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Real Value_Apr09:Purpose_July06
cover story
may 2009
4/21/09
4:48 PM
Page 32
www.capital-me.com
By Ahsan Ali
Real Value Is Real Estate Investment Still a Wise Choice? 32
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
Page 33
As a rule of thumb, if price growth is outstripping rental growth by 25% over a 12month period, do not buy!
With the global markets in a tailspin, investment appetite has vanished. The impact is much more profound for the supposed culprit – real estate. The “real” in real estate is up for debate. But despite everything, real estate is still a viable investment.
33
Real Value_Apr09:Purpose_July06
cover story
may 2009
Like all other investments, real estate is all about timing.
4/21/09
4:50 PM
Page 34
www.capital-me.com
The Basics Real estate has been an established investment class since the earliest historical records. Real estate ownership initially was the domain of royalty and the wealthy, before land reforms, urbanization and industrialization, and implementation of legal systems evolved this into a viable investment. Real estate is generally classified into residential (apartments, villas, houses, townhouses, condominiums etc,), commercial (office buildings, retail space, etc.), industrial (factory premises, warehouses etc.) and land (developed and undeveloped). The investment returns on real estate can be compared to a traditional bond. The range of the return varies from: • Conservative returns: Coupon (rental) with capital (value) net of transaction cost. • Moderate returns: Coupon (rental) with capital (value) net of transaction cost, plus capital gain equal to prevailing deposit rates/inflation. • Aggressive returns: Coupon (rental) with capital (value) net of transaction cost, plus capital gain exceeding prevailing deposit rates/inflation. The value of real estate compared to its rental yield is effectively the equivalent of the price-to-earnings valuation methodology for stocks. It is important to understand and quantify the return element for real estate, as this should drive buy/sell decisions for the investors. Price and rentals mechanics are driven by realistic demand and supply mechanics. Short-term aberrations tend smooth themselves out within a short period. In the long run, location, amenities, community, access, safety, recreational areas and other related items drive the demand for any locality. Legislation, social security, employment creation and tax incentives are just some variables impacting real estate. Government policies have a tangible and direct influence on this investment class. Disadvantages The real estate market is prone to distortion from speculative influences. The availability of credit for large segments of society tends to mushroom demand and induce speculative transactions for short-term gain. Excess liquidity from REITs, funds and other instruments tend to “crowd” investment in attractive areas, creating artificial demand and distorting prices. Real estate is not a “liquid investment.” Always assume a minimum of medium term (in excess of five years). Real estate can be a store of value, but the
34
minimum investment horizons mean that this asset class should be selected with care. The conversion of real estate to cash is usually not a simple process and can take between weeks and months. Real estate investment trusts (REITs) are securities on pools of real estate which are designed to reduce the illiquidity by enabling investors to opt in or opt out at any given point in time. Even then, because of the underlying factors, this ability is limited. Real estate requires regular maintenance and upkeep. This can be quite time consuming and problematic and can impact the investor’s cash flows. Intrinsic Value Unlike stocks and bonds, real estate has an “intrinsic” and “affinity” value. A holding period in excess of 25 years demonstrates that the intrinsic value of the property persists even when the depreciation is 100%, i.e., terminal value of land, listing as heritage site, etc. Some properties have emotional appeal based on previous ownership, aspirational value, location or other characteristics. Information pools on real estate tend to be localized by neighborhood. This is crucial; as an asset class, this means that homogenous analysis is not possible, as the investment returns can vary between two streets in the same neighborhood. The level of information expertise to generate excess return only exists with the local real estate agent. When to Buy and Sell Like all other investments, real estate is all about timing. The distinct disadvantage stems from the fact that real estate is the most affordable (lax credit terms) at the worst possible time to buy. So how do you identify the right timing? By monitoring the following three things: 1. House Price to Rental Index Common sense dictates that housing prices and rentals should rise more or less in unison. An excess demand for housing raises rentals, in turn raising house prices. This gives builders incentive to construct additional housing, inducing new residents to move to these projects, thus stabilizing prices and rentals. The rental and pricing differentiation then happens because of location, community, established amenities, etc. Even then, the higher-priced real estate attracts a higher rental rate, so as a ratio (house price/rental), an equilibrium point is reached.
