Investing indirectly means purchasing shares of companies that hold large portfolios of securities on behalf of their share holders. Indirect investing is a great opportunity for those who are willing to start investing with a small amount, having no previous knowledge or experience of stock market’s ups and downs. You can decide if indirect investing is the right choice for you after examining the following features.
The advantages associated with investing in property shares is that investors gain from greater liquidity since property company shares are publicly traded and the time taken to buy and sell these shares is far shorter than the time taken to buy and sell real property. Investors can create diversified property portfolios’ of property company shares at relatively low costs and in most cases, buying into diversified property portfolios in acquiring those shares. Transaction costs are lower than direct purchase. Finally since the price of publicly traded shares are known at any given time, there are no uncertainties as to the value of them. This is a contrast to direct investment with the buying and selling of real property, whereby it can take a matter of days to establish the values.
Possibly the biggest advantage of indirect investment is the expertise and high standard management that comes along with investing in indirect property investment vehicles, as far as someone who knows little about property investment is concerned. Property investment companies have experts specializing in investment analysis and portfolio management and these companies will always stand a better chance for positive yields as compared to a common man who barely knows about financial markets.
Furthermore another advantage with indirect investment vehicles is the opportunity for the investor to capitalise on discounts and premiums, especially in the case of close-ended funds. The net asset value of investment company’s share keep going up and down based on company’s performance and these shares are not always traded on net asset value. If sold at a price lower then net asset value, these are said to be sold at discount and if the price is higher then net asset value, they are selling at premium. This provides an opportunity to earn, even when the Net Asset Value has not changed.
Neverthless there are disadvantages to investing in property shares. Firstly, the prices of property shares move up and down with the stock market, as such they are more voliatilie. Between 1970 and 1992 the annualised standard deviation of UK property shares was 27 per cent compared to 11 per cent for direct property as measured by the Jones Lang Wooton Index (Barkham and Gelthbner, 1995). It should be noted that when the impact of gearing was removed form property share prices and when the JLW series desmoothed, the standard deviations were much clooser in magnitude. Since according to finance theory, risk-adjusted returns should equalise, property companies should offer higher average performance to compensate investors with this volatility. Secondly another disadvantage is that since property companies are taxed on their profits , their is no full tax transparency . As such tax-exempt investors such as pension funds are unable to claim back corporation tax.
A notable disadvantage of investing in indirect property vehicles is that although mutual funds are managed by qualified professionals and experts, no expert can guarantee a profit on every investment made. There are many uncontrollable variables involved and then there is always a chance of unpredictable happening, normally referred to as “the great unknown”. Mutual funds can be divided into different categories on basis of risk, for example “hybrid fund” being less risky while “specialized stock funds” falling in the high risk – high return category.
Another disadvantage is the charges involved in buying into property shares, trusts and funds. Investment companies do not provide the high quality portfolio management services for free. This can off putting to the would be investor because they also have to pay additional charges associated with dealing through a broker as most property investment companies do not offer direct purchase plans. Also, most of these companies run excessive marketing and sales campaign because of competition. Some part of this expense is also charged from investors, known as sales load.
In addition, another disadvantage is the lack of control that the investor has in guiding their investments. This can be off putting to a investor who wants control and they have to alternatively rely fully on the company’s management decisions regarding investment. Another shortcoming is that investing in property shares, trusts and funds are not guaranteed by any government body or authorities nor do they provide any specific protection. The shareholder has little influence over the acquistion and disposal decisions made by the company, nor overfinancing decisons (the amount of borrowing -gearing or leverage – and the issuing of new shares which dilute the value of existing shares). Since share prices should reflect judgements about the quality of management, the equity markets provides some form of discipline. The shareholder may also find it difficult to obtain full information on the property assets and development schemes of the company, particularly where there exist complex ownership structures with joint ventures and off balance shet holdings.
The advantages of Real Estate Investment Trusts (REITs) are alike to that of property shares in terms of lot size, liquidity, public trading and price information, with the added advantage of tax transparency. As many researchers have pointed out, there has been an explosive growth of the REIT market. For example the market capitalisation of the industry has gone from $1.88 billion in 1972 to $44.31 billion in 1994 for the total index with a substaintial amount of that growth in the equity index (without healthcare). Also the breakdown between two types of REITs in the index was as follows: 205 equity REITs with a reported value if $62.06 billion (70.4 per cent of total assest value); 32 mortgage REITs with a reported value of $21.78 billion (24.7 per cent); and 23 hybrid REITs with a reported value of $4.34 billion (4.9 per cent). This boom in the market was a direct result of the 1986 Tax Reform Act that allowed greater management flexibility and established a less restrictive tax environment as such more tax transparency, creating the conditions for growth in the REIT market. However, in common with property company shares, REITs exhibit higher volatility than the direct market.
