets, as well as management's perspective on the viability and performance of real estate, both as specific investments and as an asset class.
Although real estate mutual funds bring liquidity to a traditionally illiquid asset class, naysayers believe they cannot compare to direct investment in real estate.
Many retail investors who have not considered real estate allocations for their investment portfolios fail to realize that they may already be investing in real estate by owning a home. Not only do they already have real estate exposure, most are also taking additional financial risk by having a home mortgage. For the most part, this exposure has been beneficial, helping many amass the capital required for retirement.
The Bottom Line
Although retail investors can and should take into account home ownership when making their portfolio allocations, they might also consider additional, more-liquid investments in real estate. For those with the requisite trading skills and capital, REIT investing provides access to some of the benefits of real estate investing without the need for direct ownership. For others, who are considering a smaller allocation, or for those who don't want to be saddled with asset selection but who require maximum diversification, real estate mutual funds would be an appropriate choice.