Direct and Indirect Investment - Advantages and Disadvantages

Direct and Indirect Investment – Advantages and Disadvantages

INTRODUCTION

In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price.

When considering investing in property, one should choose between direct investment (owning one or two properties that are physically rented out and managed) or indirect investment (shares in a property loan stock or unit trust company).

Either can be rewarding, but an investor must choose the investment vehicle carefully and plan properly, says Michael Bauer, general manager of IHFM, a property management company.

DIRECT INVESTMENT

Direct investment is defined by the International Monetary Fund (IMF) as “Investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor’s purpose being to have an effective voice in the management of the enterprise.” In practice, this translates to an equity holding of 10 percent or more in the foreign firm. For example, the investor who decides to invest in a toll road is a direct investor.

ADVANTAGES OF DIRECT INVESTMENT

1. Greater potential for capital appreciation. The goal is to make money.  Direct real estate offers the best means of maximizing returns through greater potential capital appreciation from increased property values captured when properties are sold.
2. Better tax benefits. The goal is to shelter one’s income once one has earned it.  Direct real estate offers the best shelter through greater tax benefits.  Unlike REITs, direct investments can pass through tax losses, which may then be used to offset taxable gains.  Direct real estate investment can be particularly appealing to accredited investors.
3. Superior portfolio diversification.  The goal is to protect one’s assets through diversification.  Direct investment offers the best diversification benefit.  While REITs are commonly marketed as having a low correlation to the stock market, direct investments have an even lower factual correlation.

The advantage of owning a property outright and not in partnership with anyone is that it is yours and you can gear up to 100 percent of the investment (which means you own property without equity).

You earn the future rewards of that property and have 100 percent decision making ability on that property.

The disadvantage is that the risk is 100 percent yours – in terms of financial market risk (interest rates), business risks, and the risk of default when you have tenants.

INDIRECT INVESTMENT

Indirect investment is a way of investing in real estate without actually investing in the property. Indirect investment can be done in many ways, including securities, funds, or private equity. Most investors interested in indirect investment would do so through a company or advisor who has experience in this type of investing.

Indirect property investment is also defined as the acquisition of participating interests through the main stock exchange or during before hours-trading or Over the Counter (OTC), where the investor is only interested in property shares or indirectly interested in so-called “listed real estate”.

An indirect investment is a type of investing opportunity that does not require the actual purchase of the asset that ultimately generates the return. This type of arrangement is often associated with investing in real estate ventures, typically by purchasing stocks issued by a real estate company that in turn purchases and maintains the properties generating the dividends issued to the shareholders. There are a number of benefits to indirect investment, including the ability to avoid having to be directly involved in the management and upkeep of the assets involved.

Advantages of indirect investment

Indirect property investment has the following advantages:

1. Shares / Shares in funds

• General Remarks

1. Investment with low levels of capital expenditure as well
2. Investment diversification (shares, funds, bonds)
3. No involvement in refinancing, facility management, real estate management and end-users (tenants, lessees etc.)
4. Comparability / benchmarking
5. Liquidity of participating interests » sale on the stock market
6. Improved performance / higher yields (professional real estate management and facility management
7. Performance monitoring by other investors, analysts and media
8. Income stream

• For property companies limited by shares (listed on the stock market)

1. Property shares may be bought and sold on the stock market at any time
2. Visibility through option to publish real estate

• For shares in property funds

1. Return option
2. Investor protection through investment rules and supervision
3. Property bond option
4. Market making opportunities for trading in shares in property funds
5. Visibility through option to publish real estate indices 2. Companies

Disadvantages

1. Shares / Shares in funds

• General Remarks

1. Dependence on the professionalism of the fund management
2. Dependence on the protection of minority holdings and its effectiveness
3. Complete transparency
   1. of mutlisectional structures, profit transfers possible
   2. Clarification of the structures and procedures is necessary

• For property companies limited by shares

1. Risks inherent in company purpose (no restrictions on holding and trading in real estate, e.g. additional purpose as a general undertaking or total solution provider and as a property developer [e.g. Allreal AG]
2. No investment rules (in contrast to the mutual property fund, property OEICs and property CEICs)
3. Voting shares for promoter as reason for not participating in the vehicle
4. Group-related subordination and resultant risks
5. Clarify group structure

• For property funds

1. Cost intensity (marketing costs [portfolio management commission [also retrocessions], subject to marketing outlay], fund management fees, depository bank, real estate management and so on)
2. Liquidity issues (insolvency of unsellable real estate)
3. Shares are only taken back at the end of the financial year, every 12 months (exceptions are possible)
4. Closure of fund / compulsory liquidation

The differences between direct and indirect property investment?

Direct investment in property refers to when you buy the whole or part of a physical property. As a process, this is not as easy or as quick as investing in equities or bonds, as it requires more time and more capital.

As a property owner you receive rent directly from your tenant, and you can realise gains or losses from the sale of the property. As a landlord you have additional responsibilities for the management of the property. Some of these require specific and specialist knowledge, such as that held by a chartered surveyor. while

Indirect property investment involves investing in the skills and expertise of other people, such as property or fund managers. There are a number of different ways of investing indirectly in property (see the ‘How can I invest in property?’ section). One of the most common routes into the property market, particularly for commercial property, is through collective investment schemes (such as property funds), where investors’ funds are pooled together.

Investors need to be aware that making indirect investments is likely to mean the performance of their investment vehicle is not wholly related to the performance of the property or properties contained within the vehicle. In addition, the tax treatment of indirect investment vehicles may be an issue. You need to be aware of the risks involved, and you should always seek financial advice where required.

For more information on indirect investment see the ‘How can I invest in property?’ section.

 Factors to consider when choosing between direct and indirect investment?

The choice between making an indirect or direct investment tends to be based on two main factors:

The first factor is cost, or the amount of money an investor has available to invest. Most individuals simply can’t afford to buy an entire commercial property, meaning that collective investment may be the only option for them in this instance.

The second factor is risk – specifically, the risk of putting a very large investment into an individual property, or into a small number of individual properties, rather than spreading the risk through a collective investment scheme, which may invest in many different properties, possibly even in different countries.

For those people interested in residential investment, there are fewer professionally managed collective investment schemes available, and investors have typically chosen individual buy-to-let properties as their preferred investment vehicle. However, these investors still need to be aware of the risks involved in concentrating their investments in one place, as opposed to diversifying their investments.

REFERENCES

Aitken, Brian J., and Ann E. Harrison. (1999). `Do Domestic Firms Benefit from Foreign Direct Investment? Evidence from Venezuela’, American Economic Review, 605–618.

Angelucci, M., and De Giorgi, G. (2009). `Indirect Effects of an Aid Program: The Case of Progresa and Consumption’, American Economic Review, 99, 486–508.