Three Challenges with Real Asset Investments – and How to Work Around Them

Learn how to work around these three primary problems with real asset investments.

Illiquidity, a lack of expertise and the unknown dynamics of the marketplace all affect the growth of real assets. Smart investors know how to minimize their exposure.

Investors have been diversifying their portfolios with greater enthusiasm since the financial crisis of 2008. Given the failings and vulnerability of market-traded securities, they are increasingly adding real assets to their financial planning, finding asset growth in such things as precious metals, art and antiques, raw and developed land and hedge funds.

But real assets are like any class of investment: each has its challenges – which makes sense, because if there were no risk there would be little reward. For any investment to be worthwhile – even if it is daunting to the feint at heart – it must come with some vulnerabilities. The smarter investor can then pick his or her way through those challenges and figure out ways to mitigate risks.

One of the best illustrations of this is land investing. Every property, particularly land tracts that are undeveloped, has a truly unique set of variables while being subject to national economics and even to some extent the global economy. Consider the three primary challenges to land investing – illiquidity, asset knowledge and marketplace dynamics – and some ways that these investment risks can be minimized or even eliminated:

1. Illiquidity – There are two conflicting theoretical arguments about economics. One is that, essentially, everything is for sale, and that every product has a buyer. But in fact, there is friction in all markets that slow things down and prevent buyers and sellers from doing neat, instant transactions. Market-traded securities are perhaps the best examples of very liquid assets, yet trading halts and high bid-ask spreads can slow even those down.
   
   Greater illiquidity happens with real assets such as land, of course. Land investors sometimes anticipate it will take several years for the asset to reach an adequate value increase before attempting to sell it, and then the legal matters relating to the transaction generally takes months to execute. Rare antiques, art, precious metals and other real assets have similar challenges in that the transactions involve certain factors that slow the actual sale of the asset.
2. Asset knowledge – Art dealers make a handsome income for a reason: they understand art and art values. The same can be said about antique cars and other fine collectibles. Each requires deep knowledge of the asset class itself, as well as the current dynamics that affect near- and long-term values.
   
   Using the same example of raw land, knowledge of the investment and all factors affecting it require expertise on the part of the investor. To this point, it should be noted that fraudulent schemes have promoted worthless land to unsuspecting investors. Anyone investing in land should have skills in site evaluation and planning, and be able to gauge municipal planning authorities’ propensity to rezone land for alternative uses (typically, authorizing it for residential or commercial development). The land investment expert will also be able to judge how much time will be required to turn raw land into something of greater value – enabling investors to understand how long they must wait to see a return on their investments.
3. Dynamics affecting value – To see where world events can affect the price of a real asset look no further than what has happened lately to the price of gold. Between October 2012 and February 2013, prices tumbled from a high of $1800 (USD) per ounce to $1600 per ounce – after a 481 percent increase from 2002, when it traded for about $275 per ounce, the biggest gains coming after the 2008 global financial crisis.
   
   Historically, gold prices have mirrored the ups and downs of interest rates, but other factors have played a role in the stratospheric increase of gold in the past decade. These include a slowing global economy, sovereign debt problems worldwide and the downgrade of U.S. debt, as well as fears tied to deficit spending by governments.
   
   Land investment in the UK is currently driven by a distinct housing shortage. While it remains difficult for many young people to get adequate financing, that may ease in the near future. Also, more housing may be built for the rental market, which has grown considerably in recent years. The dynamic is a continuing population growth rate in England and Wales (7 percent in the decade preceding the 2011 census) juxtaposed against a woefully inadequate amount of building to replenish the housing stock. Also, the economics of one town may differ greatly from another, with pockets of growth tied to the fortunes of one or two industries.

The trick is to predict with confidence what the dynamics will be and how it might affect real asset investments. E.g., with built property, commercial and residential, it’s vacancy rates. With undeveloped property, it’s the demand for housing and the political inclination toward encouraging the development of land.

With each of these problems, the seasoned investor – or their investment advisors – will fare best when they apply deep knowledge to the specific type of asset. And just as no two assets are exactly alike, so too are the objectives and portfolios of one investor to the next.

Key Variables in Real Assets that Create Volatility

Real assets such as land are less vulnerable to price/value volatility.

Real assets including real estate are popular alternative investments. Raw land stands out among them because it is characterized by low price volatility.

The shortage of housing in the UK is the most obvious factor in discussion of land assets and the growth potential for land investments. With a solid 7 per cent (over the past ten years) growth rate of the population, the country stands above most other European countries in its need for new home construction.

