Just as ever more advanced construction techniques have enabled faster building of properties in recent years, a host of innovative financial instruments have sprung up offering investors new pathways into real estate. Listed or unlisted? Equity or debt? Mutual funds or investment trusts? This burgeoning array of investment vehicles may be giving investors greater opportunities to diversify their portfolios but understanding what form of investment is the best fit for one’s needs can be a daunting task.
Direct vs. indirect real estate investing - the main differences
Broadly speaking, real estate investment vehicles can be split into two main categories: direct and indirect. As its name suggests, direct real estate investing sees investors directly purchase physical real estate – such as office buildings, residential homes, logistics centres or hotels – with the aim of generating income and capital appreciation. The indirect approach, on the other hand, involves investing in real estate through instruments such as real estate investment trusts (REITs) or exchange-traded funds (ETFs), rather than owning the bricks and mortar itself.
According to Markus Waeber, Head Indirect Real Estate Advisory & Intelligence at Julius Baer, indirect investing appeals to many investors because of its lower entry barriers compared to direct investing. “Unless you’re a UHNWI or institutional investor with very sizable investable assets, it’s difficult to build up a global portfolio of real estate via the direct route,” he says. “Not many individual investors have the capital available to purchase properties in the commercial sector, for example, where office buildings in strategic locations can cost nine-figure sums.”
The exit barriers are also lower with indirect real estate investments, in the sense that you can generally liquidate your position much quicker. “When you buy a house or a commercial property, you’re generally tying up your finances for many years,” says Markus. “Real estate funds and stocks let you access the wealth that you build more easily and redirect funds into other investment opportunities that come your way.”
Different vehicles offer differing returns
Aside from accessibility and liquidity, the direct and indirect routes into real estate investing also differ in terms of their risk-return parameters. While each investment vehicle has its own unique risk attributes, it generally holds true that indirect investments offer greater diversification potential, especially in the hands of wealth management professionals, while direct investments offer scope for higher returns but typically require more active involvement and a sound understanding of the market.
“It’s important that you assess your own risk appetite carefully before making an allocation,” explains Markus. “If you invest in a Swiss residential real estate fund, for example, the typical annual cash-flow return might be in the region of 2-3%. In the context of the real estate market, that would be regarded as a defensive option,” says Markus.
Direct real estate investing offers the potential for higher returns, both through rental income and capital appreciation. Renting the purchased properties out to tenants provides a steady cash flow, while the value of the properties may increase over time. Statistics from Invesco reveal that, over the period 2001-2020, income from real estate globally contributed a greater share of total return than income from global equities (see table below). This indicates that a portfolio which includes real estate globally diversified has the potential to mitigate risk.
Investors who are comfortable taking a more aggressive stance might want to engage in the construction of new properties, major renovations or redevelopments. This can generate impressive returns, explains Markus: “If you have sufficient capital and an extended investment horizon, you could participate in the building of apartments, sell them on the market, and achieve a return of 20% or more.”
Nevertheless, he says this form of real estate investing should be treated with caution. “The potentially lucrative returns of a strategy like build-to-sell may sound enticing to many investors but this requires active involvement and a robust understanding of the local market,” says Markus.
Advantages of looking closer to home
Traditionally, this need for an understanding of the local market has meant real estate investors have been domestically focused. “Real estate is basically a local asset class driven by local demographics and economic trends,” says Markus. “Because of this, it can often be more effective from a performance perspective to invest in your local market, or be guided by specialists in particular countries, than to invest ‘blindly’ in a global fund covering many different markets,” adds Markus.
However, a dearth of investment opportunities in many national markets has enticed investors to build up an international portfolio. Large institutional investors and sovereign wealth funds have helped to propel this shift, attracted by the generally stable income, the scope for diversification, and the varying possibilities to reduce risks and enhance returns.
Markus advises globally active investors to assess different factors carefully before making an allocation. “In addition to considerations like currency fluctuations or overseas tax laws, it’s important to understand which instruments are available in which jurisdictions.” He cites the example of Julius Baer’s home market Switzerland: “REITs are typical across most parts of Europe, Asia and the US, but they’re not available in Switzerland. Here, however, we have listed funds that you don’t have in other countries.”
‘Get real’ when it comes to assessing your own capabilities
The low correlation to other countries and asset classes is part of real estate’s appeal as an asset class, thereby catering effectively to investors’ desire for diversification. But while the increasing number of options in many international markets has made cross-border investment more accessible than ever before, the dizzying array of variables at play means investors in real estate, as with other asset classes, Markus advises investors to pursue a core-satellite approach. “In the case of real estate, for example, it can make sense to build a core strategy around, say, a fully rented property with low leverage in a prime location, while complementing this with satellites such as exposure to property development or value-add investments with a higher loan-to-value ratio.”
No matter how investors choose to gain exposure, the long-term investment case for real estate as an asset class is compelling, with figures by alternative asset researchers Prequin revealing that 90% of investors intend to maintain or increase their allocations to real estate over the long term. Given both direct and indirect approaches to real estate investing offer their own advantages, the choice between them will depend on factors such as individual preference, available capital, risk tolerance and how hands-on the investor wishes to be.
It’s also vital as an investor that you assess your own capabilities to evaluate your allocations – especially in view of the changing interest rate environment, which makes it all the more important to select the right instruments and strategies. “It’s vital that investors seek advice from professionals with the necessary experience, network and knowledge. Real estate can offer attractive long-term returns but that also requires an experienced, long-term view,” says Markus. “As with other asset classes, time in the market, rather than market timing may be the most effective way of maximising your returns from real estate.”