Easy access to cash is key for construction companies as they rely heavily on investors to work on new and existing construction projects. To inject the funds into such projects, the concept of a real estate capital market was introduced. Graana.com, Pakistan’s smartest property portal, discusses what is a real estate capital market and how they work.
What Is Capital Market in Real Estate?
Capital markets are venues for suppliers to exchange funds with governments and companies who are in need of capital. The most common examples are stock and bond markets.
In real estate, the concept of capital markets is the same, where institutional investors and individuals invest directly or indirectly in real estate projects that require a large sum of money. The direct investment in such markets involves Real Estate Investment Trusts (REITs), where investors buy shares of a commercial or residential project.
Generally, these REITs use the share sale proceeds to buy different commercial or residential projects in various locations. In this manner, they are able to provide protection to investors from any decline in the real estate market.
Those who invest in REITs get profits in the form of dividends, which can include rental income or profit from the sale of the properties.
Furthermore, these REITs also invest in residential and commercial mortgages and use the interest payments to provide dividends to the REIT shareholders.
Besides REITs, there are many mutual and hedge fund companies that invest in several securities, which include real estate projects and loans.
These companies offer high-risk loans to borrowers who are not able to get a loan from other lenders. They offer these loans at a higher interest rate compared to other lenders.
Difference Between Capital and Financial Markets
There are a lot of similarities between capital and financial markets, but there are also some notable distinctions. Financial markets use different investment venues where individuals and organisations exchange assets and securities with other investors.
On the other hand, the main goal of investing in a capital market is to raise funds for any new or existing project. It is where most investors buy and sell stocks, bonds and other financial assets.
What Do These Capital Markets Do?
The purpose of a real estate capital market is to provide investment opportunities to individuals and long-term debts to borrowers.
In capital markets, there are different individuals that join various investors to raise the required funds for a commercial or residential project. When that real estate project starts generating profits (e.g. in the form of rental income), the developer distributes the dividends among the shareholders.
The investment in such markets is converted into equities. The individuals can sell these in the form of securities or any other type of financial instruments in the secondary market.
Primary and Secondary Markets
It is important to note that there are primary and secondary markets in capital markets. A primary market is where a construction company sells the shares of a real estate project to the investors, whereas a secondary market is where securities are traded between investors.
Let’s say an individual or company invests $10,000 in the real estate capital market. They will get a 15% return after one year, which will give the investor a profit of $1500.
The only problem is that the investor will receive this profit after one year as the individual has invested in the primary market.
However, a major benefit of a capital market is that the investor can move to the secondary market and sell part or all of the securities to another investor.
Assume that a person has invested $20,000 in a project, and he/she is expected to receive a 10% profit at the end of the year.
But, before that, the individual decides to sell all or part of the share to another investor. The other investor makes an offer of $21,000 to buy his/her stakes.
This covers the initial investment and also provides the return on the initial investment. The investor who has bought the shares will get a profit of $1000 at the end of the year. Through secondary markets, individuals can reinvest in other projects in order to diversify their investment portfolio.
Real Estate Capital Market Debt
As mentioned earlier, the capital markets in real estate offer debts to borrowers. Most of these borrowers consist of governments and construction companies as they need to raise funds to build apartments, shopping centres, industrial parks etc.
Most banks will not finance these kinds of projects due to the large amount of cash required. Apart from that, the duration of the debt in such projects is also longer, which is why most banks are reluctant to lend money for these real estate projects.
This is where the real estate debt capital market comes into play, as companies or institutions use this debt from mutual or hedge funds to raise funds for real estate projects. In this debt instrument, the mortgage loans are pooled together and then the entity sells them off to investors.
Just like any other market, real estate is cyclic and relies heavily on the demand and supply of properties. The capital investors have to remain updated on the changing market trends.
For instance, if an area has a shortage of housing and there is a high demand for properties there, then prices will likely increase.
There will be some impact of inflation and high-interest rate on the market as the operating and debt costs decrease the yields on any investment.
You should look into investing in public projects. They are less volatile and provide much better returns in the long run.
For more information about real estate investment, visit Graana blog.