Compounding this has been the reluctance of builders in the financial crisis since 2008 to construct new homes (due to stringent financing), which strongly suggests pent up demand. Even if people cannot afford to buy, they have to live somewhere, right? In fact, the construction of rental housing is on the rise and may be where real asset investing shifts.

But looking five to ten years hence, will there be a housing bubble – a rash of building followed by an oversupplied market? Not likely – the build up in demand is that critical and unlikely to be fully satisfied for a long time to come. But even without this extraordinary set of circumstances, land investing is generally less subject to price and value swings, vis-à-vis other real assets, for a number of reasons:

• Raw land appreciates in value on a linear path – Due to the finite nature of land coupled with a growing population, demand is always on the upswing. Inflation naturally pushes prices upward, and with a positive decision by planning commissions the asset can grow dramatically.
• Raw land allows diversification – While most land investment requires a minimum of £10,000 to participate, it is possible therefore for many investors to participate in multiple sites. Built properties carry a considerably higher price, effectively forcing the investor to be concentrated in fewer property investments.
• Land investment specialists know how to optimize value – The many variables of strategic land investing are best left to the professionals – because they know what they’re doing. They are able to negotiate optimal purchase and sales prices, how to time an investment and achieve local planning commission permission to convert raw land into something more productive.
• Land investing is not like an REIT – Real estate investment trusts are market-traded securities, subject to market dynamics that may have little or nothing to do with the intrinsic value of the properties in the trust. Raw land is a real asset that is much more controllable.

Real assets overall have proven to be attractive during the years of the 21st century financial crisis, albeit with variable performance from one to the next. Investors are encouraged to seek the counsel of an independent financial advisor before committing to a specific investment.

Homebuilding and Land Site Investment Are Separate Entities in the UK

Historically, homebuilders bought land, achieved zoning changes, constructed houses, then sold them. But land site developers change the equation – and reduce risk.

After five full years of an economic downturn for homebuilders, sellers and buyers, the news is instead looking up in the United Kingdom. The Wall Street Journal reported in April 2013 that homebuilder stocks were up 80% over the previous 12 months, buoyed in part by the government’s Help-To-Buy schemes announced earlier in the year.

This came about six months after Reuters reported that UK home builders were sitting on land banks, much of which was purchased in 2009 and later, when the price of land had plummeted. They are now about to leverage the value of that land, pending development consent from local planning authorities, to build new homes.

But many of those homebuilders suffered quite a bit through the earlier years of the recession, with portfolios of property that included land purchased just prior to the financial crisis of 2008. That expensive land was a drag on profits – those firms that had deep pockets might have been able to afford to carry the costs, but many homebuilders (particularly smaller ones) fell out of the business entirely because of crushing debt.

Some of this recent land investing and building history helps illustrate how the business of development on raw land has been bifurcated in recent years. Instead of builders taking on the full risk of investing, building and selling, land investment specialists now undertake the first stages. In addition, real estate analysts at Savills report that the forthcoming Basel III banking regulations could constrict debt funding, which further limits how much risk homebuilders will be willing to assume. They will instead look for smaller parcels of serviced (infrastructure-built) properties.

The new approach is for land specialists, themselves or with the help of investors, to make strategic land purchases. They engage in intensive market research to identify where growth is most critical, then investigate raw land where that might be possible, taking into account seller predispositions, existing and needed infrastructure, as well as how amenable to planning changes are local planning authorities. The land specialists might (and often do) build the infrastructure – roads, water and sewer, and electrical capacity – but then sell parcels or plots to homebuilders, who have greater experience at both construction and the marketing of the built properties.

To a land site investor, the holding of property for several years before construction begins – as happened to homebuilders since 2008 – does not fit the business model. The investor’s objective is to turn the investment as quickly as possible, and to buy land in the first place that will sell at an optimal price in the near term. This is part of why land-to-build investors are coming to real estate from other alternative investment categories: If their options are hedge funds, precious metals, real estate investment trusts (REITs) or market-traded securities, the return on investment formula places heavy weight on timing. The land investor may plan to achieve a return in as little as 18 months after acquiring raw land (note: it sometimes can take five years to bring a property to market and realise the return on investment).

A key component is of course zoning changes, taking land that might be designated for agriculture or other uses and have it designated by local authorities for residential or commercial development. Homebuilders may have this capability in-house as well, or may contract it out to others. With land investment specialists, it is an essential part of the business model and a key component of achieving profitability. Relationships with local planning authorities in strategic locations certainly aid in this process.