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
Page 35
Median US Home Price Relative to Owner’s Rent
Source: National Association of Realtors, U.S. Department of Labor
As the graph points out, any disturbance from the point of equilibrium has to be either due to exceptional demand (population displacement, natural disasters, massive surge in population due to emigration, etc.) or is pure speculation. The consequences are quite evident, as seen in the decline from 2007 until now.
As a rule of thumb, if price growth is outstripping rental growth by 25% over a 12-month period, do not buy! 2. Global Trends Real estate markets tend to exhibit similar trends globally. The important thing to realize when a trend is forming.
Source: IPD, NCREIF
35
Real Value_Apr09:Purpose_July06
cover story
may 2009
4/21/09
4:50 PM
Page 36
www.capital-me.com
By 2006, end real estate returns (local currency nominal returns) were dipping in most countries. As is evident, real estate returns tend to move in a “band” with very few outliers (in this graph, South Africa). Looking at the trend in this graph, most of the returns seem to have either plateaued or declined in the last period. Not a good indicator for increasing exposure to real estate.
3. Mortgage Data as a Predictor Mortgage delinquencies, or the inability of customers to repay their mortgage installments on time, is a leading indicator of things to come. If the level of delinquencies is shooting up, it is inevitable that foreclosures and auctions will follow.
Mortgage Default Rates
Source: Freddie Mac, March 27, 2008
Decades of credit behavior show that a mortgage loan is the last commitment that a borrower reneges on. The pyramid of default usually starts from unsecured debt (credit cards, store cards, personal loans, etc.) to vehicle loans and finally, when the consumer has no other option, mortgages. To summarize the price/earnings indexes, trends and mortgage data highlight the key characteristics of real estate drivers, such as speculative influences, demand-supply imbalances, excess liquidity, lax credit rules, potential defaults, employment outlook, consumer confidence, etc. When viewed together, they provide a very good macro insight on whether to buy, sell or stay put. Recessionary Investment Recession provides the savvy investor with great opportunities, as long as the investment objectives are clear. The key question for the investor in a reces36
sionary phase should not be how much return can be generated, but rather, how long investment can be held before divestment.
Recession provides the savvy investor with great opportunities, as long as the investment objectives are clear.
Real Value_Apr09:Purpose_July06
cover story
may 2009
4/21/09
4:50 PM
Page 38
www.capital-me.com
Past and Ongoing Real House Price Cycles and Banking Crises: Peak-to-trough Price Declines (left panel) and Years Duration of Downturn (right panel)
As the graph shows, the average price decline during banking crises has been 35.5% and recovery has taken an average of six years. What is important to note is that aside from the notable exception of Japan, in all other countries, house prices actually clawed back the loss in value and posted significant gains even beyond that. For the keen real estate investor, the average return over
38
a six-year holding period can be almost 36%. The important point is the realization of the holding period. Why Real Estate Even Now? As mentioned earlier, real estate is a “tangible” store of value. This commonsensical view is borne out by an empirical study conducted by MIT.
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
The returns generated on purchase and subsequent sales of homes in the U.S. were measured over a 27-year period. The graph above depicts 406 investment periods; for example, a property bought in 1983 and sold in 1986 generated an average return of 11.6%. The astonishing fact that emerges is that in only 11 (2.7%) of the 406 investment periods were the returns actually negative! This once again points out the fact that real estate over a longer investment horizon is a viable investment alternative. With the global equity markets in disarray, a strong point for real estate is the negative correlation between real estate and pretty much everything else. When the world is going one way, real estate should go the other way.
Page 39
Thinking Things Out The major keys to real estate investing include: 1. Clarity of investment objectives (rental yield, investment horizon, capital appreciation, etc.). 2. A good sense of timing for the investment on the basis of available macro research. 3. The ability to take an educated contrarian view during economic downturns. 4. The ability to prudently leverage to obtain the best results. With a well thought-out approach, real estate will remain a wise investment alternative.
Ahsan Ali is head of Wealth Management and SME Banking for Noor Islamic Bank in the UAE. An avid supporter of CSR and development initiatives, he is involved in mentoring, training and program management with various publicprivate partnerships. He holds an MBA from the Institute of Business Administration, Karachi University, as well an MS in Financial Economics from the School of Oriental and African Studies, London. Ali is a CFA Charter Holder, an FRM certified risk manager and a member of the Securities and Investment Institute (SII), UK. 39
cover story
may 2009
4/21/09
4:48 PM
Page 32
www.capital-me.com
By Ahsan Ali
Real Value Is Real Estate Investment Still a Wise Choice? 32
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
Page 33
As a rule of thumb, if price growth is outstripping rental growth by 25% over a 12month period, do not buy!
