This paper studies an evaluation of the risk factors between the unsecuritised (direct) Property investment markets in comparison to the securitized (indirect) property investment markets. The real estate global market functions through both direct and indirect property investment, without prejudice Investing in real estate markets overseas can turn out to be a venture into the unknown, an encounter with unfamiliar political and economic environments, unstable currencies, strange cultures and languages, it is assumed the indirect market offers the experienced investor investment opportunities that can be effectively forecast, and managed by experienced investment portfolio managers with local knowledge, while making available to the investor a wide and diverse palate of offerings in the global economy, effectively spreading and mitigating the risk and therefore hedging against the risk associated with major negative economic market downturns. The investors who directly invest in brick and mortar in direct investment is restricted and limited by funds, experience, local knowledge, empirical data, and lack of diversity that ultimately results in greater capital risk.
Key Words: Direct and Indirect property investment, Diversification, Risk, Assets, Forecast.
Real estate Investment can be done through direct and indirect processes, the concept of real estate as a financial asset has a history that exceeds any other asset class within finance. Large profits have been earned in the real estate industry in its long history. According to Brounen (2008) the size of the real estate market by the end of 2007 is estimated around 24 trillion US dollars. In two thirds of all cases, these buildings are owned by their users, which prohibits outside investors from participating. This leaves 10 trillions of "investable" real estate assets. These assets are currently occupied by tenants who pay their monthly rents and thereby provide the real estate investor a stream of cash flows, and thus a source of financial returns. The "investable" real estate market consists of 9 trillion of direct real estate assets and 1 trillion of indirect real estate. Property investments can be sub divided into two broad categories 1) Direct investment: The ownership of physical assets, that includes direct ownership for owner-occupation, and property for sale or to let to others and capital appreciation and growth over time, it is a development sector focused investment. 2) Indirect investment is a paper asset backed by property, comprising of Property company shares, Unit and investment trusts, Mortgages and loans with an investment sector focus. This will revolve around Property funds: investment in property indirectly through a property fund. If the fund performs it will provide an income in the form of dividends, or rental income, depending on the type of fund, and capital growth when sold.
Direct property investment is a traditional form of investment and has been around for 100s of years. The return to direct property usually takes the form of rental income or capital growth or both, and the risk depend on the type of property, its location, the lease terms attached to it and the quality of tenant. However, property investment has radically changed over the last 30 and 40 years with the introduction of new indirect forms. The return and risk attributes depend on the type of indirect vehicle. Investment in bricks and mortar has been shown to have many benefits, but direct real estate Investments are illiquid; require large capital commitments and considerable industry expertise. This has created demand for new financial instruments. The Real Estate Investment Trust Act of 1960 made indirect real estate investment through Real Estate Investment Trusts (REITs) possible in the United States. Similar legislation in numerous other countries has laid the foundation for a surging global property share market; the market capitalization of which has quadrupled over the past decade. This, in turn, has led to the appearance of real estate mutual funds some two decades ago, representing a third-tier real estate investment vehicle.
It also involves investing in the skills and expertise of other people, such as property or fund managers. Investors need to be aware that making indirect investments is likely to mean the performance of their investment vehicle is not wholly related to the performance of the property or properties contained within the vehicle. In addition, the tax treatment of indirect investment vehicles may be an issue.
Overseas investors in the UK are largely institutions, property companies or construction companies. They buy into UK investments because cross border investment enables them to increase the diversification of their portfolios over a wider range of investment choice. In the UK property market, inward investors already account approximately 15% of investment property. This equated to £25 billion in 2002, CB Hillier Parker,(2002).
It has been observed through research that diversification is the investors main motive for international portfolio investment in the property sector McAllister,(1999). An investor investing his/her money does so in the hope of earning more money in the future. This is true regardless of the type of investment. The future return to an investment may take the form of an income stream and/or an increase in the market price of the asset when it is sold to another party. Investors must weigh up the potential for an investment not to produce the expected capital growth or income streams. The chance of a loss in capital or income occurring is the risk associated with an investment. Typical investors aim to maximise the return on their money invested while minimising the risk of losing it. Investors usually do not have unlimited capital, and have to decide how to space their limited funds by choosing between alternative investments. The sources of income of the company will vary depending on the type of property companies. Property investment companies tend to rely on rental income while property trading companies generate their income by selling completed developments.