Land investment, particularly with raw (unbuilt) properties, involves risks just as much as with other types of investment. But by controlling for factors such as land planning, and splitting the risks – and rewards – of building and selling completed homes, residential land investors mitigate those risks. Individuals who are interested in land investments should speak with a personal financial planner to determine if any particular investment fits their overall financial portfolio.

Does a JV Investor Need An Attorney at the Outset of An Investment?

Should a land investor working in a joint venture partnership engage a solicitor?

The popularity of joint ventures for land has soared with the Limited Liability Partnerships Act 2000. But other types of partnerships might be considered.

Joint Ventures (JVs) are a common means for several individuals to collectively invest and grow an asset. As should be obvious, the risks and rewards of that asset are spread among the partners – enabling smaller investors to participate in capital growth just as much as the super-wealthy who are more able to do it on their own.

But the risk part of JVs is no light matter. Poorly managed joint venture partnerships are the stuff of legal and financial legend – even large entities such as the alliance between Honda and Rover (1981-1994) can end badly. In that case, the assets brought to the partnership included car design, engineering, distribution and marketing capacities, which proved to be a poor fit over time.

Land investment joint ventures are a bit different in that they generally require capital to invest in the land itself and the expertise to turn the property into a more productive asset. For example, in the UK a pressing need for housing makes it likely that land currently in use for agriculture on the periphery of population centres will be converted to residential and commercial uses. Land investors working in joint ventures with UK land fund mangers can do well to purchase tracts that can optimally serve these purposes. But to do it right, the investors must also know how to select land that is likely to achieve local planning authority goals for growth, and they must build the infrastructure on the land that will attract developers and builders.

Still, what needs to be central to the investor is how to limit his or her exposure in this type of investment. Savvy decision-making is the province of the investor and his or her advisors. But the engagement of legal counsel can play a role as well, by various degrees according to the type of partnership that is established.

Three types of partnerships – and questions the JV investor should

A prominent London-based law firm with a large, property joint venture practice advises its clients to look at the three most common types of partnership vehicles to assess the relative risks and appropriateness for them and their proposed investment:

General partnerships – These require no formal declarations, a relationship that is tax transparent (each participant is tax-liable for income and capital gains, not the partnership). The largest risks lie in how each member of the partnership is jointly and severally liable for debts; they are not able to ringfence losses and liabilities. The Partnership Act 1890 governs general partnerships.

Limited partnerships – These need to be registered at Companies House, and include two types of partners: limited and general. Limited partners are liable only for their investment, and they are forbidden from involvement in the management of the business under the partnership. The general partner is exposed to all liabilities, and is tasked with full management responsibilities of the business itself. The Limited Partnership Act 1907 governs this arrangement.

Limited Liability Partnerships (LLPs) – Considered a hybrid between companies and partnerships, investors enjoy limited liability (as the name implies) but also offers them involvement in the management of the business. Members are taxed only on their share of profits from the investment, which has made the investment very popular since introduced by the Limited Liability Partnerships Act 2000.

According to the solicitors who work in this area, investors need to weight the pros and cons of these three joint venture structures, as well as private limited companies and unit trusts. The process of determining which is right for the investors and the investments might take into consideration several factors, as follows:

• Development or investment? The nature of the land investment – and its size – can determine whether a simple or complex structure makes the most sense. 

•  Investor relationships. A collection of several passive investors is different from long-term partners who are comfortable with joint and several liability. In other words, the degree of familiarity with your partners can make a big difference.  

• Tax transparencies. Not only should investors’ current tax scenario play into such a decision, but ask whether the structure of the investment or your own situation will change at some future point that might affect tax liabilities as well. 

•  The liabilities in land – If a property needs remediation, for example, the partnership will have additional expenses and potential legal exposure. Good advance research should uncover this before entering a contract to purchase the property, of course, but as with any business venture there can be liabilities against which investors must protect themselves.  

• Exit routes – Should an investor need to cash out of the investment, would he or she be able to do so? Understand the liquidity and flexibility of the structure to know whether or not this is an option or risk.

As important as legal counsel may be in some investments for some investors, of equal importance is the role of an independent financial advisor. All investments should be undertaken with regard to one’s portfolio, risk tolerance and expected returns, which often benefit from the review and analysis of a professional third party.

Might the Answer to the UK Housing Shortage Be Found on Disused Farms?

Relaxed rules on the conversion of farm buildings and other structures to alternative uses illustrate a trend: the UK is open to adaptation and change.

