Many investors believe that we are now experiencing a “new normal,” an environment characterized by low-to-moderate growth and loose monetary policy. But as real returns continue to decline, many investors are turning to an asset class that has been trusted by generations of smart money: real estate. However, despite the financial innovation in this asset class, most investors are still sticking with the normal ways of real estate investing, and although there are various options available, real estate investment trusts (“REITs”) and direct ownership of real estate continue to dominate the investment landscape.

The benefits of real estate have been known for generations. Andrew Carnegie was once quoted as saying that “Ninety percent of all millionaires become so through owning real estate.” Recent empirical evidence also supports investing in this asset class. The IPD [Investment Property Databank] Global Index has produced returns of 7.8 percent annually since its inception 12 years ago and 8.8 percent over the three years ending in December 2013 (see “Hot Properties” in the December 2013 issue of The Analyst). Interestingly, real estate has also outperformed both stocks and bonds in many countries over three- and 10-year annualized periods, contrary to what theory suggests. There is also substantial empirical evidence suggesting that real estate could act as an inflation hedge and as a source of diversification and income in a traditional portfolio.

Today, this broad asset class now encompasses a diverse mix of assets—from shopping malls to retirement homes—each with their own risk/return characteristics. Investors not only have a wide choice of assets to choose from, but they also have a choice of instruments to achieve their desired exposure and optimize their portfolio with respect to their investment objectives. These instruments can provide equity-like or debt-like exposure. Here is a quick glimpse of what the investment universe consists of right now:

Equity Exposure

Direct ownership in real estate is the easiest to understand. However, it is capital intensive and more illiquid. In the case of a single large investment, there may not be any diversification benefit, as risk becomes concentrated into one position. Consequently, one can also expect higher returns from a combination of income, capital appreciation, and principal repayment. Moving further up the liquidity spectrum are limited partnerships (“LPs”) and private REITs.

LPs pool equity from several investors (usually accredited), typically for large projects during early phases of development. A general partner oversees the project while managing the investment and distributions to investors. The structure is very similar to other private equity deals with lock-in periods, minimum investment requirements, and so on. These similarities are also reflected in the risk profile of these investments, while the returns typically consist of both income and capital gains. Private REITs, as the name implies, are portfolios of income-producing properties where a majority of the income is distributed to investors. They are relatively low-risk compared to direct ownership and LPs, and most of the returns come in the form of income. However, the lack of a public market for these securities still contributes to liquidity risk.

As private REITs mature and their portfolio sizes increase, they usually take the initial public offering route and become public REITs. Hence, they carry over many of the benefits of private REITs with the added benefits of greater transparency and liquid markets. Public REITs, however, are more correlated to common stocks, and as such, compromise some of the diversification benefit. Finally, investors have the choice of investing in the common stock of real estate operating companies (“REOCs”), which can add a real estate flavour to other stocks in the portfolio.

Fixed Income Exposure

Most real estate deals are heavily leveraged, providing an avenue for those investors interested in adding to their fixed income allocations. Bonds issued by REITs and REOCs are an attractive option for investors seeking stable cash flows. Adding mortgage-backed securities and home-rental bonds now provide investors with options for different risk/return requirements. There are also plenty of opportunities available in the private markets, but investors are less aware of these.

Investors have the ability to invest directly in mortgages, either by participating in a syndicate or by providing financing directly to a borrower. Syndicated mortgage deals are similar to those offered through LPs in that they are focused on early stages of development for large projects. In addition, investors can directly finance credible borrowers in arm’s-length transactions with lien on the underlying property. In other words, the investor becomes the lender of a first or second mortgage on a property. This is the debt equivalent of direct ownership and can be easily set up through a trust company. Both forms of mortgage financing can offer yields in the high-single to low-double digits, which seems very attractive in the current environment.

Other Innovative New Approaches

Another example of innovation in the real estate investing space came to market last year with the debut of home-rental bonds by Blackstone. Quite similar to municipal revenue bonds, these securities essentially distribute the rental income from tenants to bondholders, but the underlying properties also serve as collateral. This latest creation is also the manifestation of two underlying trends. First is the shift of institutional money into single-family residences (“SFRs”) as opposed to other well-established types of commercial properties that have traditionally attracted their capital. The second trend is the continued demand from investors to get access to the many benefits of this asset class. Institutional investments in SFRs and issuance of home-rental bonds are only expected to grow, as American Homes 4 Rent and Colony Capital have followed Blackstone.

Interestingly, Canadian investors can also choose to use tax-sheltered registered accounts to invest in all of the instruments described above, with the exception of direct (equity) ownership. This makes it easier for investors to integrate these investments into their existing portfolios while also simplifying the tax consequences. What this really means is that investors can now add a real estate dimension to their existing stock and bond portfolio rather than rigidly considering real estate as a distinct asset class on its own. Investors should not just simply ask what type of real estate to invest in; rather, they should focus on how to structure the investment to create an optimal portfolio. With so many new products available, the new normal may not be that difficult to navigate after all.