Brief introduction to Real Estate
Real estate is the land, the buildings on that land and its natural resources. It can be divided in three categories: residential, commercial and industrial. Residential real estate refers to houses, condominiums and undeveloped land. Commercial real estate includes office, warehouse and buildings. Industrial real estate includes factories, mines and farms.
Factors such as jobs, crime rate and property taxes affect directly the property value. Real estate profit and losses come from rent and property appreciation. When buying a real estate property, investors in this market need to have into consideration the location, because it is one of the most important factors that will determine the value of the property. The proximity to schools, green spaces and good neighbourhoods, also influence the valuations.
The political environment and real estate
The price of real estate depends on a variety of factors for such as: monetary policy, future economic outlook, regulatory framework and political uncertainty.
Concerning the political environment, it is also important to take into account the regulation in regards to price controls. The main two policies used to control the level of prices have to do with price ceiling and floors. Price ceilings keep the price from rising above a certain level.
A recent example of the rent price controls has been Berlin. In February 2020 a new law was passed, introducing a maximum price for rents. So far, the effects on the market have been counterproductive as the cap has incentivized investors to sell.
Relevant interest rates for mortgages
When a loan is issued, it can bring with it different types of interest rates such as variable, fixed or mixed. In Europe, the majority of the mortgages have variable interest rates, calculated as a sum between the Euribor (which is the rate of banks landing money to other banks) and a certain spread charged by the credit institution. In the case of mortgages with fixed interest rates, the rate does not change over the term of the agreement and they are defined by the credit institution, taking into account the risk of lending the money.
When it comes to mixed interest rates, these have characteristics from the two types of interest rates mentioned above. Usually, mixed interest rates are calculated taking into consideration a period with fixed rates and a period with variable rates.
Renting or buying a house?
When we have rental properties, they bring passive income from the investments, regardless of what the investor is doing. But in the flipping world, there also exists active income where the money is earned through day-to-day work. In house flipping, properties are bought and sold in a short period of time. This will work for investors that will buy a property at discount, fix it and sell it. This will bring quicker returns on investment and when it is sold investors do not need to waste more time finding tenants, collecting rent checks and maintaining the property.
In the renting space, they will have someone else pay down the mortgage and provide a positive cash flow every month and an appreciation on the property. One disadvantage is that the tenant needs to cooperate and take care of the property and pay on time every month. Another point to have in consideration is that the taxes on the flipping side are very high, being subjective to capital gains that varies based on the time the investment was held. Often, flipping houses is a more taxed venture, in comparison with rental income. Small apartments tend to be more profitable for renting per square meter, being in Lisbon for a 50sq. m. around 6.32% rental yields and in 250 square meters only around 4.5%.
One important aspect to consider about the real estate market is to find out if there are some overvaluated markets. For instance, if the city center is overvalued in comparison with the periphery or if there are some cities more valued than others.
Why is that important? Well, because a monitoring of regional price trends in residential market may provide an early indication of build-up vulnerabilities in housing markets at a national level. In addition of that, exhuberant house prices in certain regions could put at risk the stability of financial institutions.
What can be observed in the euro area is that residential property prices in capital cities have grown more strongly than the average prices of the respective country. For example, in Madrid the anual growth of real residential property prices was about 6% while Spain registed an anual growth of 3%. The data is refered to the years prior to coronavirus.
However, it is not just the capital cities that can be overvalued. In some big cities, due to the environment of low interest rates, the increases in housing prices in the recent years are, according to some analysts, creating the risk of real estate bubbles. Some of these cities are Munich, Frankfurt, Toronto, Hong Kong, Paris, Amsterdam and Zurich.
In the case of Portugal, its major cities are out of that list. In the Spanish case, taking into account the situation of Madrid, the housing prices are considered to have a reasonable value. Besides that, and as a result of the coronavirus pandemic, housing prices have gotten less expensive. In Madrid, the real housing prices went up on a average of 5% per year during the years 2015-2019, making the city to be an attractive place for foreign investors due to the high rental yields. In 2020, the coronavirus and the lockdown measures hit the prices in the Spanish capital.
A question that needs to be asked is: why housing prices in some big cities have not been affected due to the pandemic situation?. The answer is actually really simple. The price has shown some resilience because of some supporting measures implemented by the governments and because of the accommodative financing conditions.