The increased productivity of farms in the United Kingdom has worked its way into national planning policies in a surprising way. Beginning in May 2013, existing agricultural buildings that measure less than 500 square metres can now be utilised for other purposes with a “light touch” neighbour consultation.

This means that farm outbuildings and homes might adapt quickly to serve as retail, financial services, office, leisure, assembly, restaurant, pub and hot food takeaway businesses. According to Communities Secretary Eric Pickles, this can have a positive impact on rural economies. “There is huge untapped potential in many disused existing buildings,” he told a website serving academics and professionals engaged in urban development. “We’re determined that every one of them is put to good use. By simplifying the process and relaxing some stringent rules we can provide a helping hand to those eager to boost their high streets or rural communities by cutting the time and costs needed to start up new businesses.”

In some of those communities, conversions to free schools might be accomplished as well. The programme also includes disused office buildings, which can also be converted to residences.

Why is this happening – and how might it address the country’s serious housing shortage?

It is largely due to the increased efficiencies in farming over the past several decades. Wheat yield as measured in tonnes per hectare rose from about six to eight from 1980 to 1995, for example. Yields have come about through more intensive use of fertilizer, increased use of pesticides, greater knowledge and expertise in farming, removal of hedges that enable more efficient farming, and European Union guaranteed pricing. Over this same period of time, the proportion of UK workers engaged in farming declined from 175 per 1,000 workers to about 100, a 42 percent reduction. With fewer people needed to work the land, it’s understandable that there has been so much consolidation of farms and the abandonment of farm buildings that go with that.

The conversion of farm buildings to pubs and office buildings to residences speaks to a generalised effort overall to open up building and land to alternative uses that fit a changing world. The UK population grew by 7 per cent between 2001 and 2011, an astonishing rate of growth in comparison to most countries in the Eurozone. This is due to a combination of immigration, higher birth rates and senior longevity. This last factor, seniors living longer, includes them remaining in their own homes longer, which contributes to the housing shortage. The National Planning Policy Framework (NPPF) has advised that more local authority be allowed to drive decisions on how land is used, in part to speed up the process of conversions of property and buildings from a former use to something more appropriate for contemporary needs.

Strategic land investing is also an attractive investment opportunity when those conversions can be made. Specialists in conversion schemes – property fund partners who purchase disused farms, for example, that can contribute more to the local economy by conversion to residential use – will work with investors to identify appropriate sites, achieve a zoning change, and build the infrastructure necessary to enable homebuilders to build and sell residences. In some areas, those may be rental homes and in others homes for purchase.

Investors interested in any such land or building conversions need to go about it carefully, of course. Real estate is a means by which many have achieved significant asset growth, but it should be done in balance with other financial assets and growth strategies. An independent financial advisor should be enlisted to make an assessment of this type of capital growth fund.

Is Another UK Land and Housing Value Bubble Building to 2008 Levels?

It seems too early say UK real estate values are approaching unsustainable levels, given the past half-decade of value deflation. But some see signs it is.

The story of land and real estate prices in the UK is Dickensian: the best of times in some places (central London, for example) with lingering reminders of the worst of times in the aftermath of the burst housing bubble of 2008 (Leeds, Bradford and Liverpool). In the latter, struggling local economies mean vacant properties and stalled housing sites.

The housing shortage may exist throughout the UK, but the economics of those different locations vary, according to a report from the Centre for Cities, Cities Outlook 2013 (the report is supported by the Local Government Association). The report largely argues for different and local approaches to the housing crisis, which is very real given the natural and immigration-driven population increase that has outpaced new house construction by a factor of two for the better part of 30 years.

The housing crash that was part of the larger worldwide financial crisis in 2008 certainly brought down real estate values everywhere. But true to the nature of housing values (as heavily documented in Cities Outlook 2013), the rebound has been spotty. London and the South East have recovered most robustly in 2013, says real estate advisor Savills. After disappointing reports in 2012 and the four years prior, house properties averaged across England and Wales rose 0.4% in May 2013, the fastest rise in six years – hearkening back to when the housing bubble was going full steam in 2007.

So does that mean a new housing bubble is forming? While that idea might strike some as ridiculous, here are a few perspectives on that possibility:

“Help to Buy” risks another bubble – According to Sir Mervyn King, the Bank of England governor, this three-year initiative which will have £12 billion of public backing, is too similar to the American government guaranteed mortgage market. By providing taxpayer underwriting of as much as 15% of mortgages on homes valued £600,000 or less, the programme might inadvertently send prices skyward.

