I opened the Globe and Mail today to read with interest the article, How the rich are investing in real estate right now, written by Thane Stenner.

Mr. Stenner had an interesting take on what he defined as four different types of real estate investors. As readers of this blog know, real estate has long been an important plank in our investment platform and I thought the subject merited further discussion of the different types of real estate investment opportunities available to high net worth investors:

Development Real Estate – A longer term investment, this category delivers some of the highest returns available in the real estate asset category. However, it is also the riskiest in that capital can be tied up for years as the property is developed and leased out to tenants.

Opportunities in this category include loans, which offer higher than market yields due to the risk associated with vacant land, and capital investments, where the investor takes ownership of a portion of the property along with the developer. An economic downturn, however, can result in these properties remaining undeveloped, and potentially tying up your investment for longer than anticipated.

Income Producing Real Estate – Both commercial property and multi-residential housing units offer an excellent way to reduce risk and earn a steady cash flow. However, for passive investors, it is important to have experienced and well-qualified property managers who understand the day to day complexities of this type of real estate. After all, who wants a call at 2:00am because of a leaky pipe?

Well-diversified portfolios will include investments in many different properties in many different geographic locations thus reducing the risk associated with any one real estate market. Income- producing residential real estate usually performs very well during economic downturns as those who are unable to afford a home turn to rentals.

Turn-Around Real Estate – An offshoot of income-producing real estate, these diamonds in the rough offer the potential for both capital gains and income. Purchasing a property that is undervalued due to a lack of capital investment and investing more to bring the units up to current standards can result in higher rental income and a capital gain when the property is eventually sold. Unlike “flipping” a house, however, investing in turn-around apartment units requires more capital and a longer term commitment. In the article,

Mr. Stenner points to the United States as another example of this category. Areas where property may be undervalued, such as Arizona for example, can present an opportunity to investors. However, investors should understand that employment, economic growth and competing developments will all have an effect on whether these investments ultimately grow in value. In addition, Canadian residents should be aware of the added costs from non-resident taxes, legal and accounting fees from having to file US tax returns if you earn income, and the potential impact of estate tax.

Mortgages – There is a large secondary market for loans completely unrelated to the big 5 banks. Developers and investors often turn to this market because they need to close faster than a bank is willing to or because the bank is unwilling to lend (for any number of reasons unrelated to the opportunity available). Often, the secondary market proves to be more flexible than the banks are willing to be. These loans are often shorter term and have higher yields and carry the property as collateral in the event that the borrower is unable to make payments.

For our part, we invest in all four of these categories, with the majority being invested in income real estate. We do so to diversify and enhance our returns.

While Mr. Stenner points to a number of publicly traded securities or Real Estate Investment Trusts (REITs) as a method for investing in real estate, in my view, this reduces one of the key advantages to real estate: risk reduction.

While these securities often do not have high correlations with the overall market, they typically still fall in value when public markets undergo periods of volatility. In 2008, the S&P/ TSX Composite Index fell 49.3% from its high. The TSX Capped REIT Index fell 62.66% from its high and that fall began much earlier than the broader market.

While it is true that REITs distribute significant cash flow, making this category attractive, they are still subject to market volatility. Private real estate investments may offer some advantages in that their value does not bounce around with the stock market everyday and potentially offer more re-development or capital gain potential than public investments. The challenge however is they are typically more difficult to access for individual investors.

Real estate should be an investment held in every investor’s portfolio. However, it is a complicated asset category and unless you have the expertise, you may want to find professional managers who understand and specialize in this area.