Real Estate - Equity or Bond?

A basic distinction investors make among different asset classes is that between debt and equity. Debt involves a contractual obligation to make predetermined payments over a specified period of time. Equity represents ownership of an investment the returns on which will be determined by its success or failure as a business over any given time period. The risk characteristics and expected returns from each type of asset are distinctly different.

The proposal that commercial real estate embodies some of the characteristics of both bonds and equities has been considered by, inter alios, Booth, Cashdan & Graff [1989], Graff [1990], Graff & Cashdan [1990], Greig & Young [1991] and Baum & Crosby [1995]. The above results support this argument, dividing the behaviour of real estate value indices into two components. Real estate investment may be viewed as behaving like a bond in certain periods, when it produces a fixed income stream (see sections 2.4.5 and 2.4.9), and an equity during others.

Young & Greig [1995, p. 241] state that

'Commercial real estate may be viewed in financial terms as a hybrid of debt - the existing lease obligations - and equity the right to release the property after the existing leases expire. Its investment performance is either more bond-like or more equity-like (sensitive to inflation and market fluctuations), depending on the nature of the lease in place, the market demand for space, and the current expected interest rate environment.'

To paraphrase, the value of real estate is underpinned by the relative yield on long-term gilts, plus a risk premium. The latter including an embedded option on economic growth.

The equity/bond characteristics described above may therefore offer a possible explanation of the bimodal behaviour observed. However, the strength of this historical relationship may have been undermined by the structure of modern day finance packages, with the prospect of a low inflation environment providing further weakness, as discussed in section 2.4.6.