The most basic definition of 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 get a leasehold interest in real estate. If you own a home, you should have an ownership interest in that home. Some jurisdictions recognise 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 vs. 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 risks and returns. 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 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 bought a real estate security, you would be 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 would be 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.
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 lend funds to an owner or purchaser of a 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 investment is quite like that of bonds.
An equity investment, on the other hand, represents a residual interest in the property. When you are an equity investor, you essentially become 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, should things go wrong (for example, all your tenants vacate and you are unable to make your mortgage payment), then the mortgagee, who has a priority interest in your property, may foreclose and you would have to forfeit your equity position to satisfy their security.
In that sense, the risks of an equity position in real estate are more like those of owning a 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 in investing in equity, but you can also make a lot more money! As the greater the risk, the greater the reward.
The Investment Selection Matrix
Now, let’s put it all together. Once you select your market and decide whether debt or equity investment is appropriate, it becomes apparent what type of security to buy or investment to make. Take a look at the following diagram:
If you chose quadrant A, Public Equity, you would purchase real estate securities such as standard equity REITs or publicly traded real estate operating companies.
If you selected quadrant B, Private Equity, you would buy direct, ownership interests in real estate properties.
If you chose quadrant C, Public Debt, you would purchase a mortgage REIT, a mortgage-backed securities (MBS) or (Commercial Mortgage-Backed Securities (CMBS).
If you found quadrant D, Private Debt, most appropriate, then you would lend money to purchasers of real estate, thereby investing in mortgages.
Next time, we will cover the types of real estate together before we zero in on financing.