Investing in property has long been seen as the ideal investment for earning long-term wealth. A vast plot of land bought for $50,000 in the 1950s could be worth as much as $10 million today, depending on the location of the property and other characteristics of the land.
Apart from anecdotes such as that above, property investment has been popular for numerous reasons, amongst which the ability to leverage and borrow at low cost and for its perceived lower correlation with the state of the economy. Leverage, in particular, is highly attractive to investors. For a million-dollar investment property, one needs to put down a small downpayment of 10-20% of the cost of the property (this varies depends on location-specific regulations). Along with this, we also observe that the cost of borrowing funds for property is far lower than the prime rate charged by banks for other collateralized loans. Investors leverage up to purchase the property, rent out the property and use the rental to repay the loan instalments. If all goes well, they own the property after 10 years.
2005-2006 has seen a boom for high end property in Asia, reminiscent of the heydays of the late 1990s.
However, one of the downsides of property investment in this form is the illiquidity of one's asset. In simple terms, this means that the piece of land or apartment or bungalow is not easily convertible into cash. Selling off an investment property would take easily more than a few weeks and it could be another few months before the transaction is completed and money is received in the bank.
The other disadvantage of property investment is the indivisibility of the investment. One buys a condominium apartment; he or she cannot easily sell off 10% or 20% of the property to raise cash as there is no ready market for investments in this form.
In recent years, financial innovations have emerged in the investment space, providing investors exposure to property and overcoming the two disadvantages described above.
Real Estate Trusts - in some countries, this is called a Real Estate Investment Trust. In this structure, a company commonly purchases commercial buildings and takes over the management of rental and maintenance. The assets are then placed in a trust and units in the trust are sold to institutional and retail investors. The income received from the rental is then distributed to unitholders after deducting management fees and other relevant costs. Real estate trusts can also comprise residential buildings, but this is less common and higher risk as rental rates are more volatile.
The real estate trust enables investors to get in on property investment without having to come up with a large amount of money, as the units in the trust are usually bought and sold on a stock exchange. For as little as a thousand dollars, investors get to hold a share in a portfolio of property investments.
Trading on an exchange also enables units of the real estate trust to be easily exchangeable for cash, as these units trade frequently.
The other benefit of this structure is that yields are more easily projected due to the long term contractual nature of commercial leases. This is not necessarily true for residential property.
The one disadvantage of this, is that investors do not get the benefit of substantial leverage, nor do they enjoy the lower cost of borrowing that comes from buying a property. In addition, there is no physical asset being owned, as the investor owns a right to the distributions of the asset, the sentimental among us might want to touch and feel a live physical building.
Lately, we have seen unit trusts specializing in property investments. In most cases, the fund manager reviews the universe of investible property trusts and selects those that fit his criteria. A property trust might also comprise infrastructure trusts and shares in property development companies.
Such property trusts and property unit trusts have done well in the last year and are gaining rapid popularity. Time will tell if they continue to realize the early promise shown.