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Real ValueIs Real Estate Investment

Still a Wise Choice?

By Ahsan Ali

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With the global markets in a tailspin,investment appetite has vanished. The impact ismuch more profound for the supposed culprit –

real estate. The “real” in real estate is up fordebate. But despite everything, real estate is

still a viable investment.

As a rule ofthumb, if price

growth isoutstripping

rental growth by25% over a 12-

month period, donot buy!

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The BasicsReal estate has been an established investment classsince the earliest historical records. Real estate own-ership initially was the domain of royalty and thewealthy, before land reforms, urbanization and indus-trialization, and implementation of legal systemsevolved this into a viable investment.Real estate is generally classified into residential(apartments, villas, houses, townhouses, condomini-ums 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 com-pared to a traditional bond. The range of the returnvaries 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 equalto prevailing deposit rates/inflation.• Aggressive returns: Coupon (rental) with capital(value) net of transaction cost, plus capital gainexceeding prevailing deposit rates/inflation.The value of real estate compared to its rental yieldis effectively the equivalent of the price-to-earningsvaluation methodology for stocks. It is important tounderstand and quantify the return element for realestate, as this should drive buy/sell decisions for theinvestors.Price and rentals mechanics are driven by realisticdemand and supply mechanics. Short-term aberra-tions tend smooth themselves out within a short peri-od. In the long run, location, amenities, community,access, safety, recreational areas and other relateditems drive the demand for any locality.Legislation, social security, employment creation andtax incentives are just some variables impacting realestate. Government policies have a tangible anddirect influence on this investment class.

DisadvantagesThe real estate market is prone to distortion fromspeculative influences. The availability of credit forlarge segments of society tends to mushroomdemand and induce speculative transactions forshort-term gain. Excess liquidity from REITs, fundsand other instruments tend to “crowd” investment inattractive areas, creating artificial demand and dis-torting prices.Real estate is not a “liquid investment.” Alwaysassume a minimum of medium term (in excess of fiveyears). Real estate can be a store of value, but the

minimum investment horizons mean that this assetclass should be selected with care.The conversion of real estate to cash is usually not asimple process and can take between weeks andmonths. Real estate investment trusts (REITs) aresecurities on pools of real estate which are designedto reduce the illiquidity by enabling investors to opt inor opt out at any given point in time. Even then,because of the underlying factors, this ability is limit-ed.Real estate requires regular maintenance andupkeep. This can be quite time consuming and prob-lematic and can impact the investor’s cash flows.

Intrinsic ValueUnlike stocks and bonds, real estate has an “intrin-sic” and “affinity” value. A holding period in excess of25 years demonstrates that the intrinsic value of theproperty persists even when the depreciation is100%, i.e., terminal value of land, listing as heritagesite, etc. Some properties have emotional appealbased on previous ownership, aspirational value,location or other characteristics. Information pools on real estate tend to be localizedby neighborhood. This is crucial; as an asset class,this means that homogenous analysis is not possible,as the investment returns can vary between twostreets in the same neighborhood. The level of infor-mation expertise to generate excess return onlyexists with the local real estate agent.

When to Buy and Sell Like all other investments, real estate is all about tim-ing. The distinct disadvantage stems from the factthat real estate is the most affordable (lax creditterms) at the worst possible time to buy. So how doyou identify the right timing? By monitoring the fol-lowing three things:

1. House Price to Rental IndexCommon sense dictates that housing prices andrentals should rise more or less in unison. Anexcess demand for housing raises rentals, in turnraising house prices. This gives builders incentiveto construct additional housing, inducing new resi-dents to move to these projects, thus stabilizingprices and rentals. The rental and pricing differenti-ation then happens because of location, communi-ty, established amenities, etc. Even then, the high-er-priced real estate attracts a higher rental rate, soas a ratio (house price/rental), an equilibrium pointis reached.

Like all otherinvestments, realestate is all about

timing.

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As the graph points out, any disturbance from thepoint of equilibrium has to be either due to excep-tional demand (population displacement, natural dis-asters, massive surge in population due to emigra-tion, etc.) or is pure speculation. The consequencesare quite evident, as seen in the decline from 2007until now.

