Real Estate 101,demystifying real estate investment

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What Is Real Estate?

Real estate is the land along with any permanent improvements attached to the land, whether natural or man-made—including water, trees, minerals, buildings, homes, fences, and bridges. Real estate is a form of real property. It differs from personal property, which are things not permanently attached to the land, such as vehicles, boats, jewelry, furniture, and farm equipment.

Key Takeaways

• Real estate is a class of “real property” that includes land and anything permanently attached to it, whether natural or man-made.
• There are five main categories of real estate: residential, commercial, industrial, raw land, and special use.
• You can invest in real estate directly by purchasing a home, rental property or other property, or indirectly through a real estate investment trust (REIT).

Understanding Real Estate

People often use the terms land, real estate, and real property interchangeably, but there are some subtle distinctions.

• Landrefers to the earth’s surface down to the center of the earth and upward to the airspace above, including the trees, minerals, and water.
• Real estate is the land, plus any permanent man-made additions, such as houses and other buildings.
• Real property—one of the two main classifications of property—is the interests, benefits and rights inherent in the ownership of real estate.

Broadly speaking, real estate includes the physical surface of the land, what lies above and below it, what is permanently attached to it, plus all the rights of ownership—including the right to possess, sell, lease, and enjoy the land.

Real property shouldn’t be confused with personal property, which encompasses all property that doesn’t fit the definition of real property. The primary characteristic of personal property is that it’s movable. Examples include vehicles, boats, furniture, clothing, and smartphones.

Physical Characteristics of Real Estate

Land has three physical characteristics that differentiate it from other assets in the economy:

1. Immobility. While some parts of land are removable and the topography can be altered, the geographic location of any parcel of land can never be changed.
2. Indestructibility. Land is durable and indestructible (permanent).
3. Uniqueness. No two parcels of land can be exactly the same. Even though they may share similarities, every parcel differs geographically.

Economic Characteristics of Real Estate

Land also has some distinct economic characteristics that influence its value as an investment:

• Scarcity: While land isn’t considered rare, the total supply is fixed.
• Improvements: Any additions or changes to the land or a building that affects the property’s value is called an improvement. Improvements of a private nature (such as homes and fences) are referred to as improvements on the land. Improvements of a public nature (e.g., sidewalks and sewer systems) are called improvements to the land.
• Permanence of investment: Once land is improved, the total capital and labor used to build the improvement represent a sizable fixed investment. Even though a building can be razed, improvements like drainage, electricity, water, and sewer systems tend to be permanent because they can’t be removed (or replaced) economically.
• Location or area preference. Location refers to people’s choices and tastes regarding a given area, based on factors like convenience, reputation, and history. Location is one of the most important economic characteristics of land (thus the saying, “location, location, location!”).

Types of Real Estate

There are five main types of real estate:

1. Residential real estate:Any property used for residential purposes. Examples include single-family homes, condos, cooperatives, duplexes, townhouses, and multifamily residences with fewer than five individual units.
2. Commercial real estate:Any property used exclusively for business purposes, such as apartment complexes, gas stations, grocery stores, hospitals, hotels, offices, parking facilities, restaurants, shopping centers, stores, and theaters.
3. Industrial real estate:Any property used for manufacturing, production, distribution, storage, and research and development. Examples include factories, power plants, and warehouses.
4. Land:Includes undeveloped property, vacant land, and agricultural land (farms, orchards, ranches, and timberland).
5. Special purpose:Property used by the public, such as cemeteries, government buildings, libraries, parks, places of worship, and schools.

How the Real Estate Industry Works

Despite the magnitude and complexity of the real estate market, many people tend to think the industry consists merely of brokers and salespeople. However, millions of people in fact earn a living through real estate, not only in sales but also in appraisals, property management, financing, construction, development, counseling, education, and several other fields.

Many professionals and businesses—including accountants, architects, banks, title insurance companies, surveyors, and lawyers—also depend on the real estate industry.

Real estate is a critical driver of economic growth in the U.S. In fact, housing starts—the number of new residential construction projects in any given month—released by the U.S. Census Bureau is a key economic indicator. The report includes building permits, housing starts, and housing completions data, divided into three different categories:

• Single-family homes
• Homes with 2-4 units
• Multifamily buildings with five or more units, such as apartment complexes

Investors and analysts keep a close eye on housing starts because the numbers can provide a general sense of economic direction. Moreover, the types of new housing starts can give clues about how the economy is developing.

Example: Housing Starts

For example, if housing starts indicate fewer single-family and more multifamily starts, it could indicate an impending supply shortage for single-family homes—which could drive up home prices. The following chart shows 20 years of housing starts, from Jan. 1, 2000, to Feb. 1, 2020.

20 years of housing starts. Source: Federal Reserve Bank of St. Louis.

How to Invest in Real Estate

There are a number of ways to invest in real estate. Some of the most common ways to invest directly include:

If you buy physical property (e.g., rental properties, house flipping), you can make money two different ways: Revenue from rent or leases, and appreciation of the real estate’s value. Unlike other investments, real estate is dramatically affected by its location. Factors such as employment rates, the local economy, crime rates, transportation facilities, school quality, municipal services, and property taxes can drive real estate prices up or down.

Cons

• Is usually illiquid
• Influenced by highly local factors
• Requires big initial capital outlay
• May require active management and expertise

You can invest in real estate indirectly, as well. One of the most popular ways to do so is through a real estate investment trust (REIT)—a company that holds a portfolio of income-producing real estate. There are several broad types of REITs, including equity, mortgage, and hybrid REITs. REITs are further classified based on how their shares are bought and sold:

• Publicly traded REITs
• Public non-traded REITs
• Private REITs

The most popular way to invest in a REIT is to buy shares that are publicly traded on an exchange. Since the shares trade like any other security traded on an exchange (think stocks), it makes REITs very liquid and transparent.

Like many stocks, you earn income from REITs through dividend payments and appreciation of the shares. In addition to individual REITs, you can also invest in real estate mutual funds and real estate exchange traded funds (ETFs).

What We Like

• Liquidity
• Diversification
• Steady dividends
• Risk-adjusted returns

Mortgage-Backed Securities

Another option for investing in real estate is via mortgage-backed securities (MBS). These received a lot of bad press due to the role they played in the mortgage meltdown that triggered a global financial crisis in 2007-08. However, MBS are still in existence and traded.

The most accessible way for the average investor to buy into these products is via ETFs. Like all investments, these products carry a degree of risk. However, they may also offer portfolio diversification. Investors must investigate the holdings to ensure the funds specialize in investment-grade mortgage-backed securities, not the subprime variety that figured in the crisis.

MBS Examples

Two popular ETFs that give ordinary investors access to MBS include:

• The Vanguard Mortgage-Backed Securities ETF (VMBS): This ETF tracks the Bloomberg Barclays U.S. MBS Float Adjusted Index, made up of federal agency-backed MBS that have minimum pools of $1 billion and minimum maturity of one year.
• The iShares MBS ETF (MBB): This ETF focuses on fixed-rate mortgage securities and tracks the Bloomberg Barclays U.S. MBS Index. Its holdings include bonds issued or guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac, so they are AAA-rated.