Distinctly different

Real estate cannot be viewed as one homogenous asset class as the risks and returns vary between categories


Real estate is usually lumped together as one asset class but sophisticated investors differentiate between the various categories within real estate. This is essential since the risks and returns vary between the various categories and investors need to understand these risks and returns before investing. In Oman, one can broadly segment the real estate industry into residential, retail and office space. We can talk about these being different asset classes although they are all real estate. There are other categories like hotels and warehouses but these are relatively small and specialised.

The table gives the risk/reward profile of the three asset classes

RESIDENTIAL
The lowest risks and returns are in the residential segment. It is by far the largest segment and constitutes over 80 per cent of the real estate industry. Relative new comers in real estate are better off sticking to this segment. Banks not entirely familiar with the real estate industry are better off funding residential projects, be it for investment purposes or personal use (mortgages). Occupancy stays over 80 per cent even in normal downturns and variation in rentals within the asset class is small.

In the case of mortgages, the income of the borrower acts as an additional security and lenders in developing countries like India rely more on the income of the borrower rather than the value of the underlying asset. Lenders in the USA ignored the income of the borrower and wrote mortgages to sub-prime borrowers depending only on the underlying asset value. When home values declined in the USA, the lenders lost billions. In India even when real estate prices declined, real estate lending has had the lowest write offs.

OFFICE SPACE
The office space segment is smaller, more risky and overall gives a better return. However the returns are not uniform and depend on location, car park, quality of building etc. One can suffer long periods of vacancy and rents can be low for extended periods of time. This market is more prone to booms and busts with busts lasting longer than booms.

RETAIL
The retail category can be segmented into shopping malls and street retailing. In the case of shopping malls the returns depend entirely on the developer’s ability to put together a tenant mix that can drive footfall and the tenant mix depends on the confidence that the developer can inspire in his ability to deliver footfall.

Returns from street retailing depend entirely on location. There can be a difference of 300 to 400 per cent, in the rents, that a good location can command compared to a poor one. This should be, but usually never is, fully reflected in land prices and developers would be well advised to look closely at such inefficiencies in the market to generate higher returns in commercial and commercial/residential buildings.

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