Chapter 9-Equity and property markets Flashcards
- Explain the relationship between ordinary shares and the ownership of companies.
Ordinary shares are securities held by the owner of an organisation. In a small company all the equity shares may be held by a few individuals or institutions; in a large organisation there may be many thousands of shareholders.
- What form does the distribution of profits to shareholders take?
The distribution of profits to shareholders takes the form of regular payments of dividends.
- Explain fully the relationship between dividends and company profits.
Since dividends are related to the company profits that are not known in advance, dividend rates are variable.
It is expected that as company profits increase over time; dividends per share will also increase - though there are likely to be fluctuations. This means that in order to construct a cashflow schedule for an equity it is necessary first to make an assumption about the growth of future dividends; it also means that the entries in the cashflow schedule are uncertain - they are estimates rather than known quantities.
In practice the relationship between dividends and profits is not a simple one. From time to time, companies hold back some profits to provide funds for new projects or expansion. Companies may also hold back profits in good years to subsidise dividends in years with worse profits. Additionally, companies may be able to distribute profits in a manner other than dividends, such as by buying back the shares issued to some investors.
- For how long will equities continue to pay dividends to shareholders?
Since equities do not have a fixed redemption date, they can be assumed to continue indefinitely (unless an investor sells the shares or the company buys them back), but it is important to bear in mind the risk that the company will fail. In this case, the dividend income will cease and the shareholders will only be entitled to any assets remaining after creditors are paid.
- What is the consequence of possible company failure for the cashflows received by the equity investor?
The future positive cashflows for the investor are therefore uncertain in amount and may even be lower, in total, than the initial negative cashflow.
- What are listed shares and what are the main advantages of listed shares for the investor?
Most equity investment by financial institutions and individuals is in shares that are listed on a stock exchange. In order to obtain a listing companies have to comply with the stock exchange’s regulations, which give investors a measure of protection.
Listed shares are also generally more marketable than unlisted ones and are easier to value because a meaningful market value can usually be ascertained.
- Give three ways in which equity shares can be categorised.
Shares may be classified by size of company, expected profits growth, or industrial sector.
- Describe in detail the two main reasons why equity analysts often specialise in a particular industry.
Practicality
Investment analysts specialises within particular investment sectors because:
* the factors affecting one company within an industry are likely to be relevant to other companies in the same industry
○ Resources: companies in the same sector will use similar resources and will therefore have similar input costs
○ Markets: companies in the same sector supply to the same markets, and will therefore be similarly affected by changes in demand.
○ Structure: companies in the same sector often have similar financial structures and will therefore be similarly affected by changes in interest rates.
* much of the information for companies in the same industry will come from a common source and will be presented in a similar way
* no single analyst can expect to be an expert in all areas, so specialisation is appropriate
* the grouping of equities according to some common factor gives structure to the decision-making process. It assists in portfolio classification and management
Correlation of investment performance
After adjusting for overall market movements, the share price movements of companies within industrial groups tend to correlate more closely with each other than with companies in other industries. The share price movements reflect the change that have occurred in the operating environment. These changes affect companies in individual industries in similar ways. For this reason, listings of share prices are often sub-divided by business section, and major markets have separate indices for the different sectors.
- Describe the main characteristics of direct property investment.
- Nature of return: property is a real asset and would therefore be expected to provide a hedge against unanticipated inflation.
- Cashflow pattern: leases are for fixed terms with relatively infrequent rent reviews. These may be upward-only. The income stream might increase in steps every few years. However, for a property that is rented at a level above current market rents, the income stream may be fixed for many years.
- Marketability: property is very unmarketable. It can take a long time to buy or sell and dealing costs are high.
- Security: the security of income depends very much on the quality of the tenant. Rent payable by a company is a prior charge on its profits, but cost of recovery in arrears can be high and there is a risk of voids - periods when the property is not let. Owing to its political significance, property is susceptible to government intervention such as rent and planning controls.
- Spread: Capital values of buildings can be volatile over the longer term, although infrequent valuations and stable valuation methods reduce short-term volatility. As land is indestructible, a good site is always likely to have some value.
