Having finally sat down to watch ‘The Big Short’ over the weekend, I can recommend the film as a worthy eye opener to the fundamental cause behind the meltdown of the US housing market in 2008, which unfortunately triggered the eventual global recession.

Real estate as an Investment tool can take on many forms. Investors have a choice as to whether to invest directly in physical property or indirectly expose their portfolios to real estate publicly traded securities. The former is a popular Investment strategy in Malta that sees a good part of locals investing in physical properties and renting them out to benefit from rental income.

This approach requires active management and investors must commit to ongoing decisions, particularly relating to a property’s maintenance and sale (if any).

The more passive investor doesn’t have to invest the sizeable amount required for a property purchase. With real estate publicly traded securities, investors can invest amounts of different sizes and gain indirect exposures to real estate markets via shares in real estate investment trusts (REITs), through mortgage backed securities (MBS) or directly in property related debt or equity instruments.

REITs are basically tax exempt real estate funds at a corporate level. The underlying assets can take the form of equity or debt depending on the fund management’s decisions to invest in physical property or mortgages.

Focusing on the mortgage backed security (MBS), the underlying assets are a pool of mortgages. Therefore the coupon received on a MBS is derived and dependent on the underlying mortgage cashflows.

The 2008 Meltdown in the US housing market, despite regulatory weakness in the US economy, was the result of increased defaults on underlying mortgages following interest rate hikes in mid-2006.

Collaterised debt obligations (CDO), a more complex form of MBSs, sold in tranches (depending on mortgage ratings attributed by regulators), were hardly hit when interest rates reset in 2006. The lowest tranches, i.e the mortgages with the highest default probability and largest coupon, were first to experience a rise in defaults as most of the underlying mortgages were tied to variable interest rates.

A lot has been done to improve regulation in monitoring MBSs and CDOs since 2008 and the US housing market has since been marginally improving. This week in fact saw building permits and housing starts increase 6.6% and 3.6% month on month respectively. Inflation as measured by the consumer price index was also up +0.4%, indicating a rise in consumer confidence in the US economy.

Real estate value is directly correlated to inflation. Hence, when equities and fixed income securities drop in price when the US Federal Reserve comes to increase interest rates, holding direct or indirect real estate exposure in a portfolio is a good means of diversification.

With a 64% chance of a 0.25% rate hike by the end of the year (Bloomberg data), rates are still low enough to support increases in building permits and housing starts complimented by higher real estate prices through rising inflation.

Investing in REITs, CDO’s or MBSs may yet again become an option to consider in the US, but until a FED rate hike occurs it would be best to consider these assets only when continued increases in inflation , consumer confidence and economic data are recorded.

This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.