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What is property?

Direct vs indirect

What is 'indirect investment' in the property market?

Indirect property investment is when you invest in a product that invests in property - meaning you're not investing directly in the property yourself. This can include investing in a product whose performance is based (to a greater or lesser extent) on some measure of property performance. Examples include buying units in a property fund, contributing to a pension plan with property in its portfolio, and buying shares in a publicly quoted property company.

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What are the differences between direct and indirect property investment?

Direct investment in property refers to when you buy the whole or part of a physical property. As a process, this is not as easy or as quick as investing in equities or bonds, as it requires more time and more capital.

As a property owner you receive rent directly from your tenant, and you can realise gains or losses from the sale of the property. As a landlord you have additional responsibilities for the management of the property. Some of these require specific and specialist knowledge, such as that held by a chartered surveyor.

Indirect property investment involves investing in the skills and expertise of other people, such as property or fund managers. There are a number of different ways of investing indirectly in property (see the 'How can I invest in property?' section). One of the most common routes into the property market, particularly for commercial property, is through collective investment schemes (such as property funds), where investors' funds are pooled together.

Investors need to be aware that making indirect investments is likely to mean the performance of their investment vehicle is not wholly related to the performance of the property or properties contained within the vehicle. In addition, the tax treatment of indirect investment vehicles may be an issue. You need to be aware of the risks involved, and you should always seek financial advice where required.

For more information on indirect investment see the 'How can I invest in property?' section.

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What's the difference between open-ended funds and closed-ended funds and what does it mean for me?

In terms of property, open-ended simply refers to a property investment vehicle where the amount of money available to be invested in property by the fund manager is equal to the amount of money individual investors have put in. If more money is invested by individuals, the manager subsequently has more money available to invest in property. If investors decide to withdraw their money, the manager has to sell property to realise enough funds to repay investors.

In practice, the manager will always keep some money in cash, or easily realisable investments, so the fund can handle inflows and short-term demands for repayments effectively.

Investors generally buy units in an open-ended vehicle, and the number of units increases or decreases as investors enter or leave the vehicle. The value of those units increases or decreases depending on the value of the property held in the vehicle.

In contrast, a closed-ended vehicle (for example a property company, including REITs) is one where a fixed amount of money is raised from individual investors for the initial investment in property and the number of shares in the vehicle does not vary, under normal circumstances. The manager is, therefore, not directly affected by investors' decisions to buy or sell shares in the investment vehicle. The value of the shares is, therefore, dependent on how much other investors are willing to pay for those shares, based on the underlying value of the property assets and the income they generate. 

Under normal, stable market conditions both vehicles are effective, but investors should note that in either rapidly rising or rapidly falling property markets, open-ended vehicles may be less flexible than closed-ended vehicles. As an example, in a rapidly rising market the manager of an open-ended fund may be under pressure to quickly invest cash raised from investors, even when this may not be the best strategy. In rapidly falling markets the opposite is true - the manager may be under pressure to sell assets to realise cash to repay investors. This, in turn, can lead to either acceptance of poor prices for assets, or to delays in or closure of redemptions.

Investors in closed-ended funds may suffer, as the value of their shares often differs from the value of the assets owned by the investment vehicle. These are known as discounts or premiums to Net Asset Value (NAV).   

For more information on indirect investment, see the 'How can I invest in property?' section.

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What are the factors to consider when choosing between direct and indirect investment?

The choice between making an indirect or direct investment tends to be based on two main factors:

The first factor is cost, or the amount of money an investor has available to invest. Most individuals simply can't afford to buy an entire commercial property, meaning that collective investment may be the only option for them in this instance.

The second factor is risk - specifically, the risk of putting a very large investment into an individual property, or into a small number of individual properties, rather than spreading the risk through a collective investment scheme, which may invest in many different properties, possibly even in different countries.

For those people interested in residential investment, there are fewer professionally managed collective investment schemes available, and investors have typically chosen individual buy-to-let properties as their preferred investment vehicle. However, these investors still need to be aware of the risks involved in concentrating their investments in one place, as opposed to diversifying their investments.

For more information on indirect investment see the 'How can I invest in property?' section.

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What are derivatives?

A property derivative is a complex financial contract, the value of which depends on the returns of a real estate index.

To explain derivatives further, according to Hull (1997), "a derivative (or a derivative security) is a financial instrument whose value depends on the values of other, more basic underlying variables". A property derivative, for example, will have a value based on the returns of a real estate index.

Specifically, that means the profit or loss from this instrument depends on the value of another asset or event - for example, the price of a stock, the change of an index value, the amount of snow falling at a certain ski resort, the temperature in a certain city, and so on.

Derivatives may be used by personal investors, high-net-worth individuals, and institutional investors - although not all types are typically used by, or considered suitable for, all groups.

Personal investors can invest in property derivatives to get 'synthetic exposure' to the real estate market. The main derivatives available for retail investors are: structured retail products, securitised derivatives, spread betting, contracts for difference, binary bets, options and exchange traded futures.

High-net-worth individuals can - in addition to derivatives instruments available to personal investors - invest in 'over-the-counter' instruments, such as forwards, and swaps.

Institutional investors, such as banks, property companies and fund managers, will normally trade on regulated exchanges and over-the-counter to increase or decrease their exposure to the real estate market.

For more information you can visit the MSS Real Estate/ Reita Property Derivatives Guide. Please note that this area is aimed at professional advisers only. Property derivatives carry a high level of risk, and prospective investors should consult with their legal, tax and financial advisers in relation to the legal, tax, financial or other tax consequences of a property derivatives investment.

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This guide is supported by the Investment Property Forum Educational Trust (IPFET) in partnership with Reita