As a rule of thumb, if price growth is outstripping rentalgrowth by 25% over a 12-month period, do not buy!

2. Global TrendsReal estate markets tend to exhibit similar trendsglobally. The important thing to realize when a trendis forming.

Median US Home Price Relative to Owner’s Rent

Source: IPD, NCREIF

Source: National Association of Realtors, U.S. Department of Labor

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By 2006, end real estate returns (local currencynominal returns) were dipping in most countries. Asis evident, real estate returns tend to move in a“band” with very few outliers (in this graph, SouthAfrica). Looking at the trend in this graph, most of thereturns seem to have either plateaued or declined inthe last period. Not a good indicator for increasingexposure to real estate.

3. Mortgage Data as a PredictorMortgage delinquencies, or the inability of customersto repay their mortgage installments on time, is aleading indicator of things to come. If the level ofdelinquencies is shooting up, it is inevitable that fore-closures and auctions will follow.

Decades of credit behavior show that a mortgageloan is the last commitment that a borrower renegeson. The pyramid of default usually starts from unse-cured debt (credit cards, store cards, personal loans,etc.) to vehicle loans and finally, when the consumerhas no other option, mortgages.To summarize the price/earnings indexes, trendsand mortgage data highlight the key characteristicsof real estate drivers, such as speculative influences,demand-supply imbalances, excess liquidity, lax cred-it rules, potential defaults, employment outlook, con-sumer confidence, etc. When viewed together, theyprovide a very good macro insight on whether to buy,sell or stay put.

Recessionary InvestmentRecession provides the savvy investor with greatopportunities, as long as the investment objectivesare clear. The key question for the investor in a reces-

sionary phase should not be how much return can begenerated, but rather, how long investment can beheld before divestment.

Mortgage Default Rates

Source: Freddie Mac, March 27, 2008

Recessionprovides the

savvy investorwith great

opportunities, aslong as theinvestment

objectives areclear.

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As the graph shows, the average price declineduring banking crises has been 35.5% and recov-ery has taken an average of six years. What isimportant to note is that aside from the notableexception of Japan, in all other countries, houseprices actually clawed back the loss in value andposted significant gains even beyond that. For thekeen real estate investor, the average return over

a six-year holding period can be almost 36%. Theimportant point is the realization of the holdingperiod.

Why Real Estate Even Now?As mentioned earlier, real estate is a “tangible” storeof value. This commonsensical view is borne out byan empirical study conducted by MIT.

Past and Ongoing Real House Price Cycles and Banking Crises:Peak-to-trough Price Declines (left panel) and Years Duration of Downturn (right panel)

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The returns generated on purchase and subse-quent sales of homes in the U.S. were measuredover a 27-year period. The graph above depicts406 investment periods; for example, a propertybought in 1983 and sold in 1986 generated anaverage return of 11.6%. The astonishing fact thatemerges is that in only 11 (2.7%) of the 406investment periods were the returns actually neg-ative! This once again points out the fact that realestate over a longer investment horizon is a viableinvestment alternative.With the global equity markets in disarray, astrong point for real estate is the negative corre-lation between real estate and pretty much every-thing else. When the world is going one way, realestate should go the other way.

Thinking Things OutThe 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 onthe basis of available macro research.3. The ability to take an educated contrarian viewduring economic downturns.4. The ability to prudently leverage to obtain thebest results.With a well thought-out approach, real estate willremain a wise investment alternative.

Ahsan Ali is head ofWealth Managementand SME Banking forNoor Islamic Bank inthe UAE. An avidsupporter of CSR anddevelopment initiatives,he is involved inmentoring, training andprogram managementwith various public-private partnerships. Heholds an MBA from theInstitute of BusinessAdministration, KarachiUniversity, as well anMS in FinancialEconomics from theSchool of Oriental andAfrican Studies,London. Ali is a CFACharter Holder, an FRMcertified risk managerand a member of theSecurities andInvestment Institute (SII),UK.

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