The ultimate motivation for indirect or direct investment in real estate is profit, the motivation and appetite is justified by the attendant requirements and risk factors required to achieve maximum returns, the investor will have to justify the process and avenues (direct or indirect) for investment based on salient, pertinent and relevant factors unique to the investors experience, the motivation of an investor for indirect investment will be justified by the intent to have a formalised and structured approach to investment with all the requisite legal and financial safeguards, diversity and predictability, whereas direct investment requires a hands on approach with all the attendant risk factors, common to the unstructured investment market, such as a requirement for experience, assess to development funds and know how, local knowledge, human capital and resources to effectively execute a successful direct investment. The table below shows the annual investment returns in percentage from 1998 to 2012 on direct and indirect property investment.
Figure 1: IPD property fund index annual investment returns (%)
Lately, the Asian Pacific Emerging Markets has been of great interest to the International Real Estate Investors, the motivation behind this investment interest is the additional diversification benefits, the strong economic performance of the region, the very high returns the Asian economic would generates and the growth potential of the region in the nearest future. Indeed in a survey of investors in the UK and Asia "higher returns" and the potential for "capital appreciation" were ranked one and two as the main reasons to hold foreign property in Asia, (Lim 2000). For example over the period 1966-1991 the average annual real economic growth rate for Hong Kong, Japan, Singapore and Malaysia was greater than 6% while the comparable figures for the US and UK were between 2% and 3% respectively (Greenwood, 1993) Divecha, Drach, and Stefek, (1992) argued that the globalisation of the world’s financial system has led to the emergence of a number of key financial centres in London, New York and Tokyo, whose real estate markets are closely tied to the modern day international financial network, as a result their real estate markets are a lot integrated and so offers low diversification benefits (Stephen, 2000). Thus the benefits from indirect property portfolio diversification will be greater when pairing a matured market with an emerging market.
Indirect real estate investment are usually in the form of Real estate mutual funds, REITS (Real Estate Investment Trusts), buying shares in a publicly quoted property company, securities,A funds, orA private equity company,A listed property companies, UK offshore property investment companies, investment trust companies, life bonds, authorised and unauthorised property unit trusts, limited partnerships, Property Authorised Investment Funds (PAIFs). Indirect property investor can also invest via property syndicates, from within a Self-Invested Personal Pension (SIPP) and pension funds. The structured nature of indirect investment offers the investor confidence and an avenue for risk assessment and legal framework to support the investment, whereas direct property investment such as Buy-to-let: purchase of property with a view to letting it and achieve an income, in the form of rent from a tenant, as well asA capital growthA if the property is sold for a profit, or alternatively purchase of property directly with a view to renovating it and selling it for a profit offers no structure or framework for assessment, it is a deregulated form of investment open to all kinds of risk.
A Real Estate Investment Trust (REIT) is a real estate company or trust that buys, sells, develops and manages property assets. REIT’s elect to qualify under certain tax provisions to become owners of property and mortgages, and to pay dividends without prior deduction of corporate taxes. Before REITs were introduced listed property companies suffered from double taxation, the corporation had to pay corporation tax and investors had to pay tax on their dividends. There was much pressure to change this situation as compared with direct property investment. Listed property companies were at a disadvantage, as when investing directly there was only one taxation charge (tax on rental income). This structured approach to investment offers a vast array of options to the investor, low unit costs, publicly traded with up-to-date pricing while direct investment with all the attendant hands on requirements is still plagued by Government intervention e.g. planning and environmental controls, building regulations, rent controls in housing, development incentives etc. These regulations add to the management obligations and in some countries capital gains and transfer taxes that increase the cost of trading in direct investment.
Property as an investment medium requires a significant amount of specialist management and administration. Research has shown that additional cost of management is linked with direct property investment this provide an important barrier to direct investment in the property sector (Newell and Worzala, (1995). However, the day to day obligations include maintenance, rent collection, rent reviews and lease negotiations. This adds to the costs of holding this type of asset as investors either have to employ their own specialists or the services of a property management practice. Whereas ownership of an indirect property interest can be regarded as a passive form of investment, requiring no management input beyond the decisions to buy and sell. Investing in indirect property interest takes away the problems associated with direct involvement in management. The high cost of buying and selling direct property rights inhibits market participants from responding rapidly to changing conditions, and raises the gross return required by investors. Indirect property investment on the other hand can be held with little day-to-day input required.
