CHAPTER 20 INVESTMENTS IN REAL ASSETS Fundamentals of

CHAPTER 20 INVESTMENTS IN REAL ASSETS Fundamentals of Investments FIN-330

Investments in Real Assets Learning Objectives 1. Understand the advantages and disadvantages of real assets. 2. Explain the portfolio significance of the correlations between real estate and other assets. 3. Explain the characteristics of investing in real estate. 4. Discuss the various forms of financing for real estate investments. 5. Explain the traditional appeal of precious metals as a form of investments. 6. Understand the factors that influence the value of collectibles.

Real Assets Real assets are tangible assets that may be: 1. 2. 3. 4. Seen Felt Held Collected Real assets during inflationary environments have at times outperformed financial assets. Examples: Real Estate, Gold & Silver, Diamonds, coins, stamps, antiques, art 20 -3

Wealth Indices of Investments in Equity REITs and Basic Series Index (Year. End 1971= $1) Returns by Asset Class 1. Small Company Stocks 2. Equity REITs 3. Large Company Stocks 4. Long Term Governments 5. Treasury Bills 20 -4

Advantages and Disadvantages of Real Assets A. Advantages 1. 2. 3. 4. Outperform real assets during inflationary periods Many believe real assets are good hedges against inflation* Helps to diversify your investment portfolio Relatively uncorrelated with financial assets B. Disadvantages 1. Markets tend to be illiquid, charge larger commissions 2. Do not produce current income (except real estate) 3. Require insurance and in some cases specialized storage

Real Estate as an Investment A. More that 60% of U. S. households own real estate as a home or investment B. Brokerage and investment firms are very active 1. Creating and selling Mortgage-Backed Securities (MBS) 2. Real Estate Investment Trusts (REITs) dominate C. Real Estate takes many forms 1. 2. 3. Single & Multi-family housing Condominiums and time shares Commercial real estate: malls, industrial parks, buildings, hotels and motels

Real Estate as an Investments may include: A. Homes B. Duplexes C. Apartments D. Offices E. Industrial buildings F. Shopping centers G. Hotels and motels H. Undeveloped land 20 -7

Real Estate as an Investment A. The Tax Reform Act of 1986 1. Substantially increased wait time to take full advantage of real estate tax deductions 2. Severely restricted writing-off of paper real estate losses by passive investors against other forms of income 3. Result: R. E. less attractive to investors and speculators B. Other Issues 1. Various tax reforms blamed for declining economic conditions in late 1980’s and throughout the 1990’s. 2. Lower than normal rates and loose lending standards led to oversupply and speculation

Real Estate as an Investment C. Other Considerations 1. Historically, only small cap stocks have out performed real estate on a risk-adjusted basis 2. Real estate also provides steady cash flow 3. Population growth rates drive demand, which in turn drives increase in supply to meet demand. a. The downside is that supply growth frequently exceed rate of population growth b. The result is the all too familiar “housing bubble” and its related financial problems.

Valuation & Forms of Real Estate Ownership A. Three Major Methods 1. The Cost Approach: to replace – similar v-v duplicate 2. Comparative Sales Value: what similar properties sold for 3. The Income Approach: a. How much NOI is generated and at b. At what rate is it capitalized? c. How does NOI change over time? B. Occasionally all three methods are combined

Valuation of Real Estate: The Income Approach The stream of net earnings generated by an income-producing property capitalized as a measure of that property’s worth Annual net operating income Capitalization rate (Cap rate) = Valuation 20 -11

Valuation of Real Estate: The Income Approach Future realistic values of annual rentals minus expenses such as property taxes, insurance, … Annual net operating income Capitalization rate (Cap rate) = Valuation The rate of return required by investors in similar-type investments 20 -12

Financing of Real Estate A. Types if Mortgages 1. 2. 3. 4. 5. 30 -Years fixed rate (conventional mortgage, 20% down) Adjustable Rate (ARM) Graduated Payment (GPM) Shared Appreciation (GPM) Equity Participation (EPM)

Forms of Real Estate Ownership of real estate can take many forms: A. Individual or Regular Partnership B. Syndicate or Limited Partnership C. Real estate investment trust (REIT) 20 -14

Forms of Real Estate Ownership Syndicate or Limited Partnership A. General partner forms partnership 1. 2. B. Limited partners purchase participation units 1. 2. C. Public offering Involves larger total amounts SEC registration Private offering 1. 2. G. 5 -25% Blind pool or are specific projects identified? 1. 2. F. Liability limited to initial investment No responsibilities – merely investors Front-end fees to General Partner 1. D. E. Unlimited liability Responsible for managing property Local in scope Maximum 35 investors Secondary (resale) markets exist but dealer spreads and commissions high 20 -15

Forms of Real Estate Ownership Real Estate Investment Trust A. B. C. D. E. F. Similar to mutual funds or investment companies Trade on organized exchanges or over-the-counter Pool investor funds No minimum investment other than cost of share Most liquid type of real estate investment Large secondary market 20 -16

Forms of Real Estate Ownership Real Estate Investment Trust (continued) A. To qualify, trust must receive 75% of income from real estate 1. 2. Rents Interest on mortgage loans B. Must distribute at least 95% of income as cash dividend C. Equity Trusts 1. Buy, operate, and sell real estate as investment D. Mortgage Trusts 1. Make long-term loans to real estate investors E. Hybrid Trusts 1. F. Engage in activities of both equity and mortgage trusts There are more than 400 REITS in existence 20 -17

Gold and Silver A. Precious metals 1. Most volatile of real asset investments B. Historically, gold and silver: 1. Move up in value during troubled times 2. Decline in value during stable & predictable periods 3. Major price-driving factors: Rumors of wars, political instability, inflation. 4. Best advertised as “hedges against uncertainty” C. Silver: important industrial uses

Other Collectibles A. B. C. D. E. F. G. Art Antiques Stamps Chinese ceramics Rare books Baseball cards Precious Gems

Homework Assignment A. Questions: 1, 2, 3, 6, 11, 12