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  2. Asset Classes
Module 2 · Lesson 6/6

Real Estate and REITs

Rental property, private real estate funds or listed REITs – how to invest in real estate, where the returns come from and why interest rates matter so much.

4 min read Beginner 10 exercises

Key takeaways

  • Real estate returns come from rent plus changes in value, minus costs for maintenance, management, taxes and vacancies.
  • Almost every property is bought with debt. Leverage magnifies gains and losses – and makes real estate highly sensitive to interest rates.
  • REITs make real estate tradable every day and easy to diversify.
  • Listed real estate swings like stocks; private funds look smoother partly because they are appraised, not traded.
  • A home you live in is first a consumption and life decision, and only second an investment.

Real estate enjoys a special kind of trust. It’s tangible, produces rent and has rewarded many owners handsomely. Yet property follows the same economic laws as any other investment. Understanding them helps whether you’re a landlord, a fund investor or a shareholder.

Where the return comes from

The return on a rental property has two parts:

  1. Rent minus running costs: maintenance, property management, insurance, property taxes and vacancies. What’s left is net operating income.
  2. Change in value: does the property’s market value rise or fall?

Transaction costs are easy to underestimate. Agent commissions, closing costs, transfer taxes and inspections can add up to many percent of the price when you buy and again when you sell. Those costs are gone immediately and have to be earned back.

Leverage: debt as an amplifier

Few people buy property entirely with their own money. A mortgage covers most of the price – and acts as leverage:

How a mortgage magnifies returns on equity Property $400,000 · $80,000 down · $320,000 mortgage Value −10% Value +10% −$40,000 +$40,000 on your equity −50% on your equity +50% Without a mortgage it would be ±10%.
Here the mortgage multiplies every change in value by five. It works in both directions.

Leverage pays as long as the property earns more than the loan costs. With rates near zero that was easy. When rates rise, the math turns: financing gets more expensive, and what buyers are willing to pay for a property falls at the same time.

Ways to invest

Route Pros Cons
Rental property Control, leverage, tax advantages in many countries Concentration risk, high transaction costs, work, hard to sell quickly
Private real estate funds Diversified, low reported volatility High fees, redemption limits, appraisal-based valuations
REITs and real estate stocks Trade daily, easy to diversify via ETFs Swing like stocks
REIT ETFs Hundreds of property companies in one security Rate-sensitive, often US-heavy

REITs

A REIT (real estate investment trust) is a company that owns and rents out property – office towers, apartments, warehouses, data centres, cell towers. US REITs must distribute at least 90% of their taxable income to shareholders and in return pay essentially no corporate income tax. Most of their dividends are taxed as ordinary income rather than at the lower qualified dividend rate, which is why many investors hold them in tax-advantaged accounts.

Private, non-traded funds

Private real estate funds value their buildings through appraisals, typically quarterly. Their share prices therefore look very stable. That’s partly an illusion: the true market value fluctuates, it is just reflected with a delay. In late 2022, several large non-traded REITs had to limit redemptions when investors rushed for the exits.

Your own home: investment or life decision?

Whether buying or renting is better can’t be answered in general. It depends on prices, rents, mortgage rates, taxes, maintenance, how long you’ll stay and what you’d do with the down payment as a renter. A home you own offers security, freedom and protection from rent increases. Financially, though, it’s also a large, concentrated and illiquid investment in a single place.

Summary

Real estate earns rent and changes in value, weighed down by high transaction and maintenance costs. Debt acts as leverage – a turbo when rates are low, a risk when they rise. REITs make the asset class tradable and diversifiable, but swing like stocks. That concludes Module 2: you now know the major asset classes. The next module shows how to measure their return and risk – and how to combine them wisely.

Time to practise

10 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.

Test your knowledge

0/3

01You buy a $400,000 property with $80,000 down and a $320,000 mortgage. Its value rises 10%. What is the gain on your equity (before costs)?

The property gains $40,000. On $80,000 of equity, that’s 50%. A 10% fall would wipe out half of your equity just as fast.

02What is a defining feature of a US REIT?

The high payout requirement is the key feature. In return, REITs generally pay no corporate income tax on distributed earnings.

03Why did many REITs fall sharply in 2022?

Higher rates raise borrowing costs and the return investors demand. Property values calculated from fixed rents fall – and heavily indebted landlords come under pressure.

Terms from this lesson

LeverageREIT