Accordingly to UBS, prices in some European cities went up by more than 5%, which is not sustainable. Therefore, even with the price resilience mentioned above, a correction phase will be likely to happen once the subsidies fade and the pressure on incomes increases.
We also have to consider the fact that people, because of the pandemic situation, are working from home much more often and are realizing that they can work from a lot of different places, so they don’t need to live so close to cities as they used to. Also because of the pandemic, some people are losing their jobs so they do not have the same capacity to afford a house in the city.
From the investors perspective, selling properties should have some consideration. Price-to-rent ratios have reached really high numbers and rental growth is uncertain, so investors may find other assets with better risk-return characteristics.
The turmoil that took place in the financial markets in March 2020 as a consequence of the coronavirus and the uncertainty about its effects produced a sudden flight to safety among investors in order to hedge their portfolios against the likely depreciations. The huge demand of the so-called safe haven assets at that time, taking into account the low supply of these and the disruption in some of their markets, made investors to think about new assets to decrease the volatility of their portfolios. In addition to what happened during March, the current economic environment, characterized by the negative or quasi-negative yields of Government Bonds and the continuous interventions of the central banks, raises some concerns about the feasibility of the traditional safe haven assets.
From an investor’s point of view, a safe haven asset is highly convenient since it protects the portfolios during times of financial stress. This is because these assets usually have a low or negative correlation with the general market and hence, they constitute an effective store of value through the business cycle.
Traditionally, the market has just considered three safe haven assets: gold, risk free government bonds and foreign exchange reserves. The level of safety of these assets can be mainly explained by the liquidity and depth of the markets in which they are traded, as well as the low credit risk associated to them.
Although being historically considered reliable assets in times of financial turmoil, a closer look at the data shows that their performance during the stock market crash of March 2020 was not as good as expected. In a recent study, Cheema, Faff and Szulczyk analyse the evolution of gold, foreign exchange (dollars and Swiss francs) and US Treasuries during March of 2020.
The results show that due to the correlation with the general market, the US Treasuries and foreign exchange were the only safe haven assets in March 2020. Between the two currencies selected, the Swiss franc showed less volatility than the US dollar. When it comes to gold, they show that it did not act as a safe haven asset during the March crash as it was positively correlated with the S&P 500 losses.
As mentioned at the beginning, the estate of the economy nowadays is also not good for the performance of traditional safe haven assets. The low or negative yields of some of the Government bonds in some of the major economies have increased the opportunity cost of using those as a portfolio hedge. With the depressed interest rates environment, investors have to pay for keeping of those government bonds while, at the same time, they are giving up some positive returns they would get if their cash was invested in other assets. In the case of foreign exchange reserves, the central banks decisions, completely disconnected from investors necessities, can produce sudden changes in the value of some currencies, affecting their correlations with the business cycle.
Is it possible for real estate assets to become safe haven assets?
The shortcomings affecting the traditional safe haven assets and the need to protect the portfolio’s performance have prompted investors to take into consideration new assets.
Some of these candidates are included in the broader category of real estate. But, seeing the performance of real estate during some recessions, can these be considered reliable when it comes to portfolio protection?
In a general way and, taking into consideration what we have previously mentioned, it is possible to say that real estate assets lack some of the characteristics that are required to be a safe haven asset. This is mainly due to two reasons that have to do with the core characteristics of safe haven assets.
- Firstly, real estate assets tend to be cyclical assets that suffer depreciations during times of economic turmoil.
- Secondly, the markets in which they are traded lack the liquidity and depth necessary to avoid possible depreciations if investors were to dump a huge amount of these assets.
These results can be observed looking at the volatility of some indices during the year 2020.
As it is shown in the table, the real estate indices shown higher volatilities than the general market in Europe and United States. This higher degree of volatility can be positive if we want to achieve higher returns in our portfolios but, it is not convenient if our aim is to smooth the performance of our investments in the short term. In light of this results, we can say that real estate assets are not good candidates to become the new safe haven assets.
When an investor wants to integrate the real estate market, there are multiple ways for that person to understand and to figure out what are the best choices. Below, there are 7 measures that should be taken into account by every real estate investor.
