Capital investment properties refer to real estate purchased mainly for investment purposes rather than owner-occupation. There are four basic forms of capital investment properties: private equity, public equity, private debt and public debt. They differ in ownership structure, liquidity, transparency, diversification benefits and risks. The valuation of investment properties relies heavily on income approach, which converts expected cash flows into present value. Risks of investment properties arise from fluctuating supply-demand dynamics, operating performance, capital availability, information asymmetry about true value, and illiquidity. This article analyzes valuation methods and risk factors of capital investment properties.
Four formats of capital investment properties
According to ownership and capital structure, there are four formats of investment properties:
Private equity: Direct ownership by individuals, partnerships, LLCs or private equity funds. It offers full control but lacks liquidity.
Public equity: Indirect ownership through publicly traded stocks and funds like REITs and REOCs. It provides liquidity but less control.
Private debt: Direct mortgage loans and private debts backed by properties. It has credit risks but offers higher yields.
Public debt: Mortgage-backed securities (MBSs) like CMBSs and RMBSs. It is liquid but sensitive to interest rates.
Investment properties derive cash flows from rental income, price appreciation, or both. Private formats offer higher expected returns but with lower liquidity and transparency. Public formats provide better diversification and professional management.
Valuation relies heavily on income approach
Various methods are used to value investment properties. Income approach is the most common one, including direct capitalization and discounted cash flow (DCF) methods.
Direct capitalization converts the first year’s net operating income (NOI) into asset value based on cap rate. DCF discounts expected future cash flows to present value based on discount rates. They differ in treatment of NOI growth rate.
Other approaches like cost method and sales comparison are also used sometimes. But they are less suitable for income-generating properties. Income approach captures the properties’ fundamentals better from an investment perspective.
The choice of valuation method and inputs like NOI and cap rate significantly affects assessed value of properties. It is important to use reasonable assumptions and sufficient market data.
Risk factors of investment properties
Despite income stability, investment properties also face various risks:
Supply-demand imbalance can lead to vacancy and loss of rental income. Population demographics, regulations, business cycles all affect demand.
Operating risks related to securing tenants, maintaining assets, controlling expenses. Management capability is key.
Valuation risks as appraisal involves subjective judgments with informational disadvantage and lag. Market disruptions can suddenly impact value.
Liquidity risks due to lumpy capital, high transaction costs and costs and lengthy selling process. Forcesfire sales may happen.
Leverage magnifies cash flow volatility. Interest rate moves severely impacts property prices and refinancing costs.
Obsolescence, environmental issues, market disruptions all pose downside risks to properties’ income generation.
Investors must assess impact of macroeconomics, demographics, regulations, technology disruptions etc. on property fundamentals.
Capital investment properties have distinct risk-return profiles. Investors should choose suitable format based on objectives, constraints and risk appetite. Valuation relies heavily on income approach and subjective assumptions. Various factors can disrupt properties’ income generation, so robust risk management is critical.