![]()
Introduction
The purpose of this chapter is to explore the rationale for investing in real estate, to present the context in which real estate is traded and to consider the economic basis of the market. Any consideration of the attributes of the property market must be made initially in the context of the overall investment market with its wide, sometimes bewildering, range of opportunities, the object of which is to gain a worthwhile return on the capital invested. For this reason, the broad investment market will be described briefly before passing to a more detailed consideration of the differences inherent in the property investment market.
Any adviser on investment in real estate should have a broad understanding of the opportunities for investment elsewhere in the market which may be the first choice for many investors. In any free market economy decisions will be determined by the wishes of individual investors and their interaction with the market for the public good.
The overall investment market
The initial motivation for saving in one form or another is to provide a safety net available should some unexpected expense arise. In addition, there is a general concern that the future is better provided for where there are savings, the return on which will be available to augment, for example, a pension or even to provide one. Where an individual has a level of income sufficient not only to provide a required standard of living there are two broad choices – increase consumption or reserve some or all of the surplus for wealth accumulation and as a foil to the uncertainties of the future. But any savings accumulated in this way should be invested effectively; otherwise, the value of the capital is reduced by the effect of inflation. Where interest rates are low and a level of inflation exists, it is possible for the total amount saved to have a lower purchasing power. Savings may be intended to act as an insurance against currently unknown future major expenditure, for a specific future expense such as school fees, to provide funds for a major purchase, to repay a mortgage or to provide or supplement retirement income.
There is almost no end to the type and range of investments available although the modest saver would wish to avoid the more volatile ones which, while capable of providing substantial gains, may put capital at undue risk.
The choice is initially between consumption and investment; the latter is more likely to take place where a reasonable return on capital may be anticipated. That return may be in the form of regular interest payments, in capital gains or a combination of the two. Depending on various factors, including risk and accessibility, the return will tend to vary. There is a hierarchy of investment opportunities where, in general, a high return suggests a more than average risk. It is important that investment decisions are made after detailed enquiry and in full knowledge of the circumstances.
Investors in real estate have a range of opportunities open to them. They will look for a satisfactory return reflecting the level of risk inherent in any particular choice.
The components of a sound investment
Investment opportunities abound, and range from the safe guaranteed government deposit or bank saving accumulating a low rate of interest but lacking growth to schemes offering high returns in untested ventures where there is a real alternative – the chance of making a loss. Each investor determines an acceptable level of risk although the actual risk is not always readily identifiable. By its nature, risk is uncertain and its containment challenges all investors.
Investments differ greatly and all have their strengths and weaknesses. There is probably no such thing as a perfect investment, although the aim is always to achieve the one most likely to serve the particular needs of the investor. A number of the important contributors to any successful investment are discussed below.
Investors will determine strategy by a wide range of tests, each seen as a tradeoff between risk and return. The starting point in selecting an investment is to look at its main attributes. In the case of stocks and shares the main considerations are, briefly, that any investment:
● is easily and speedily bought and sold, with low dealing and transfer costs
● provides a positive income (i.e. an income at least above the rate of inflation)
● has the prospect of capital growth
● is homogenous and divisible
● is fully definable and documented
● is an investment for which there is likely to be a continuing demand
● requires minimal management
● is not affected by exchange rates
● is not politically sensitive.
Having made an initial selection, the investor will be guided by a range of criteria including:
● Security: The investor will wish to be assured either that the investment is permanent or that it will survive the length of the investment period.
● Risk: Investors have different levels of preference for risk. Some are risk averse; in other words they are not prepared to accept any level of risk, in which case their investments are limited to accounts where the investment is guaranteed by government or otherwise secure from default. Currently, such accounts show very low levels of interest to the extent that when inflation is taken into account, many are loss producing. Governments normally guarantee their offerings and in some other cases give limited protection to some other investments; for example, in the United Kingdom (UK) bank deposits are protected up to a maximum of £85,000. Many investors hold securities with a spread of volatility to reduce their overall level of risk in their portfolios. It is sometimes claimed that all interest rates are the same, which is a way of indicating that in each case, the pure interest element is similar, any surplus being in compensation for the perceived risk taken on. In accepting a level of risk, the professional investor is making a judgement as to the likely outcomes spread across the portfolio.
