Real estate has often been a favorite among investors, seen as a stable and tangible asset. However, real estate investing is not as straightforward as it seems. Such investments come with their own set of challenges, and when viewed through a long-term, growth-oriented lens, they may not always be the optimal choice. This article explores these complexities, revealing the hidden challenges of real estate investing and highlighting the potential advantages of diversifying into other growth assets.

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Stability with Complexity

Real estate investments typically encompass residential properties, commercial buildings, and land. Direct investment in these assets could generate a stable income through rents and the potential for long-term capital appreciation. Investing in real estate through funds can offer diversification benefits compared to purchasing individual properties. However, direct ownership and fund investments each have unique considerations that must be considered when evaluating your own circumstances and needs.

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Challenges of Real Estate Investing

One of the main challenges in real estate investing is the size of the investment required. Properties in prime locations are often very expensive, demanding substantial capital, which can lead to a concentration of investments. This also tends to necessitate the use of debt to fund the high cost of acquisition, increasing the investment’s sensitivity to interest rate fluctuations that could significantly impact expected returns. While investing through funds can help diversify these concentrated investments, the reliance on debt remains high. This is especially true for strategies focused not just on acquiring rental properties, but also on achieving capital appreciation through development projects.

Real estate's inherent illiquidity makes it difficult to swiftly convert property into cash without a significant impact on market price. If you need cash for an unexpected opportunity or expense, selling property isn’t a quick process. It could take many months to find a buyer and finalize the sale, often requiring you to settle for less than the property's true value. Yet, not all investors need quick access to cash. Long-term investors with stable income sources might find that the illiquidity of real estate can be beneficial, reducing the temptation to sell during market downturns and encouraging a more disciplined, long-term investment perspective.

Timing is crucial when attempting to maximize real estate returns. However, real estate valuations, regardless of sector, are also often influenced by changes in local regulations, economic and global conditions, with geopolitical factors exacerbating these challenges. The effects of these issues on real estate values can last for long periods, making it harder to liquidate a property at the right time and price, especially when there’s a need to access cash. Vigilance, adaptability and patience are often important required traits.

The costs associated with real estate transactions are substantial. These include agent fees, legal fees, and taxes, which can significantly reduce overall returns. Additionally, ongoing maintenance and management costs can add to the financial burden. Unlike stocks or bonds, real estate requires constant care and attention. This ongoing responsibility can turn what seemed like a passive investment into an active job.

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Real Estate Investing from a Shariah Compliance Perspective

Investing in real estate while adhering to Islamic Finance principles introduces additional considerations. Conventional real estate investments often involve high levels of debt, which is typically interest-bearing and not permissible. This reliance on debt can be a significant limitation for Shariah-compliant investors, who must seek alternative Shariah-compliant financing structures. This may take the form of Ijara (leasing), which is not always available to them, or to limit the use of debt considerably, which could impact their capacity and bargaining powers when making acquisitions.

Moreover, the source of rental income must comply with Shariah principles. Properties rented out to businesses involved in non-permissible activities, such as alcohol sale or gambling, cannot be included in a Shariah-compliant portfolio. These restrictions usually limit the pool of potential investments available.

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Advantages of Growth Investing

While real estate can deliver return and potential growth, it’s not without risks, such as those highlighted above. Whether you’re investing for income or for growth, or both, a cleaner approach would be to allocate funds between pure-play income, such as fixed income securities, and growth equity strategies as opposed to expecting a mix from one asset category. Growth funds, like equity funds, often offer more diversified exposure, spreading risk across different sectors and geographies. These assets typically have higher growth potential compared to real estate.

Private equity investments, for example, can provide significant returns by investing in high-growth companies. These investments often align well with Islamic finance principles, focusing on equity-based investments and risk-sharing models. By including these high-growth opportunities in your portfolio, you not only diversify your investments but also position yourself for potentially higher returns.

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Referring to the graph above, we can see that private equity has outperformed the other private market categories. Furthermore, it is interesting to note that private debt has delivered a reliable income, even when considering the bottom quartile of private debt funds with a 7% IRR.

Exploring Diverse Opportunities for Long-Term Growth

Investors seeking to align their financial goals with long-term growth strategies should explore a range of investment opportunities. While long-term returns are possible by investing directly in real estate, the outcome is far from certain. Ongoing costs of maintaining and renting out the property, as well as tax implications and economic developments make real estate investing less reliable than one may initially think.

Broadening your perspective beyond real estate can highlight the clear advantages of investing in growth assets, mainly equities. The journey may be challenging, but with the right mix of assets and a clear strategy, building a diversified portfolio that generates the right level of growth and income for your specific requirements is very feasible.

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Author

Saad Adada, CFA

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