London and the South East most at risk of a bubble – CNBC-TV, the financial news network, is also using the “B word” to describe what is happening in these specific areas, where prices rose faster than the national average of 0.4% in May (0.9% in London and 0.5% throughout the prosperous South East). “The gap between supply and demand in London is the largest it has been since spring 2009, said the Hometrack property analytics firm’s director of research, Richard Donnell. “In the last six months, demand has grown by 15% [in London] while supply has declined by 0.6%.” He says there is a reluctance to put homes on the market in these particular areas, given the uncertainties over jobs and housing availability elsewhere.

Basel III banking regulations and debt funding may restrict development – Real estate analysts at Savills forecast that serviced land (property with infrastructure, transport access and built structures) will achieve the 2007 peak values by about 2016. But because debt funding is limited, house builders will likely focus on smaller sites and build in lower volumes. This will tend to put a crimp on overall development such that the supply will remain tight, inadequate for the still-growing UK population.

The Savills analysis that homebuilders will lack necessary financing does not take into account the newer two-step model for developing raw land into built housing. Homebuilders now have an option: take on the full risk and extended time frame of development by buying raw land from farmers and other owners, or wait for an investor team to do about half of that work for them. In the latter scenario, investors in UK land, led by land development specialists, identify land with optimal development potential. Those specialists will have a well-informed approach to buying, being familiar with local zoning authorities who can make a designation change from, say, agriculture to residential and commercial uses. Once a purchase is made and that use designation secured, the investors often build key infrastructure features, such as streets and public utilities. Only then will a homebuilder step in to purchase lots ready to build. Profits may be split between both entities, investors and homebuilders, but so too is the risk cut by half.

Individuals who wish to participate in the investment phase are urged to do so with the help of a personal financial advisor.  The personal financial advisor can assess the value of alternative investment in land within a holistic view of one’s total wealth portfolio. They also should identify a strong land investment organisation that can illustrate success with earlier projects.

How Do Private Investors Work with the Homes & Communities Agency?

Government involvement in housing is typically centred on social housing. But private funders also work with the HCA on investment properties.

The purpose of the Homes & Community Agency (HCA) is to encourage development of private housing that is affordable and which enriches local communities. Historically, funding has come from the National Affordable Housing Programme, however part of the Agency’s work is to marry private investment with its projects. Current objectives include working with strategic land investment companies to bring projects to live, bringing empty homes back to use, continuation of the Mortgage Rescue scheme, restoring social housing in disrepair and supporting the FirstBuy affordable home ownership scheme.

The agency has been very instrumental in aggregating private investors with housing organisations. Included in this are the Get Britain Building programme, involving the Agency with the Notting Hill Housing Group and the Greater London Authority in a £90 million plan to rent 140 new rental units in London. The arrangement provides investors with income as well as capital growth, a combination not always found in to-let housing investments.

Another private-public investment programme is the Build to Rent Fund, which involves the Department for Communities and Local Government, the Homes & Communities Agency and the Greater London Authority.

These programmes are key parts of how the government is working to address the critical need for housing in the UK. London Mayor Boris Johnson is in full support of such efforts: “With London’s population expanding at record pace, we need to build around a million new homes in the next 25 years to meet demand and avert a possible housing crisis,” he says. “Increasing supply in the private rented sector has a massive part to play in this. Building new, well-designed homes to rent will also lead to a more balanced rental market for Londoners, as well as providing construction jobs and stimulating growth for London’s economy by making it an even better place to live and work in.”

Of note, rental housing has significantly grown since the financial meltdown of 2008. The Office of National Statistics reports that 3.8 million more people are renting today than in 2009. Investors see opportunity in both rental and to-buy development.

The HCA also works on land regeneration (remediation and reclaiming contaminated land), development of local infrastructure and public sector landowners. The goals of all investments made by the Agency are to contribute to overall economic growth, as housing is integral to prosperity and quality of life. Part of how the agency accomplishes that within the government’s “Plan for Growth” is to providing expertise on housing and physical regeneration.

All of this underscores the need to be creative on multiple fronts at addressing the critical housing shortage facing the UK. Housing is integral to economic strength as much as quality of life, both of which have suffered in the past several years. Private investment plays a similar role, as investors and homebuilders endeavour to develop new market-rate housing, for sale or to-let, in areas where the growing local economy requires it.

Private investors in housing need to do necessary due diligence on any investment, ideally through an independent personal financial advisor.