The basics of real estate investing
Although many of us inherently feel that real estate is a good investment, it is worth exploring in more detail what's behind such feelings & experiences.
Real estate as an investment vehicle has matured significantly over the last three decades. As an asset class, it has become much more institutional in nature, (i.e.) many companies such as pension funds and insurance companies have chosen to invest in them. For larger investors, real estate has in many cases become a third pillar after equities and government / low risk bonds.
Why real estate and why now?
There are several reasons why real estate is often considered a good investment by institutional and experienced investors alike.
Real estate provides two sources of returns often driven by slightly different factors which impact supply and demand.
The first part of the total return is derived from the rental income that the tenant (or guest if it is a hotel or vacation rental property) pays to the owner.
Residential the demand for standard residential housing (and hence rental levels for residential space) are partly driven by the job market which is closely linked to the wider economy. A stronger economy supports more job growth/movement (often including also population growth) and higher salaries. A good example is the residential market in Prague, where economic growth combined with population growth and low job vacancies is driving up wages and disposable incomes. In such situations, individuals tend to be able to pay more for rent.
One of the specific attractions of residential or holiday properties is that rental contracts are often short (one year at most or indeed only days or weeks for guests staying in holiday lets). This means that landlords can often quickly and regularly adjust the required rent levels to keep up with inflation and market conditions.
Vacation Properties – the demand for vacation properties is more driven by the tourist industry which itself can be influenced by a number of factors including for example, the weather, country / city / resort level marketing efforts, the availability of attractions on-site/nearby, the economies (and especially the wage growth) in the countries and areas from where tourists originate, exchange rates, accessibility and even work from home policies amongst others.
Capital value appreciation
The second element of the total return is the increase in the market price (capital value appreciation), where the value of the asset increases over time. This tends to be more strongly linked to developments in the capital markets (including interest rates and inflation rates). In times of economic growth, inflation, if present, has the effect of increasing the replacement cost of the real estate and therefore the value of real estate increases over time, especially when interest rates are lower.
Real estate differs from stocks and bonds in its risk and return characteristics. Typically, real estate has lower risk and lower return than stocks and higher risk and higher return than government bonds. But even within a single asset class there can be significantly different risk/return ratios. For example, real estate development projects present higher risks and so require higher expected returns whereas in contrast, prime properties in prime locations fall lower on the risk curve and as such investors do not demand such high levels of expected returns.
Investing in real estate tends to be a good way to protect your money against inflation. There are several reasons for this. Firstly, assuming interest rates remain relatively stable, real estate values can increase during times of inflation, which means that its value can rise along with rising prices in the economy. In addition, rents are also typically increased in line with inflation, meaning that rental income rises alongside rising costs, helping to offset the eroding effects of inflation.
Residential properties and holiday lets in Europe
There are a variety of reasons why residential and vacation rentals are attractive opportunities to invest in.
In respect of residential markets, the build-to-rent (BTR) and private rented sectors (PRS) are becoming an increasingly sought-after asset class in Europe. One recent contributing factor is the fact that both the office and retail sectors have fallen out of favour with many investors over the past two years due to the impacts of work from home on the office markets and, similarly, the impact of on-line shopping on the physical retail market.
In respect of vacation rentals, global tourism markets are increasingly opening up and tourist numbers increasing following the Covid and the slow return to full capacity which has helped to increase demand for vacation rentals in Europe. Vacation rentals as a wider industry have also seen huge investments in recent years especially in technology and visibility helping to create a more mature, understandable market which is important for all investors, but particularly the larger institutional investors as they seek to understand the risks, returns and opportunities in the sector.
The forces described above all impact on the demand side of the equation in particular. Rental levels and capital values are ultimately a result of an interaction of supply and demand. In respect of supply, in many areas across Europe whether specific urban areas or tourist resorts, there is a limited supply of development projects (for example due to challenging planning regulations) to accommodate the potential demand and this is a further contributing factor to rental and capital value growth.
As we are still rather early in the impact of these new demand-side trends described above, it suggests that now would be a good time to invest in order to be ahead and benefit from the expected growth curve.
Real estate investments can play a material role in helping to achieve portfolio diversification. Real estate typically has a low correlation with other market classes such as stocks or bonds. This means that the value of real estate may not decline (or rise) in the same way or at the same time as other investments. Because of this low correlation, investing in real estate can help to reduce overall portfolio risk. In addition, property investments can provide regular rental income that can serve as a stable source of cash-flow and help enhance the overall performance of the portfolio. Diversification into real estate can thus provide investors not only with potential capital appreciation, but also with stable income and reduced risk of the wider portfolio.
The rules for diversification apply at all times and there is no better time than the present to include real estate as an asset class in your portfolio and start profiting from the diversification benefits.
Real estate and barriers
Investing in real estate is challenging. There are several barriers that limits investor access and participation. Some of these barriers include the following.
- Financial requirements - One of the main barriers is the need for sufficient financial capital to purchase real estate. Properties usually require high initial investments such as purchase price, down payment, brokerage fees and maintenance costs. These financial requirements can limit access for smaller investors.
- Market Knowledge and Risk Management - Investing in real estate requires a certain level of market knowledge, including analysis and understanding of trends and property values in a given location. Property and asset management demand specialist skills to manage risks associated with tenants, maintenance and legal matters.
- Limited Liquidity - Real estate is typically a less liquid investment compared to other asset classes such as stocks or bonds. Selling a property may take longer and require additional effort and costs associated with the sale, such as legal representation and brokerage fees. Limited liquidity may limit the ability to access funds quickly when needed.
- Regulatory and Legal Matters - Investing in real estate is often subject to various legal and regulatory matters. These include rent control laws, building codes, consumer protection laws and others. Investors must be familiar with local laws and regulations and ensure compliance with all relevant laws and regulations.
- Time and maintenance needs - Investing in real estate requires time and effort for management and maintenance. The investor must be prepared to invest time and resources in managing the property, including finding tenants, carrying out repairs and maintenance, and dealing with various issues related to the property
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