- Yield: In comparison with index-linked government bonds, property is less marketable and less secure. Investors would therefore be expected to require a higher return from property. Property management costs are high although the tenant is often responsible for building maintenance and insurance.
- Marketability: Property is very unmarketable. It can take a long time to buy or sell and dealing costs are high. This is because:
○ Unit size: the unit size of most investment in property is large and, in general, single properties are indivisible.
○ Uniqueness: each property is unique.
○ Valuation: property valuation is a matter of professional judgement and there is no central market with quoted property prices. There may be significant variations in valuations carried out by different valuers or by the same valuer on different bases. As sales take place infrequently the property market is characterised by a lack of information. - Obsolescence: land is virtually indestructible and buildings normally have a long life if maintained in a satisfactory condition. Buildings can, however, suffer from obsolescence. This results in a slowdown in the relative rate of growth in value between old and new buildings. In time, expenditure on modernisation becomes necessary.
It is possible for the investment characteristics of individual property assets to be substantially changed by the owner. Examples of this would be redevelopment of an existing property or renegotiation of a lease with a sitting tenant.
- Distinguish between freehold and leasehold property investment.
Freehold ownership is in perpetuity. A freeholder has the right to occupy the building or let it out and, subject to planning restrictions, to refurbish the property or develop it. There may be various restrictions on what can be done with the land. These include: covenant, easements such as rights of way, planning and building regulations and statutory requirements not to cause a nuisance to others.
Where possession has been given to a third party under a long lease, the building revert to the freeholder at the expiry of the lease. The leaseholder pays the owner of the property an annual ground rent. Compared with freehold investment, a leasehold interest is of a fixed term and provides a higher initial rental yield and a capital loss if the lease is held to the termination date.
- What are the main vehicles that exist for pooled property investment?
Various vehicles exist for pooled property investment. These include open-ended unitised funds and closed-ended investment trusts.
These vehicles normally have constitutions that specify the types of property that they can invest in, limits on liquidity, management charges that can be deducted from the fund etc.
- Discuss the merits of investment in property company shares.
Exposure to real property can also be gained by investment in the shares of a property company. The largest companies can invest in properties beyond the scope of most pooled funds. Property companies will generally not have restrictions on the investments they can make or the management expenses they can incur. The larger property companies also invest in property developments, which carry a greater risk than investing in an existing building with existing tenants.
- List the main expenses associated with initially investing in property and subsequent managing a property portfolio.
Expenses of initially investing in property include:
* legal fees
* surveyor’s fees
* taxes on the purchase
* bid-offer spread if investing via a property unit trust
Expenses incurred in the management of a property portfolio include:
* rent collection
* rent review
* valuation expenses
* management fees
Additionally for a freehold property:
* depreciation and possible obsolesence
* refurbishment at the end of a lease
- Discuss the factors to take into account when deciding whether to invest directly or indirectly in property.
Control vs expertise
Direct property investment gives maximum control over investments. However, specialist expertise is needed to select and manage a direct property portfolio, which the investor may not have.
Diversification
Direct property investment gives diversification away from equities. However, small funds cannot afford to invest directly in big properties and they will struggle to get adequate diversification within the property sector through direct property investment.
Through indirect property investment using a pooled property fund, investors can gain exposure to large or unusual properties
Marketability
Direct property investments are less marketable and less divisible than indirect property investments in particular property unit trusts where marketability is guaranteed.
Valuation
Indirect property investments are easier to value as shares or units are likely to have readily available quoted prices.
Direct property investments are infrequently and subjectively valued leading to lack of volatility in the short term.
Expenses
For a small fund the fixed costs of direct property investment would be a significant proportion of the fund size, putting the fund at a competitive disadvantage. For a large fund, direct property investment avoids the additional management charges associated with indirect property investment.
Indirect property investment could result in cost savings from economies of scale.
Expected return and volatility of return
Property development companies or investment trust companies can borrow against their portfolios, this may enable the investor to gear returns, which is likely to cause more volatile returns but also higher expected returns.
Other
The taxation treatment of direct and indirect property investments may be different, making one of the two options more favourable to the investor.
Direct property may be favourable if the investor wants to physically occupy the property.