The process of obtaining information about potential investment in foreign countries on direct property investment is a major problem. Practical research carried out suggests that problems associated with finding suitable investment opportunities are very important for institutional investors. The "dumb foreigner" effect will be more important in markets where information is scarce and which are poorly researched. Indirect property market which is similar to the Equity market will tend to be more transparent and are "information rich" compared to direct property market McAllister, (1999). Moreover, trading of large properties in some locations and the lack of a transparent market also lead to uncertainty about value. The attractiveness of indirect property investment vehicles is largely the ability to avoid some of these difficulties linked with direct property investment whilst still investing in the property market (thereby benefiting from the diversification offered by the property cycle).
Property market has generally been declared to be inefficient compared to other asset class due to its characteristics of having a high search cost, and having no central market. These two features put together inhabit the information, operational and allocative efficiency of property investment compared to shares and bonds. Burton,(2003) explains that the major success of listed indirect property investment, is it being indexed, measured and unitised like shares and bonds. This makes it impossible for a single participant to constantly outperform the market after accounting for search cost and transaction cost. Listed Indirect property investment can readily be assessed by the efficient market hypothesis (EMH) as share prices of property companies are relatively determined by demand and supply of shares and not by prices and return from previous transaction that creates weak form efficiency. On the contrary semi strong efficiency is achieved by listed indirect investment through the proper incorporation of all public information and company prospects in share price movement. The semi-strong efficiency that exists in listed property investment and the volume of documented transaction of property interests makes forecast more realistic and more accurate.
A good level of portfolio diversification can be achieved by purchasing shares of one/few property companies (assuming assets are well diversified). This involves scrutinizing the type, age, location and tenure of individual properties, and how they contribute to the company’s portfolio. This refers to the ability to sell an asset at any time without suffering any loss associated with the timing of the sale. The portfolio risk can be reduced by selecting investments with returns that are not perfectly correlated. The risk that can be removed through diversification relates to the individual characteristics of the investment. This risk is called non-market also referred to as non-systematic or specific risk. However, there is a certain degree of risk that cannot be diversified away. This may be referred to as systematic or non-specific risk created by general economic conditions. The major advantage of international indirect property investment is the reduction in property specific risk through the securitisation of property interest and the reduction in systematic risk through the investment in negatively correlated economies. Fraser,(1993).
The benefits associated with international portfolio diversification are abundant and information is readily available just like the equity market and the risk and return advantages of international diversification are very large for investors.
There are some principal factors that influence the income yields of indirect and direct property investments as identify by Fraser (1993)
Liquidity: This refers to the time that it takes to realise the cash tied up in an investment. Investors tend to prefer more liquid assets and must be offered extra return to overcome their liquidity preferences. Indirect property investments are regarded as fairly liquid. There is an active secondary market (Stock exchange) for Indirect property investments making it significantly easier to sell them quickly and cost effectively. Direct property assets on the other hand can take time to sell; transaction costs associated with the sale can also be significant.
Lumpy: Property comes in various sizes and forms, indirect investment offers the flexibility to acquire investment in various forms and structures it allows the holding of a diversified property portfolio with assess to a large pool of funds which is always a hindrance to the small player. Properties often cannot be divided, so each can represent a large position within the portfolio.
Homogeneity: Indirect investment can take advantage of the homogenous nature of shares and gilts in a real estate investment company, whereas no two properties are the same and can give a portfolio with an identical structure to accentuating the unpredictability of the return. Heterogeneity of property can lead to uncertainty about its value.
These factors affect the risk premium of a share (rpS), and subsequently the investor’s required rate of return. The same factors also affect other investments that are perceived as risky. This includes direct and indirect property investments.
Long term nature of holding: Direct investment in land and property have in themselves long term durability compared to other goods, but over time require repair and refurbishment at a cost and they depreciate through wear and tear, whereas though depreciation affects assets of companies, it will have less correlation to the shares owned by an indirect investor.
Immobility: Direct investment in properties provides very little or no room for mobility as property is fixed to a location, it cannot be moved, whereas indirect investment can be bought, sold and moved from one market to another offering differential opportunities.
Although direct and indirect property investment offers different prospects in terms of information costs, diversification, risk exposure, liquidity, volatility and quality of performance measurement, the underlying assets of indirect and direct property investment vehicle are still subject to the performance of the property market. It is also appropriate for institutional investors interested in international portfolio diversification to be involved in research of international investment performance which ensures that a low correlation or possibly a negative correlation is achieved when compared with home country.
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