Real Estate Definition

Real estate is property made up of land and the buildings on it, as well as the natural resources of the land, including uncultivated flora and fauna, farmed crops and livestock, water and mineral deposits.

Although the media often refers to the "real estate market," real estate actually can be grouped into three broad categories based on its use: residential, commercial, and industrial. Examples of residential real estate include undeveloped land, houses, condominiums, and townhouses; examples of commercial real estate are office buildings, warehouses, and retail store buildings; and examples of industrial real estate include factories, mines, and farms.

Real estate is a tangible asset and a type of real property. Real property includes land, buildings and other improvements, plus the rights of use and enjoyment of that land and all its improvements. Renters and leaseholders may have rights to inhabit land or buildings that are considered a part of their personal estate, but these rights themselves are not, strictly speaking, considered real estate.

(Real property is not to be confused with personal property, which includes intangible assets like investments, along with tangible assets: furniture and fixtures like a dishwasher, even if you are renting a home—provided you bought and installed it with the lessor's permission).

Let's take a closer look at two categories of real estate.

Residential Real Estate and Home Ownership

In the 2019 edition of its annual home-value analysis, the real estate website Zillow estimated the total value of all U.S. homes in 2018 was $33.3 trillion, 71% higher than the nation's gross domestic product (GDP) of $19.4 trillion at the time. Homeownership, also known as owner-occupancy, is the most common type of real estate investment in the United States. According to the National Multifamily Housing Council, roughly two-thirds of residents own their home. Often, they have financed the purchase by taking out a particular type of loan known as a mortgage, in which the property acts as collateral for the debt.

Individuals shopping for a mortgage to invest in real estate in the form of an owner-occupied home are faced with a variety of options. Mortgages can either be fixed-rate or variable-rate. Fixed-rate mortgages generally have higher interest rates than variable-rate mortgages, which can make them more expensive in the short run. Fixed-rate loans cost more in the short-term because they are protected from future interest rate increases.

Banks publish amortization schedules that show how much of a borrower's monthly payments go to paying off interest versus how much goes to paying off the principal of the loan. Balloon loans are mortgages that don't fully amortize over time: The borrower pays interest for a set period, five years for example, and then must pay the remainder of the loan in a balloon payment at the end of the term.

Also, mortgages can come with heavy costs, including transaction fees and taxes, which are often rolled into the loan itself. Once potential homeowners have proven their eligibility and secured a mortgage from a bank or other lender, they must complete an additional set of steps to make sure the property is legally for sale and in good condition.

Commercial Real Estate

Commercial real estate is used for commerce and includes anything from strip malls and free-standing restaurants to office buildings and skyscrapers. It is often distinguished from industrial real estate, which is practical space used in the manufacturing of products. Buying or leasing real estate for commercial purposes is very different from buying a home or even buying residential real estate as an investment. Commercial leases are generally longer than residential leases. Commercial real estate returns are based on their profitability per square foot, unlike structures intended to be private residences. Moreover, lenders may require more money for a down payment on a mortgage for commercial real estate than for a residence.

Unlike other investments, real estate is dramatically affected by its surroundings and immediate geographic area; hence the well-known real-estate maxim "location, location, location." With the exception of a severe national recession or depression, residential real estate values, in particular, are affected primarily by local factors, such as the area's employment rate, economy, crime rates, transportation facilities, quality of schools and other municipal services, and property taxes.

There are key differences in residential and commercial real estate investments. On the one hand, residential real estate is usually less expensive and smaller than commercial real estate and so it is more affordable for the small investor.

On the other hand, commercial real estate is often more valuable per square foot and its leases are longer, which theoretically ensures a more predictable income stream. With greater revenue comes greater responsibility; however, commercial rental real estate is more heavily regulated than residential real estate and these regulations can differ not only from country to country and state by state but also by county and city. Even within cities, zoning regulations add a layer of unwanted complexity to commercial real estate investments.

There is also increased risk of tenant turnover in commercial rental agreements. If the lessee's business model is bad, their product is unattractive or they are simply poor managers, they might declare bankruptcy, which can abruptly stop expensive real estate from generating revenue. Moreover, just as land can appreciate in value, it can also depreciate. Once-hot retail locations have been known to decay into rotten shopping centers and dead malls.

One can invest in real estate directly by buying actual properties or parcels of land; or indirectly, by buying shares in publicly traded real estate investment trusts (REITs) or mortgage-backed securities (MBS). The indirect methods may offer less return and less control, but they are vastly more liquid than owning actual property, and don't require in-depth knowledge of the real estate business.

Investing directly in real estate results in profits (or losses) through two avenues, which haven't changed in centuries:

1. revenue from rent or leases
2. appreciation of the real estate's value

Appreciation

Appreciation is achieved through different means, but the increase in a property’s value isn't actually realized until the owner sells it outright, or refinances his mortgage on it. Raw and undeveloped land, like the territory right outside a city’s borders, offers the biggest potential for construction, enhancement, and profit. Appreciation can also come from discovering valuable materials on a plot of land, like striking oil. Or, simply by a rise in the area around the land you own.

As a neighborhood grows and develops, property values tend to climb. The gentrification of urban neighborhoods in some American cities over the last few decades has often resulted in a dramatic increase in real estate prices. Scarcity can play a factor, too. If a lot is the last of its size or kind in a prestigious area—or one in which such lots rarely become available—it obviously gains in marketability.

Income

Income from real estate comes in many forms. The biggest generator is the rent paid on land already developed into residential or commercial properties. But companies will also pay royalties for discoveries on raw land, or they may pay to build structures on it, like cell towers or pipelines.

Income can also come from the indirect type of real estate investments. In a REIT, the owner of multiple properties sells shares to investors and passes along rental income in the form of distributions. Similarly, in an MBS, the interest and principal payments from a pool of mortgages are collected and passed through to investors.

Both REITs and MBS trade like stocks, with real estate as their underlying security. So they may offer capital appreciation as well if an investor can sell the shares at a price higher than the amount he paid for them.

Mortgage-backed securities got a lot of bad press from the role they played in the mortgage meltdown that triggered a global financial crisis in 2007. But they are still in existence and traded today, and the most accessible way for the average investor to buy into them is via exchange-traded funds (ETFs). Although they do carry a degree of risk, these funds offer diversification and specialize in investment-grade MBS, not the subprime variety that figured in the crisis.

As of April 2019, the top-performing vehicles include:

Vanguard Mortgage-Backed Securities ETF (VMBS), which tracks the Bloomberg Barclays U.S. Mortgage-Backed Securities Float Adjusted Index, made up of federal agency-backed MBS that have minimum pools of $250 million and minimum maturity of one year. Priced around $52 per share, the fund has a dividend yield of 3.44%.

iShares Barclays MBS Bond ETF (MBB), which focuses on both fixed-rate and adjustable rate mortgage securities, and tracks the Bloomberg Barclays U.S. MBS Index. Its holdings include bonds issued or guaranteed by government-sponsored enterprises like Fannie Mae and Freddie Mac, so they are AAA-rated. Trading around $105 per share, it offers a yield of 3.02%.

SPDR Bloomberg Barclays Capital Mortgage Backed Bond ETF (MBG), which also uses the Barclays U.S. MBS Index as a benchmark, but adopts a more aggressive approach in an effort to boost returns. Price at $25 per share, it offers a yield of 3.38%.