Real estate represents a significant portion of most people's wealth, and this is especially true for many homeowners in the United States. The average American has nearly one-third of his or her net worth tied up in real estate, translating to a valuation of nearly $20 trillion dollars for the entire market. The size and scale of the real estate market make it an attractive and lucrative sector for many investors. This article will look at some of the main factors that affect the real estate market and the variety of investments available.
Factors That Influence Real Estate
- Interest Rates
- The Economy
- Government Policies/Subsidies
For example, the baby boomers who were born between 1945 and 1964 are an example of a demographic trend with the potential to significantly influence the real estate market. The transition of these baby boomers to retirement is one of the more interesting generational trends in the last century, and the retirement of these baby boomers, which began back in 2010, is bound to be noticed in the market for decades to come. (For more on the baby-boomer trend, see Boomers: Twisting The Retirement Mindset.)
There are numerous ways this type of demographic shift can affect the real estate market, but for an investor, some key questions to ask might be: i) How would this affect the demand for second homes in popular vacation areas as more people start to retire? Or ii) How would this affect the demand for larger homes if incomes are smaller and the children have all moved out? These and other questions can help investors narrow down the type and location of potentially desirable real estate investments long before the trend has started.
However, when looking at the impact of interest rates on an equity investment such as a real estate investment trust (REIT), rather than on residential real estate, the relationship can be thought of as similar to a bond's relationship with interest rates. When interest rates decline, the value of a bond goes up because its coupon rate becomes more desirable, and when interest rates increase, the value of bonds decrease. Similarly, when the interest rate decreases in the market, REITs' high yields become more attractive and their value goes up. When interest rates increase, the yield on an REIT becomes less attractive and it pushes their value down. (To learn more about these effects, see How Interest Rates Affect Property Values.)
However, the cyclicality of the economy can have varying effects on different types of real estate. For example, if an REIT has a larger percentage of its investments in hotels, they would typically be more affected by an economic downturn than an REIT that had invested in office buildings. Hotels are a form of property that is very sensitive to economic activity due to the type of lease structure inherent in the business. Renting a hotel room can be thought of as a form of short-term lease that can be easily avoided by hotel customers should the economy be doing poorly. On the other hand, office tenants generally have longer-term leases that can't be changed in the middle of an economic downturn. Thus, although you should be aware of the part of the cycle the economy is in, you should also be cognizant of the real estate property's sensitivity to the economic cycle.
What's the Best Investment?
The size and scale of the real estate market make it an attractive and lucrative market for many investors. Investors can invest directly in physical real estate or choose to invest indirectly through managed funds. Investing directly in real estate involves purchasing the residential or commercial property to use as an income-producing property or for resale at a future time. Indirect ways to invest in the real estate market include investing in real estate investment trusts (REITs), real estate exchange traded funds (ETFs), commingled real estate funds (CREFs) and infrastructure funds. Due to the higher liquidity available in the market, the lower transaction costs and lower capital requirements, average investors prefer to indirectly invest in real estate.