It is a sector ripe with opportunity but fraught with problems. And probably more than any other asset class, the dynamics in different geographies are very different. So global investors need access not only to great research and due diligence capabilities, but an ability see how real estate in different countries provides yield and capital growth potential to wildly varying degrees.
Take China and Australia as a good example of this polarity. According to Martin Lamb, Head of Property in Asia Pacific for Russell Investments, “China is the most difficult market to gauge. It’s overbought and there’s an over-supply of assets. Plus you have all the legal issues of moving capital and ensuring that your proceeds as agreed. By contrast, Australia is the most compelling market in the region from a risk/return perspective. It is one of the few places that has escaped the ravages of the recession. Plus yields are three or four times what they are in the rest of Asia.”
Pension funds focusing on long-term liabilities in their investment style are increasingly looking to real estate to match their criteria. David Lee, portfolio manager with T. Rowe Price, comments: “Real estate has proved to be a high-yield asset class, coupled with offering investors an attractive risk/return profile, compared with the broader equities market. These characteristics fit well with the liability-driven investment approach of pension funds.”
Currently, the global real estate sector offers a 2009 estimated earnings yield of 9.7% (10.8% including emerging markets), compared with 9.0% for global equities and just 3.2% for US 10-year bonds, according to UBS.
Lee says, “Some investors also compare fixed-income yields with REIT dividend yields as a measure of relative value. In particular, institutional investors looking to fund long-term liabilities have often used investments in income-producing properties in a manner similar to that of long-term bonds. The cashflow characteristics of income-producing properties can be very similar to those of a long bond or, even better, an inflation-linked bond.”
The case for international investing in bonds and equities is well established, and acceptance of these arguments is reflected in institutional portfolios. However, the vast majority of investors’ real-estate portfolios remain largely invested within their own
individual country or region. In reality, this historic domestic bias is largely explained by the difficulty of investing outside domestic property markets, but new real-estate vehicles now make global real-estate markets easily accessible. And with stocks now available at close to their historical lows, Lee believes there is a realistic prospect that commercial real estate will be among the first to enjoy a bounce back.
While stock markets have rallied robustly in Asia this year, commercial private property markets in the region are showing significant variation in their recoveries. Perhaps the most disturbing fact is that an estimated US$300bn of commercial real-estate debt is set to mature in 2009-2011. With the securitisation markets largely closed and many banks facing capital constraints, this is one of the biggest issues facing commercial real-estate markets over the coming year.
The private equity real estate industry is also facing a transformative year. Russell’s Martin Lamb says, “Pension funds are rethinking their investment rules in an effort to mitigate or avoid the dreaded “denominator effect”, which can result in forced sales of LP interests into the thin secondary market. Fund sponsors are reassessing their staffing, strategies and future capital-raising plans. And investment managers are refining their fund sponsor evaluation, due diligence and monitoring methodologies.”
While the fundamentals of manager evaluation are arguably timeless, Lamb suggests the current environment does demand that certain elements of a fund sponsor’s strategy, staffing, and operations receive enhanced scrutiny and analysis.
“Many of the largest blue-chip funds were also among the most active investors during the past three years and, ironically, also enjoyed the greatest access to debt capital. Nearly all of these funds have underperforming assets in their portfolio inventory today; some on a massive scale. Funds burdened by the asset management demands of legacy investments, who seek to raise new equity capital, will need to satisfy investors that the prior fund remains well staffed to deal with legacy issues, and that senior management will have adequate time to focus on new opportunities.”
The need for risk management as a senior-staffed function in real estate private equity funds is long overdue, says Lamb. “We believe this issue, taken as a whole, is of greater importance and relevance to investors’ prospective returns than marginal changes to fee structures. As an anecdotal observation, we believe that some of the difficulties fund portfolios are encountering today, such as poorly defined exit strategies, or debt maturities mismatched to projected investment holding periods, would have been avoided if risk mitigation had been the sole focus of a senior staffer on these funds.
“Best practice includes a separation between the deal origination and deal underwriting teams, and the siting of qualified non fund-affiliated members on the investment committee. The most potent risk mitigation tools involve deal screening and deal structuring at the term-sheet stage - a fund as a whole can significantly de-risk its investment portfolio using these two tools alone.”
An example of an investment group that has avoided the debt trap in Asia is AEW. The Singapore arm of the $40bn Boston-based based real estate group, has made a virtue of adding value to out of favour properties in prime locations. It has recently brought to market two completely refitted prime properties in Singapore and has identified new opportunities in Shanghai and in the Soho area of Hong Kong.
AEW’s Singapore-based managing director Peter Wittendorp is not one to get carried away by the hype that besets the real estate markets of Asia. He has looked at a lot of property, much of it distressed in recent times, but invariably the numbers do not add up. He says, “We might have looked at 60 deals for our latest Value Investors fund, then we might bring that down to perhaps a dozen, and then we have to walk away. It’s frustrating for the acquisition team, but we have to get it right.” Wittendorp says AEW typically has a 50% loan to value on projects, “so the real estate has to make it work”.
The current environment, says Lamb, “is unpleasant and challenging for investors and fund sponsors alike. We believe that in the near to mid-term, funds will have to “earn their return” through, for example, greater due diligence of market conditions and prospective partners, value engineering early in development projects, more intensive cash management, and greater involvement in leasing and operations activities.”