The advantages of investing in Property Unit Trusts and Managed Funds is that they offer relatively low unit costs , allowing investors to acquire an interest in a diversified property portfolio without excessive commitment of capital. However there are potential disadvantages in terms of lack of management control and illiquidity. In theory, there is some liquidity in that units may be redeemed on a monthly basis. In practice, in a poor market or when a when a high proportion of units are attempting to sell, the manager may defer redemption. Furthermore, the spread (gap between unit purchase and redemption prices) tends to increase when there is selling pressure, harming performance. Finally, since selling pressure tends to occur in falling markets, sales take place in poor conditions and are, in effect, forced rather than open market sales. These disadvantages temper the benefits in terms of lot size and diversification.
The disadvantages of conventional debt instruments such as mortgages, mortgage debentures and bonds is that the lender as a investor cannot benefit from any growth in rents and capital values: there is downside, but no upside risk. The risk-adjusted return will, therefore, change with conditions in the property market. Innovative forms of debt funding have similar characteristic. Deep discount bonds are sol below par (that is, at less than their face and redemption value) so that the investor obtains capital growth on redemption. A number of hybrid debt-equity instruments have been developed which enable the investor to participate in market performance. Since convertible mortgages are loans secured on a property (or, possibly, a portfolio of properties). The lender has an option to convert some or all of the loan into a direct or indirect equity interest in the property. Thus, the lender can benefit from greater than anticipated growth in the property market. The borrower can benefit from lower interest rates or from the lender permitting a higher loan to value ratio, thus reducing the borrowers own equity input. Furthermore there are tax and accounting advantages in participating mortgage structures for both the borrower and the lender, whereby the lender receives a premium related to the sale price (or agreed valuation) at redemption. However, a legal problem – the fact that the lender’s call option acts as ‘a clog the equity of redemption’, preventing a borrower from clearing debt and thus owning the asset unencumbered – has, at the time of writing, not been decisively resolved and has been the subject of Law Commission deliberations in the UK.
The principal advantages of property derivatives relate to their low unit costs , the ability to gear up investment and the ability to gain exposure to the property market without incurring high levels of specific risk (for example, a PIC enabled an investor to track the IPD portfolio – then valued at some £40bn) for just £250,000. However, there are a number of drawbacks. These include questions about the information content of commercial property indices, lags in the publication of the indices and the fact that the investor is buying into average performance and cannot hope to ‘outperform’ the market. he key condition for successful development of property derivatives is the establishment of an active secondary market. This requires sufficient market capitalisation, investors prepared to trade actively in the market (as opposed to buying the initial offering and holding it to redemption) and, critically, differences in opinion as to future trajectories of the underlying assets or index. There must be buyers and sellers. Once established, it is possible that price movements in the derivative market will, as in other capital markets, have implications for pricing in the underlying direct property market.
The introduction of UK REITs means small investors are now able to invest indirectly in a truly diversified property portfolio, buying low cost and easily tradable units, instead of having to purchase, say, entire properties.
A major advantage of UK REITs is their tax-efficient nature. Investors avoid the double taxation that any investor in property company shares faces, as tax won’t be payable on rental or capital gains earned within a REIT (as the REIT organisation is exempt from corporation tax on qualifying property income and gains). Investors will only be liable for the tax due on income received as dividends.
Because UK REITs pay out such a large portion (90%) of their profits in dividends, they’re also particularly attractive to small income-seeking investors.
Without the challenges associated with the current double taxation regime, UK REITs may differ from existing quoted property companies in that their prime focus may be less about capital growth than maximising shareholder dividends.
They are able to meet the needs of the property investment market and the small investor in that they offer regular and potentially high-yielding returns. Also access to property investment for small investors is for minimal outlay as such there is less exposure to their investments. It offers portfolio diversification for investors and as such more leverage against risk. Buying into REITs offers a more attractive form of diversification than by buying into a wider range of bonds or equities simply because they have a higher correlation with diversification than equities and bonds have (reita.org, All about REITs) Liquidity – easy to buy/sell Lower transaction costs compared to buying property directly (stamp duty on direct property is up to 4%, whereas buying shares in a UK REIT will only be subject to stamp duty of 0.5%)Access to property investment in a variety of sectors and geographical locations Strong corporate governance.
The major concern about investing in REITs as a means of gaining exposure to the commercial property market is their correlation to equities. Because REITs are stock market listed companies, the performance of their shares is inevitably affected by the performance of the market. In the short-term, ie over periods of less than 18 months, the performance of REITs shares is likely to be more closely correlated to that of other shares than it is to that of commercial property. Having said that, commercial property, whether direct or indirect, should be considered for long-term investment rather than short-term speculation.
Like any investment, the value of a REIT can go down as well as up and past performance isn’t necessarily an indicator of future performance. If you are looking for advice on where to invest, Reita would always recommend seeking independent financial advice from an investment professional.