ROI – Return on Investment
This rule is maybe the simplest rule when comparing markets and understand if it is a good investment to take.
The rate consists on dividing the monthly rent by the total purchase price of an investment property. A good way to measure an investment, with this rate, should be 1%. For example, renting an apartment for 1.500€, at least, that we bought for 150.000€ is a good example of a good investment opportunity. This ratio is a good measure to consider, but should not be followed blindly, since there are many other fundamental factors.
EVA – Economic Value Added
The Economic Value Added measures a company’s financial performance, based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis, as seen in the formula bellow.
EVA = Net Operating profit after taxes – (Invested Capital * Weighted average cost of capital)
This measure is a very good way to compare between businesses and choose what is best for every investor’s profile.
OER – Operating Expenses Ratio
The OER determinate the gross annual operating income that is spent under annual operating expenses. So, it should be computed as total operating expenses minus depreciation divided by gross revenue.
A good example is the 50% rule, that says that the OER ratio should be around 50%, but the lower it is, the better. The expenses are more difficult to calculate, and the depreciation of a certain property as well, but this expense should include fees, utilities, trash removal, maintenance, insurance, repairs, and many others.
Down Payment Requirements
Whether you are an investor or just someone that wants to buy a house for yourself, you always need to consider the down payment requirements.
For owner-occupied properties, the rate of the down payment should be around 3,5%, since in 2020, you could borrow up to 96.5% of the value of a home with a Federal Housing Administration loan (in the U.S). But for an investor, the down payment could change a lot, and vary with many factors. The down payment requirements for a vacation rental can be different than for an investment property and so conventional loans can be different than commercial loans.
The overall rule for a property investor says that typically it will be needed, at least, 20% of the final price. Although, an investor should always remember that just because it has 20% to do an investment for a certain house, there are other expenses that should be consider, like the interest rate of the loan.
PIR – Price to Income Ratio
This ratio, it is again a perfect measure not only for investors, but also for regular people that just want to buy a house to live on.
PIR is a measure of the affordability of a house, computed as median house prices to median familial disposable incomes in percentage or years of income. This ratio measures the median house prices to median familial disposable incomes in percentage or years of income.
Rules vary for how much you should buy a house, with the other costs that the negotiation will bring. But some lenders, indicate that a home’s sale price should not exceed 2.5 times your annual salary. Following this example, if your annual salary is 100.000€ you should avoid buying a home that costs more than 250.000€.
NPV – Net present value
A very famous form of analyzing investments is thru the Net Present Value formula. This formula sums the cash inflow/outflow discounted back to its present value, considering the time value of money. If the NPV is higher than zero, we should invest, if it’s below, we should reject.
In order to calculate the NPV, the investor should:
- Identify all cash inflows and cash outflows.
- Determine an appropriate discount rate (r).
- Use the discount rate to find the present value of all cash inflows and outflows.
- Take the sum of all present values.
PI – Profitability Index
The PI ratio is very related with the NPV formula written above, since every time NPV is positive, that will correspond with a profitability index that is greater than one.
PI differs from NPV in one important aspect, comparison. Since it is a ratio, it provides no indication of the size of the actual cash flow. For example, a project with an initial investment of 100.000 € and a present value of future cash flows of 1.2€ million would have a profitability index of 1.2.
This measure has the same purpose as the NPV, that is to calculate if the rate of return the investor desires is achieved on their investment.
Between the 7 ratios presented, there are many other ratios to take into account as net taxable income, depreciation, city migration, development patterns, transports around the area, and several others. No matter which approach is used, the most important prediction to an investment success is the research, the know-how the market works and what is the investor goal.
What are investors searching for?:
Are some markets overvalued?:
UBS Global Real Estate Buble Index – UBS GLOBAL Real Estate Buble Index (2020)
Cidades com maior risco de bolha imobiliária – Idealista (2020)
Real estate and the safe haven assets:
Rethinking safe haven assets – J.P.Morgan (2019)
Real estate in France, a safe haven asset? – Accuracy (2020)
The influence of the Covid-19 pandemic on safe haven assets. – VOXEU (2020)
Methods to Analyze a Real Estate Investment:
Down Payment Requirements:
Realty Income Corporation: