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2022 Curriculum CFA Program Level II Alternative Investments

Real Estate Investments

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Real estate offers investors long-term stable income, some protection from inflation, and generally low correlations with stocks and bonds. High-quality, well-managed properties with low leverage are generally expected to provide higher returns than high-grade corporate debt (albeit with higher risk) and lower returns and risk than equity. Real estate investment can be an effective means of diversification in many balanced investment portfolios. Investors can choose to have the equity, or ownership, position in properties, or they may prefer to have exposure to real estate debt as a lender or owner of mortgage-backed securities. Residential real estate constitutes by far the largest portion of the real estate market, most of which is owner occupied. Nonetheless, we will focus almost exclusively on rental, or commercial, properties. These include office buildings, shopping centers, distribution facilities, and for-rent residential properties.

Private real estate investments often hold the greatest appeal for investors with long-term investment horizons and the ability to accept relatively lower liquidity. Pension funds, sovereign wealth funds, insurance companies, and high-net-worth individuals have been among the largest investors in private real estate. Securitized real estate ownership—shares of publicly traded, pooled real estate investments, such as real estate operating companies (REOCs), real estate investment trusts (REITs), and mortgage-backed securities (MBS)—has historically provided smaller investors with ready access to the asset class because of low share prices and the benefits of higher liquidity and professional management. Institutional investors also pursue securitized real estate when the market capitalization of the vehicles can accommodate large investor demand. In fact, institutional ownership of US REITs has increased from 6.6% in 1990 to 64.5% in 2015, according to a 2019 research paper (Huerta, Ngo, and Pyles 2019).

Regardless of vehicle type, the risk profile of the underlying investment can vary significantly. High-quality properties in leading markets with long-term leases and low leverage have a conservative risk profile, as do those mortgages that represent only slightly more than half of the asset’s value. Older properties with short-term leases in suburban markets with ample room for new development and higher leverage constitute higher-risk properties. Below-investment-grade, non-rated, and mezzanine debt similarly carries higher risk. Development property is often considered the riskiest because of long lead times and the dependence on contractors, suppliers, regulators, and future tenants for success.

Section A presents real estate as an asset class, delves into its role in portfolios, and contrasts the different characteristics of the major property types. Sections B and C explore private and public investing, respectively, with particular attention to valuation. Investment valuation and performance can be analyzed at the property and vehicle level. The end of the reading returns to the role of real estate in the portfolio and discusses whether investors’ goals are best served by choosing private or public real estate vehicles.

Learning Outcomes

The member should be able to:

  • compare the characteristics, classifications, principal risks, and basic forms of public and private real estate investments;
  • explain portfolio roles and economic value determinants of real estate investments;
  • discuss commercial property types, including their distinctive investment characteristics;
  • explain the due diligence process for both private and public equity real estate investments;
  • discuss real estate investment indexes, including their construction and potential biases;
  • discuss the income, cost, and sales comparison approaches to valuing real estate properties;
  • compare the direct capitalization and discounted cash flow valuation methods;
  • estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods;
  • calculate the value of a property using the direct capitalization and discounted cash flow valuation methods;
  • calculate and interpret financial ratios used to analyze and evaluate private real estate investments;
  • discuss types of REITs;
  • justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income;
  • describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation;
  • calculate and interpret the value of a REIT share using the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches; and
  • explain advantages and disadvantages of investing in real estate through publicly traded securities compared to private vehicles.


Real estate property is an asset class that plays a significant role in many investment portfolios and is an attractive source of current income. Investor allocations to public and private real estate have increased significantly over the last 20 years. Because of the unique characteristics of real estate property, real estate investments tend to behave differently from other asset classes—such as stocks, bonds, and commodities—and thus have different risks and diversification benefits. Private real estate investments are further differentiated because the investments are not publicly traded and require analytic techniques different from those of publicly traded assets. Because of the lack of transactions, the appraisal process is required to value real estate property. Many of the indexes and benchmarks used for private real estate also rely on appraisals, and because of this characteristic, they behave differently from indexes for publicly traded equities, such as the S&P 500, MSCI Europe, FTSE Asia Pacific, and many other regional and global indexes.

General Characteristics of Real Estate

  •  Real estate investments make up a significant portion of the portfolios of many investors.
  • Real estate investments can occur in four basic forms: private equity (direct ownership), publicly traded equity (indirect ownership claim), private debt (direct mortgage lending), and publicly traded debt (securitized mortgages).
  • Each of the basic forms of real estate investment has its own risks, expected returns, regulations, legal structures, and market structures.
  • Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk. The returns to equity real estate investors have two components: an income stream and capital appreciation.
  • Many motivations exist for investing in real estate income property. The key ones are current income, price appreciation, inflation hedge, diversification, and tax benefits.
  • Adding equity real estate investments to a traditional portfolio will potentially have diversification benefits because of the less-than-perfect correlation of equity real estate returns with returns to stocks and bonds.
  • If the income stream can be adjusted for inflation and real estate prices increase with inflation, then equity real estate investments may provide an inflation hedge.
  • Debt investors in real estate expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate. Thus, debt investments in real estate are similar to other fixed-income investments, such as bonds.
  • Regardless of the form of real estate investment, the value of the underlying real estate property can affect the performance of the investment. Location is a critical factor in determining the value of a real estate property.
  • Real estate property has some unique characteristics compared with other investment asset classes. These characteristics include heterogeneity and fixed location, high unit value, management intensiveness, high transaction costs, depreciation, sensitivity to the credit market, illiquidity, and difficulty of value and price determination.
  • There are many different types of real estate properties in which to invest. The main commercial (income-producing) real estate property types are office, industrial and warehouse, retail, and multi-family. Other types of commercial properties are typically classified by their specific use.
  • Certain risk factors are common to commercial property, but each property type is likely to have a different susceptibility to these factors. The key risk factors that can affect commercial real estate include business conditions, lead time for new development, excess supply, cost and availability of capital, unexpected inflation, demographics, lack of liquidity, environmental issues, availability of information, management expertise, and leverage.
  • Location, lease structures, and economic factors—such as economic growth, population growth, employment growth, and consumer spending—affect the value of each property type.
  • An understanding of the lease structure is important when analyzing a real estate investment.
  • Appraisals estimate the value of real estate income property. Definitions of value include market value, investment value, value in use, and mortgage lending value.
  • Due diligence investigates factors that might affect the value of a property prior to making or closing on an investment. These factors include leases and lease history, operating expenses, environmental issues, structural integrity, lien/proof of ownership, property tax history, and compliance with relevant laws and regulations.
  • Appraisal-based and transaction-based indexes are used to track the performance of private real estate. Appraisal-based indexes tend to lag transaction-based indexes and appear to have lower volatility and lower correlation with other asset classes than transaction-based indexes.

Private Equity Real Estate

  •  Generally, three different approaches are used by appraisers to estimate value: income, cost, and sales comparison.
  • The income approach includes direct capitalization and discounted cash flow methods. Both methods focus on net operating income as an input to the value of a property and indirectly or directly factor in expected growth.
  • The cost approach estimates the value of a property based on adjusted replacement cost. This approach is typically used for unusual properties for which market comparables are difficult to obtain.
  • The sales comparison approach estimates the value of a property based on what price comparable properties are selling for in the current market.
  • When debt financing is used to purchase a property, additional ratios and returns calculated and interpreted by debt and equity investors include the loan-to-value ratio, the debt service coverage ratio, and leveraged and unleveraged internal rates of return.

Publicly Traded Real Estate Securities

  •  The principal types of publicly traded real estate securities available globally are real estate investment trusts, real estate operating companies, and residential and commercial mortgage-backed securities.
  • Publicly traded equity real estate securities offer investors participation in the returns from investment real estate with the advantages of superior liquidity; greater potential for diversification by property, geography, and property type; access to a larger range of properties; the benefit of management services; limited liability; protection accorded by corporate governance, disclosure, and other securities regulations; and in the case of REITs, exemption from corporate income taxation within the REIT if prescribed requirements are met.
  • Disadvantages include the costs of maintaining a publicly traded corporate structure and complying with regulatory filings, pricing determined by the stock market and returns that can be volatile, the potential for structural conflicts of interest, and tax differences compared with direct ownership of property that can be disadvantageous under some circumstances.
  • Compared with other publicly traded shares, REITs offer higher-than-average yields and greater stability of income and returns. They are amenable to a net asset value approach to valuation because of the existence of active private markets for their real estate assets. Compared with REOCs, REITs offer higher yields and income tax exemptions but have less operating flexibility to invest in a broad range of real estate activities and less potential for growth from reinvesting their operating cash flows because of their high income-to-payout ratios.
  • In assessing the investment merits of REITs, investors analyze the effects of trends in general economic activity, retail sales, job creation, population growth, and new supply and demand for specific types of space. They also pay particular attention to occupancies, leasing activity, rental rates, remaining lease terms, in-place rents compared with market rents, costs to maintain space and re-lease space, tenants’ financial health and tenant concentration in the portfolio, financial leverage, debt maturities and costs, and the quality of management and governance.
  • Analysts make adjustments to the historical cost-based financial statements of REITs and REOCs to obtain better measures of current income and net worth. The three principal figures they calculate and use are (1) funds from operations or accounting net earnings, excluding depreciation, deferred tax charges, and gains or losses on sales of property and debt restructuring; (2) adjusted funds from operations, or funds from operations adjusted to remove straight-line rent and to provide for maintenance-type capital expenditures and leasing costs, including leasing agents’ commissions and tenants’ improvement allowances; and (3) net asset value or the difference between a real estate company’s asset and liability ranking prior to shareholders’ equity, all valued at market values instead of accounting book values.
  • REITs and some REOCs generally return a significant portion of their income to their investors and, as a result, tend to pay high dividends. Thus, dividend discount or discounted cash flow models for valuation are also applicable. These valuation approaches are applied in the same manner as they are for shares in other industries. Usually, investors use two- or three-step dividend discount models with near-term, intermediate-term, and/or long-term growth assumptions. In discounted cash flow models, investors often use intermediate-term cash flow projections and a terminal value based on historical cash flow multiples.