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What Is a Real Estate Capital Market?

By K. Kinsella
Updated May 22, 2024
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A real estate capital market consists of individuals and institutional investors that invest money either directly or indirectly into real estate. Construction firms are heavily reliant on cash infusions from the capital market to finance work on new and existing buildings. Since real estate investments are secured by property or mortgages, the real estate capital market normally exposes investors to lower levels of risk than investments in unsecured capital markets.

Direct investments in the capital market often involve real estate investment trusts (REITs). When investors buy shares in a REIT, the share sale proceeds are used to buy commercial or residential real estate. Normally, a single REIT owns a wide variety of property located in different locations so as to protect investors in the event that real estate prices decline in a particular market. Investors receive dividends that are comprised of rental income or the profits generated by property sales. REITs help to drive the real estate market because construction companies can sell properties to these funds and use the sale proceeds to fund the construction of new developments.

Aside from buying real estate, some REITs invest in commercial or residential mortgages. The interest payments on the underlying loans are passed on to the REIT's shareholders as dividend payments. In most instances, REITs buy large pools of mortgages from investment companies and these firms use the sale proceeds to finance more loans. Real estate purchases tend to increase when financing is readily available which means that REITs indirectly bolster the real estate capital market.

While REITs only invest in real estate and mortgages, many mutual funds and hedge fund companies invest in a wide variety of different securities that may include real estate and loans. Fund managers regard these types of investments as relatively stable when compared with equity investments and many firms maintain a fixed percentage of real estate related assets in many types of investment funds. Therefore, construction companies and lenders have to keep building properties and writing loans to satisfy the demand for real estate related securities.

Many finance companies only write loans for creditworthy borrowers, while construction companies typically verify the assets of individuals before accepting bids on new homes. This means that people with poor credit or minimal income are often unable to buy real estate or obtain loans. Some players in the real estate capital market assist these people by offering to finance high-risk loans and real estate developments. These fund companies mitigate the risks involved by charging higher interest rates than conventional lenders. Additionally, many companies sell some of these high-risk securities onto other investors.

What Do Real Estate Capital Markets Do?

Capital markets do two things. First, they provide long-term debts, and second, they provide investment opportunities. This is how they are used in real estate

Real Estate Capital Market Debt

Governments, investors, businesses and other institutions often need to borrow large sums of money for major real estate projects. Not everyone has access to millions of dollars for a large apartment complex, manufacturing plant or community recreation center. In addition, banks are not always willing or able to finance these types of projects, either due to inadequate credit or the amount of money required.

Not only do these projects need significant capital to get started, but they need to pay the debt over the long term. Debts that take more than one year to pay off are considered long-term. These loans are used for assets whose lifecycle lasts more than one year. In real estate, the building may take more than one year to complete, and the income from the asset will continue well beyond one year. These financing tools can be used by both the public and private sectors.

Real Estate Capital Market Investment

Individuals can also invest in capital markets. These investors join with a pool of others to raise capital for large real estate projects. These individuals and companies are then repaid via dividends when the property begins making money, such as when rent is being collected regularly. Because the loans are spread among many investors, the individual risk is reduced significantly.

Investments in these markets are turned into equities, which can also be sold as securities or other types of financial instruments in a secondary market. Whereas the primary market is where the loans originate, the secondary market allows other investors to become involved and make a return.

Consider the following example. John invests $50,000 in a real estate capital market. He expects to receive a 10% return after one year, making him $55,000. The challenge is that his money is tied up in this investment for a full year, and he typically won’t make one penny on the money until the end of the year. This is a primary market investment. However, because John owns the equity, he can move to the secondary market and sell all or part of the equity. Let’s say that Lauren wants to purchase John’s equity stake in the project. She offers him $53,000 for the investment halfway through the year. John walks away with his original $50,000 investment, which he should reinvest in another project immediately, along with a $3,000 profit. Lauren will receive her initial investment of $53,000 along with a profit of $2,000 at the end of the year.

Is the Real Estate Market an Efficient Capital Market?

The real estate market is cyclical. Both the public and private markets’ efficiencies rely on the local supply and demand at any given time. Therefore, capital investors need to be aware of the point each market is in its cycle. For example, if a community has an abundance of available real estate, property prices will fall, but if a community is experiencing a shortage, prices will rise. This can be broken down further. If housing is scarce, multifamily projects may have significant returns, at least until more single-family homes are built. In addition, if a community lacks retail or manufacturing space and the local population and GDP can support these businesses, these investors should expect high returns.

Public projects tend to be less volatile than private projects simply because the local, state or federal government is taking out the loan to improve the social, economic and environmental well-being of states, counties and cities.

In the past, governments have implemented strict regulations on financial institutions and capital market tools, which led to the failure of many of these investments. However, in the 1970s, many of these regulations were dropped or reduced, improving the efficiency and success of these markets. However, they are still impacted by inflation, which increases debt costs, operating costs, equity yield requirements and capitalization rates while decreasing yields, valuation and demand.

What Does a Real Estate Capital Markets Analyst Do?

A real estate capital market analyst is responsible for selling real estate projects and transactions. They are heavily involved in local real estate market research. This research includes financial modeling, market evaluations and macro and microeconomic conditions. It is used in executive summaries and other market reports for each project and to suggest financing or project alternatives.

Analysts also underwrite loans to ensure a project will be profitable. They review and analyze real estate documents, such as leases, appraisals and loans. These individuals prepare marketing materials, contract negotiations, memos and client meetings. These professionals typically work for real estate developers and asset management firms.

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