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By

Kunal Moktan

Why rent yielding real estate is the investment of choice of every sophisticated investor

While one might think that the universe of investible asset classes available today are vast and offer a variety of options to investors, in essence, the final choice comes down to a surprisingly few options.

 

Any reasonably sophisticated investor evaluates an investment with 4 primary criteria:

 

  1. Capital preservation
  2. Returns (and the risks attached to the realization of those returns)
  3. Inflation
  4. Liquidity

A pure play capital preservation strategy would mean investing in securities issued by the government like a treasury bill or a government security. However, even these are subject to interest rate risk. Interest rate risk means the chance of the value of the security going up or down depending on changes in interest rates. When interest rates go down securities with higher interest rates become more valuable and vice versa. How sensitive a security is to interest rate depends on duration. Duration is the length for which the security has been issued. For example, a 30-day G-Sec has much lower interest rate risk vs. a 10-year G-Sec.

 

Therefore, the lowest risk security to invest would be a short duration government issued bond (called G-sec in India). The returns are commensurately lower for these securities.

 

Instrument Yield
10-year G-Sec 6.39%
5-year G-Sec 5.94%
3-year G-Sec 5.78%
2-year G-Sec 5.57%
1-year G-Sec 5.35%
IDBI short term fund (1.89 years Modified Duration) 6.34%

 

Inflation is the rate at which goods and services become costlier. Any investment must therefore be measured against a yardstick of inflation to see whether the returns at the very least cover the erosion in the value of dormant capital (also called “real return”). Since inflation is a gradual process and not always perceptible, it is easy to overlook its effects over the short to medium term – a mistake many seasoned investors make in portfolio allocation.

 

Liquidity is largely a function of the total investible surplus. Every investor should ideally keep a certain portion of his/her total holdings in assets, which can be easily liquidated to meet special needs.

 

An astute investment manager may well be able to craft a strategy with a mix of debt, equity and hybrid securities managed actively to optimize returns on a portfolio bearing in mind these 4 criteria of capital preservation, risk-adjusted returns and inflation. For an investor, this will mean finding the right manager and paying higher fees for active asset management.

 

This is where investing in a rent-yielding real estate asset becomes compelling. A rent-yielding asset could be a leased commercial building, a retail mall / store, a warehouse or a hotel. The most commonly available of these is commercial real estate.

 

Commercial real estate provides 8-9% annual returns through rental yield and an opportunity to participate in the appreciation of the underlying property, giving it characteristics of both debt and equity. By virtue of being a real asset the principal amount is also considerably safer. The real icing-on-the-cake is the annual inflation-linked rent escalations. Most commercial leases escalate by 5% every year or 15% every 3 years providing a strong cushion against inflation. The real rate of return is therefore always 8-9% with the capital appreciation providing the additional equity kicker.

 

If invested in an institutional grade property with a blue-chip tenant, the credit risk of rents not being paid or the tenant vacating can be significantly reduced. A seasoned real estate investor will increase stickiness by requiring the tenant to do the fit-outs or TIs and by signing a “lock-in”, a term used to bind tenants to a building for a longer term.

 

As rents are paid monthly, the recurring monthly cash flow is an important source of steady annuity income that can be reinvested in other assets like a Systematic Investment Plan or withdrawn to meet daily expenses. With a sufficiently large investment corpus diversified across tenants, geographies and asset classes, these monthly cash-on-cash returns can ultimately enable investors to become financially independent, the holy grail of all investment planning.

 

Investor Real Estate
($ bn)
1. Allianz Real Estate $72.4
2. China Investment Corporation (CIC) 52.9
3. Abu Dhabi Investment Authority (ADIA) 51.2
4. APG (Dutch Pension Fund) 48.4
5. TIAA (Teachers Insurance and Annuity Association of America) 47.2
6. AXA 36.3
7. Temasek (Singapore) 35.3
8. QIA (Qatar Investment Authority) 35.0
9. CPPIB (Canadian Pension Plan Investment Board) 33.9
10. CalPERS (California Public Employees’ Retirement System) 33.4

 

Source: Top 100 real estate investors (June 2019, IPE Real Assets)

 

It therefore comes as no surprise that the asset class has attracted investments from some of the largest sovereign wealth funds, pension funds, and investment managers. As per IPE, some of the world’s largest institutional investors invested $33-72 billion into the asset class in 2019.

 

Kunal Moktan

 

The author is the co-founder and chief investment officer at PropShare Capital, India’s first and largest commercial property investment platform.

 

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