With the global markets in a tailspin, investment appetite has vanished. The impact is much more profound for the supposed culprit – real estate. The “real” in real estate is up for debate. But despite everything, real estate is still a viable investment.
33
Real Value_Apr09:Purpose_July06
cover story
may 2009
Like all other investments, real estate is all about timing.
4/21/09
4:50 PM
Page 34
www.capital-me.com
The Basics Real estate has been an established investment class since the earliest historical records. Real estate ownership initially was the domain of royalty and the wealthy, before land reforms, urbanization and industrialization, and implementation of legal systems evolved this into a viable investment. Real estate is generally classified into residential (apartments, villas, houses, townhouses, condominiums etc,), commercial (office buildings, retail space, etc.), industrial (factory premises, warehouses etc.) and land (developed and undeveloped). The investment returns on real estate can be compared to a traditional bond. The range of the return varies from: • Conservative returns: Coupon (rental) with capital (value) net of transaction cost. • Moderate returns: Coupon (rental) with capital (value) net of transaction cost, plus capital gain equal to prevailing deposit rates/inflation. • Aggressive returns: Coupon (rental) with capital (value) net of transaction cost, plus capital gain exceeding prevailing deposit rates/inflation. The value of real estate compared to its rental yield is effectively the equivalent of the price-to-earnings valuation methodology for stocks. It is important to understand and quantify the return element for real estate, as this should drive buy/sell decisions for the investors. Price and rentals mechanics are driven by realistic demand and supply mechanics. Short-term aberrations tend smooth themselves out within a short period. In the long run, location, amenities, community, access, safety, recreational areas and other related items drive the demand for any locality. Legislation, social security, employment creation and tax incentives are just some variables impacting real estate. Government policies have a tangible and direct influence on this investment class. Disadvantages The real estate market is prone to distortion from speculative influences. The availability of credit for large segments of society tends to mushroom demand and induce speculative transactions for short-term gain. Excess liquidity from REITs, funds and other instruments tend to “crowd” investment in attractive areas, creating artificial demand and distorting prices. Real estate is not a “liquid investment.” Always assume a minimum of medium term (in excess of five years). Real estate can be a store of value, but the
34
minimum investment horizons mean that this asset class should be selected with care. The conversion of real estate to cash is usually not a simple process and can take between weeks and months. Real estate investment trusts (REITs) are securities on pools of real estate which are designed to reduce the illiquidity by enabling investors to opt in or opt out at any given point in time. Even then, because of the underlying factors, this ability is limited. Real estate requires regular maintenance and upkeep. This can be quite time consuming and problematic and can impact the investor’s cash flows. Intrinsic Value Unlike stocks and bonds, real estate has an “intrinsic” and “affinity” value. A holding period in excess of 25 years demonstrates that the intrinsic value of the property persists even when the depreciation is 100%, i.e., terminal value of land, listing as heritage site, etc. Some properties have emotional appeal based on previous ownership, aspirational value, location or other characteristics. Information pools on real estate tend to be localized by neighborhood. This is crucial; as an asset class, this means that homogenous analysis is not possible, as the investment returns can vary between two streets in the same neighborhood. The level of information expertise to generate excess return only exists with the local real estate agent. When to Buy and Sell Like all other investments, real estate is all about timing. The distinct disadvantage stems from the fact that real estate is the most affordable (lax credit terms) at the worst possible time to buy. So how do you identify the right timing? By monitoring the following three things: 1. House Price to Rental Index Common sense dictates that housing prices and rentals should rise more or less in unison. An excess demand for housing raises rentals, in turn raising house prices. This gives builders incentive to construct additional housing, inducing new residents to move to these projects, thus stabilizing prices and rentals. The rental and pricing differentiation then happens because of location, community, established amenities, etc. Even then, the higher-priced real estate attracts a higher rental rate, so as a ratio (house price/rental), an equilibrium point is reached.
