Historically, an investment in direct real estate has been attractive for the following reasons:
- Investors benefit from the expectation of earning an income as they collect rental payments from tenants
- Investors can expect a capital return as the value of the investment increases over time
- Direct property acts as an inflation hedge, as investors can reasonably expect rental income and property values to rise in line with inflation
- Investors can use debt financing as a means to amplify their returns, as long as the yield of the property exceeds the cost of funding. Naturally, this can work both ways.
DIRECT PROPERTY: DRAWBACKS
On the whole, investment in direct property can be highly profitable if done correctly. However, there are also a few drawbacks:
- Management of the property requires expertise and time. If not managed correctly, capital and income loss can be expected
- Unexpected inflation, especially of operating costs, can reduce prospective returns if the investor is unable to pass this on to the tenant
- The cost and availability of capital to acquire the asset may be in short supply and prevent the initial investment occurring
- The time and costs associated with conducting due diligence on a potential investment will reduce prospective returns.
So how can investors be exposed to real estate-related returns without the drawbacks of holding a direct investment? The answer is to invest in listed property, which enables participation in real estate returns ‘indirectly’.
There are two main types of listed equity property investments:
- Capital-focused funds, which concentrate primarily on growing the net asset value (NAV) of their underlying property portfolio. The implication is that shareholder return is focused purely on capital growth of the property portfolio, with no distribution or yield, as the profits are continually reinvested back into the business
- An investment in real estate investment trusts (REITs), which pay out biannual distributions to their shareholders, as they focus on income generation from their property portfolio. Active management is integral to growing the distributions received by investors.
LISTED PROPERTY: ADVANTAGES
The advantages of investing in listed property include:
- Publicly traded real estate securities are far more liquid than physical real estate as securities are traded daily on the stock exchange
- Less capital is required to participate in real estate returns since individual shares can be bought, as opposed to an entire property
- Investors have access to professional management teams responsible for the daily operations of the properties and allocation of capital to drive profit. Additionally, specialist debt management is provided, which often translates into higher returns
- Investors are able to invest in premium properties and share in returns that were previously inaccessible. Shares in listed real estate that have invested in these buildings allow ownership stakes in these assets
- Limited liability is afforded to investors, who stand to lose only what they’d initially invested
- The exchange on which listed property trades requires stringent financial reporting, disclosure and governance often not evidenced in private transactions.
Qualifying REITs on the stock exchange are also exempt from corporate tax, as a REIT distribution is considered to be a return of capital. However, investors won’t escape tax – they’ll be taxed on their distributions at their respective income levels.
PREDICTABLE EARNINGS
REITs provide a relatively predictable earnings stream as their income generation is fixed by contracts between the landlord and tenants. The predictability of earnings and the high yield offered by REITs – they’re required to pay out 75% of distributable earnings – are attractive to investors looking for consistent income in their portfolios.
Another appealing tax attribute of REITs is that they’re not subject to capital gains tax (CGT) on the disposal or transfer of assts. This creates flexibility for the fund to manoeuvre the portfolio to extract value without triggering CGT.
The market for listed property has grown and allowed investors to overcome a few of the issues associated with direct real estate investment, while giving them access to the same set of returns. Increased liquidity, access to a diversified property portfolio and specialist management team, and exposure to the same profile of real estate inflation-hedged returns makes listed property an attractive addition to an investment portfolio.
