What are Capital Markets & How Do They Work?
It would be so easy to start your real estate investment journey by finding the right property, securing funding, and taking the leap of fun and faith. But every expert you talk to will tell you to make sure you “do your research” before jumping into any investment market. And that’s a big term you’ll hear battered around a lot: market.
Understanding the term “capital market” is important as you research the perfect investment property. Capital markets combine the stock market, which trades in equity, and the bond market, which handles debt trading. In contrast to money markets, where debt and equity trading is based on short-term transactions and gains, capital markets focus on long-term trading and investment.
How can capital markets affect real estate investing and development? Read on to understand how your knowledge of capital markets can drive your profits and losses and help you realize other avenues to invest in real estate.
How capital markets work
The capital markets allow companies and governments to raise money by issuing securities for investors to buy in the form of stocks and bonds. The “capital” generated is then used to finance new research and development projects and build infrastructure and investments that can drive economic growth and productivity.
How capital markets affect real estate investing
Like other sectors of the economy, capital markets allow real estate investors to access financing for real estate development and investments.
Here are some examples of the role capital markets play in real estate investing:
Debt financing
The bond markets allow real estate developers and property owners to raise debt capital by issuing real estate bonds or mortgage-backed securities. These debt instruments ensure investors can offer loans for real estate projects or acquire mortgage-backed assets, providing a stable funding source to acquire and develop more property. In layperson’s terms, debt financing is how investors, such as yourself, secure funding for your first real estate purchase.
Equity financing
Real estate investment trusts (REITs) make up a significant portion of the capital markets in the real estate sector. REITs are companies that own and manage income-generating real estate assets. They raise capital by selling shares to investors through stock exchanges like the New York Stock Exchange (NYSE), allowing individuals to invest in a diversified portfolio of real estate properties.
REITs make it possible for both institutional and retail investors to access the benefits of real estate ownership and receive dividends from rental income. Many people who invest in stocks and bonds also invest in REITs to diversify their portfolios.
Securitization
Capital markets enable the “securitization” of real estate assets, which means that a group of real estate holdings can be converted into securities to trade on the stock market. Mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS) are examples of securitized real estate vehicles.
Securitized real estate loans and property holdings can be bundled together and sold to investors, creating liquidity and more investment opportunities in the real estate market.
Portfolio diversification
Investors can access a broader range of properties across different sectors, geography, and property types by investing in real estate securities, like REITs or real estate mutual funds.
Diversified portfolios help reduce investment risk by spreading that risk across several assets rather than having a large portion of your investment capital tied to a few stand-alone properties and projects.
Liquidity
Even basic fix and flip real estate projects take time, so real estate investors often have to wait much longer to realize returns than with other investment classes.
Through publicly traded REITs or real estate securities, investors can easily buy or sell shares at any time, which provides access to capital more quickly than is possible with direct property ownership.
Economic growth
By providing financing for real estate development, acquisition, and refinancing, capital markets spur investment and economic activity in the construction and real estate sectors, leading to more job creation, further infrastructure development, and economic expansion.
The impact of capital markets on real estate investing
Here are some examples of how fluctuations in the capital markets can impact the real estate sector:
Financing costs
Capital market fluctuations, like changes in interest rates, can affect the cost at which real estate investors borrow money. Higher interest rates make real estate loans for property acquisitions and development more expensive. Interest rates also affect refinancing costs for existing loans.
Property value
Capital markets can also impact property valuations by affecting demand and prices. During periods of economic uncertainty or market volatility, real estate investors may experience fluctuations in property values, impacting overall returns.
Access to capital
During periods of market volatility or economic downturns, lenders and investors could become more cautious, making it more difficult to access financing due to more restrictive lending standards.
Development and construction
Fluctuations in capital markets can also affect development and construction. In a sluggish economy, developers can struggle to access financing and find it more challenging to pre-sell or lease real estate to nervous consumers. This can lead to a slowdown in new construction and development.
The impact of capital market fluctuations on real estate investing also varies depending on local market conditions and property type.
Real estate investors should pay attention to capital market trends, interest rates, and economic indicators to get a sense of the potential risks and opportunities in the real estate market.
Capital markets enhance real estate liquidity, provide financing options, promote transparency and price discovery, and offer diversification opportunities for investors. They play a vital role in attracting investment into the real estate sector, supporting its growth, and contributing to the economy.