If you want to profit from real estate stocks, there’s one important thing you need to know…
Not all listed real estate stocks are the same.
If you want to build out a diversified real estate stock portfolio, it’s crucial that you understand this. You see, some real estate stocks offer growth… meanwhile others offer value… and others offer income.
And different real estate stocks present very different risk/reward profiles. For example, at one end of the spectrum we have stable, low volatility income-generating investments… and at the other end, we have speculative growth plays. And then there’s everything in between.
As investors, this gives us the flexibility to structure our real estate portfolio in a way that suits our preferred risk/return profile. And it allows us also to diversify across different property types within different property sectors.
To explain… there are four different types of real estate stocks.
These property companies are like manufacturers. They buy raw material (land), they manufacture (build) and then they sell the completed product. One big difference is that the development process involves a much greater time frame than the typical manufacturing process.
This is a buy-and-sell model. It’s all about buying land, building, selling, buying land, building, selling… the faster and more efficiently a company can do this, the more profitable it can be.
Pure developers all have certain characteristics… Their businesses are highly cyclical, as are their earnings. So investors should be ready to stomach volatility. This business model has highest asset turnover of all property models.
And in many markets, these stocks have a high beta. That means that they tend to go up and down at a greater rate than for the overall market.
Property developers are by far the largest group by market capitalisation in Asia, but a relatively much smaller group in other developed markets like North America, Europe and Australia/New Zealand.
2. Investment property companies
This group typically buys or builds properties that are intended to be held for longer term rental income and capital growth.
Rentals and capital values can be cyclical, but earnings are typically less volatile than for developers. Earnings, being driven largely by rentals, are generally more reliable and more predictable.
These companies generally have low asset turnover (they hold on to assets for long periods), and therefore a typically lower return on equity/return on capital.
In Asia, these tend to be the second biggest group in the sector, but are a smaller part of the sector in the U.S.
3. Real estate investment trusts (REITs)
These are a particular type of real estate company that follow very specific rules dictating what the companies can do and how they behave.
The vehicles hold investment properties for the long term and are required by law to pay out approximately 90 percent of their net income as dividends to their shareholders. They are not normally required to pay out profits derived from asset sales to shareholders or gains from property revaluations.
In most jurisdictions, there’s a set amount of development that these companies can undertake. And in some places, maximum gearing (borrowing) levels may also be preset – along with the jurisdiction of properties allowed to be held in a vehicle.
Such vehicles are designed to provide a low risk, high dividend real estate based asset class for investors.
Earnings and dividends tend to be fairly predictable and have low volatility. Earnings growth tends to be low (it is based on rental growth to a very large extent), along with the return on equity.
REITs tend to have a lower beta, in that shares will tend to go up less than the overall market but go down less than the overall market in a falling market.
In the U.S. and Australia, REITs are by far the largest single sector of the listed real estate space. They are a much smaller proportion in Asian markets. In the U.S. and Australia, REITs have been around a long time, but are a much newer development in Europe and Asia.
4. Real estate services, suppliers, contractors
This group includes real estate agencies, property management companies, real estate finance companies, construction companies and buildings materials suppliers.
Many banks have a high proportion of their total loan books allocated to real estate of one kind or other – including real estate services such as materials and equipment suppliers. In Asia, many banks have had more than 50 percent of their loan books exposed to real estate in one way or other at various times.
In markets such as the U.S., there is a body of specialist real estate finance companies that operate in different parts of the real estate market.
Which real estate stock to buy depends on the market
Depending on what’s going on in the market, there may be good reasons to focus on one type of real estate stock over another.
For example, in an environment of low interest rates, investors are usually desperately searching for low-risk yields. That demand has led investors to the REIT space in some markets. Dividend yields tend to be substantially higher than interest on bank deposits or bonds.
Or consider this… housing development slowed dramatically in many countries in the immediate aftermath of the 2008 global financial crisis. As demand for housing came back on line with the economic recovery, it was met with a shortage of new supply. So developers were needed to fill the gap… increasing their prospects.
Rapid growth in populations or exports can also increase the demand for new housing, buildings or manufacturing centers… another positive tailwind for developers.
So before you invest in real estate stocks, consider the risks, rewards and the type of market we’re in.