● Liquidity: The future is unknown and ideally the investor would wish to be able to dispose of the investment if funds are required urgently and unexpectedly. For this reason, an investor on a small scale will probably keep most assets in a fairly accessible form, the penalty for which is lower returns. Investors with larger funds will deal with this issue by balancing the portfolio to ensure that only a proportion of funds rather than the entire fund will be available at short notice if required.
● Income flows: The expected return should take account of all the benefits and disadvantages of the particular investment; regular and foreseeable payments are usually an important consideration.
● Growth prospects: Part of the return may be in the form of a capital gain on disposal and part may be in the increase in income over the period that an investment is held.
● Divisibility: The ability to sell part of an investment holding without creating problems for the remaining part of the holding is an important consideration.
● Ease of transfer: The complexities of acquisition or disposal tend to be reflected in the timescale. Where extensive enquiries are a prerequisite, as in real estate, the time taken will inevitably increase.
● Costs of transfer: Costs vary according to the type of investment. Extended transfer periods tend to be accompanied by greater formalities and higher costs; where the costs of transfer are significant there will be a tendency to hold the investment for longer periods.
Few proposed investments will meet all the criteria; the investor will judge the acceptability by any additional benefits offered by way of compensation. The overall investment package is crucial.
The investment market varies from country to country but is made up broadly of three strands:
● Government issues: In the UK a variety of products are offered by, or underwritten by, the Treasury where the initial investment is guaranteed.
● Equities: These are commonly known as shares and there are a wide range of offers that can be acquired through a central exchange. There is an opportunity to explore the background and performance of the issuing company in order to assess the quality of the investment. Stocks and shares are traded through central exchanges; information regarding the background and performance of companies is available. There is a level of oversight by regulatory bodies although the level of risk will vary, so a careful assessment of all the known information should be collated and studied.
● Other investments: The main return on some investments may be in substantial gains on disposal. There is almost no end to the type and range of investments available, although the modest saver would wish to pursue those with a good track record of dividends and an element of growth. Investors will tend to avoid those capable of providing substantial gains if there is a real risk of loss of capital.
Stocks and shares may be traded through stock exchanges which exist in most developed countries. Major exchanges exist in the UK, New York and Hong Kong. There are also various subsidiary markets, mainly for smaller trades. Numerous private sector facilities offer investments but with a range of risk, requiring a degree of familiarity and investigation before committing to purchase.
Range of investments
Government stock and shares of most commercial companies can be bought and sold. Information on trades and prospects is widely available in newspapers and specialist publications, and advice may be commissioned from a financial adviser. By comparison, the property market is much less transparent and will be considered later as the principal focus of this chapter. Meanwhile, some information concerning the stock market follows to enable the reader to appreciate the size and complexity of what is on offer.
Government stock
Numerous issues are underwritten by government and are regarded as risk free, but only in the sense that the initial investment will be returned on maturity at the end of the fixed period for which it was issued. Should the investor wish to redeem the investment before maturity, it will be sold in the market and, depending on the conditions at that time, may sell for more or less than its issue price. For example, the purchase of government stock with a nominal value of £100 and an interest rate of 3 per cent for a term of ten years will pay an annual rate of 3 per cent and the initial capital investment will be returned at the end of the period. But should the investor wish to cash the investment after say five years, the market will dictate the price according to whether it is regarded as a good investment at that time. If, in the meantime, government stock has been issued showing a return of say 5 per cent, an investor is likely to discount any offer price for the stock.
Equities
Equities are normally bought and sold through financial exchanges. In the UK, stocks and shares can be traded through the London Stock Exchange (LSE) or through subsidiary or alternative markets. Most financial activities are regulated, although risk is largely a matter for the investor.
Ordinary shares are issued at a price related to the notional value of the company so that each purchaser is an equity shareholder. Where a business prospers, the notional value is likely to increase, meaning that the shares may be sold at a profit. A dividend is declared each year based on the trading experience of the company; a dividend may be paid even where the company has not made a profit, although it would not be likely to happen often. Conversely, where the company is growing rapidly, it may decide to limit dividends to allow it to build up capital as a cheaper way of funding expansion. Additional equity capital may be raised through rights issues where existing shareholders are offered the opportunity to buy further shares, sometimes at a discounted price.
Other ways in which a company may raise capital is through debentures or unsecured loan stock. The return on the offer will be fixed at a rate expected to attract purchasers. Debentures are a form of mortgage secured on the assets of the business and should the company de...