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
Page 35
Median US Home Price Relative to Owner’s Rent
Source: National Association of Realtors, U.S. Department of Labor
As the graph points out, any disturbance from the point of equilibrium has to be either due to exceptional demand (population displacement, natural disasters, massive surge in population due to emigration, etc.) or is pure speculation. The consequences are quite evident, as seen in the decline from 2007 until now.
As a rule of thumb, if price growth is outstripping rental growth by 25% over a 12-month period, do not buy! 2. Global Trends Real estate markets tend to exhibit similar trends globally. The important thing to realize when a trend is forming.
Source: IPD, NCREIF
35
Real Value_Apr09:Purpose_July06
cover story
may 2009
4/21/09
4:50 PM
Page 36
www.capital-me.com
By 2006, end real estate returns (local currency nominal returns) were dipping in most countries. As is evident, real estate returns tend to move in a “band” with very few outliers (in this graph, South Africa). Looking at the trend in this graph, most of the returns seem to have either plateaued or declined in the last period. Not a good indicator for increasing exposure to real estate.
3. Mortgage Data as a Predictor Mortgage delinquencies, or the inability of customers to repay their mortgage installments on time, is a leading indicator of things to come. If the level of delinquencies is shooting up, it is inevitable that foreclosures and auctions will follow.
Mortgage Default Rates
Source: Freddie Mac, March 27, 2008
Decades of credit behavior show that a mortgage loan is the last commitment that a borrower reneges on. The pyramid of default usually starts from unsecured debt (credit cards, store cards, personal loans, etc.) to vehicle loans and finally, when the consumer has no other option, mortgages. To summarize the price/earnings indexes, trends and mortgage data highlight the key characteristics of real estate drivers, such as speculative influences, demand-supply imbalances, excess liquidity, lax credit rules, potential defaults, employment outlook, consumer confidence, etc. When viewed together, they provide a very good macro insight on whether to buy, sell or stay put. Recessionary Investment Recession provides the savvy investor with great opportunities, as long as the investment objectives are clear. The key question for the investor in a reces36
sionary phase should not be how much return can be generated, but rather, how long investment can be held before divestment.
Recession provides the savvy investor with great opportunities, as long as the investment objectives are clear.
Real Value_Apr09:Purpose_July06
cover story
may 2009
4/21/09
4:50 PM
Page 38
www.capital-me.com
Past and Ongoing Real House Price Cycles and Banking Crises: Peak-to-trough Price Declines (left panel) and Years Duration of Downturn (right panel)
As the graph shows, the average price decline during banking crises has been 35.5% and recovery has taken an average of six years. What is important to note is that aside from the notable exception of Japan, in all other countries, house prices actually clawed back the loss in value and posted significant gains even beyond that. For the keen real estate investor, the average return over
38
a six-year holding period can be almost 36%. The important point is the realization of the holding period. Why Real Estate Even Now? As mentioned earlier, real estate is a “tangible” store of value. This commonsensical view is borne out by an empirical study conducted by MIT.
Real Value_Apr09:Purpose_July06
4/21/09
4:50 PM
The returns generated on purchase and subsequent sales of homes in the U.S. were measured over a 27-year period. The graph above depicts 406 investment periods; for example, a property bought in 1983 and sold in 1986 generated an average return of 11.6%. The astonishing fact that emerges is that in only 11 (2.7%) of the 406 investment periods were the returns actually negative! This once again points out the fact that real estate over a longer investment horizon is a viable investment alternative. With the global equity markets in disarray, a strong point for real estate is the negative correlation between real estate and pretty much everything else. When the world is going one way, real estate should go the other way.
Page 39
Thinking Things Out The major keys to real estate investing include: 1. Clarity of investment objectives (rental yield, investment horizon, capital appreciation, etc.). 2. A good sense of timing for the investment on the basis of available macro research. 3. The ability to take an educated contrarian view during economic downturns. 4. The ability to prudently leverage to obtain the best results. With a well thought-out approach, real estate will remain a wise investment alternative.
Ahsan Ali is head of Wealth Management and SME Banking for Noor Islamic Bank in the UAE. An avid supporter of CSR and development initiatives, he is involved in mentoring, training and program management with various publicprivate partnerships. He holds an MBA from the Institute of Business Administration, Karachi University, as well an MS in Financial Economics from the School of Oriental and African Studies, London. Ali is a CFA Charter Holder, an FRM certified risk manager and a member of the Securities and Investment Institute (SII), UK. 39
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