Commercial property is an increasingly important element in investors’ long-term holdings. And with good reason: in a low-growth environment, property has the potential to add extra ‘zing’ to portfolio returns, as well as acting as an effective diversifier. At Henderson Global Investors we’re forecasting global property returns of around 10% annaully as far ahead as 2010. Best of all, investing in commercial property no longer requires deep pockets and the patience of the Buddha. By using a property equities fund, investors of all sizes can now get highly diversified and highly liquid access to global property markets.
Global property equities are closed-end companies that are listed on the world’s stock markets and provide exposure to a variety of property sectors. These include retail, offices, industrial units, hotels and residential. (see figure 1). The majority of property equities provide exposure to commercial property in the form of the retail and office sectors, which have the lowest risk profiles of the property market, and where returns are primarily in the form of income from rents.
Global property equities provide attractive returns that are typically higher than returns on fixed income assets and, in recent years, have outperformed equities. At the same time property equities have exhibited lower levels of risk than equities in terms of volatility of returns. As mentioned above, we forecast that global property returns are likely to be in the region of 10% annually between 2005 and 2010.
Almost half of the forecast returns from property equities is in the form of dividends, which are primarily generated by rents paid by businesses. The length of these rental agreements, which may run for up to 25 years, ensures a steady, bond-like income stream with a degree of insulation against inflation. When combined with property equities’ potential for capital growth, the result is an investment offering the income potential of bonds and the growth qualities of equities.
Property equities show low correlations with equities and bonds. At the same time, their high levels of income and the stability of underlying asset values make them ideal tools for reducing risk and enhancing returns in a diversified global portfolio. Figure 2 shows how a balanced global portfolio of equities and bonds could benefit from gaining exposure to global property markets.
One of the main reasons for property equities’ excellent diversification potential is that the different markets represented in a global portfolio exhibit exceptionally low correlation with each other. Figure 3 shows the average correlations between major regions and countries in respect of equities, bonds and property equities. The correlations of property equities across these regions is much lower than for other assets, because the major drivers of returns are determined by local supply, demand, policies and regulations.
Property equities are a highly efficient method of gaining exposure to property markets. Although property equities are subject to equity-like fluctuations in the short term, over the long term they behave like real estate. In comparison
to investing directly in individual properties, property equities are highly liquid, enabling a greater degree of flexibility and risk control in an investment strategy.
For many investors, further efficiencies are provided by the tax transparency of real estate investment trusts (REITs). Rather than suffering tax at the fund level, the final tax suffered on investment in REITs is determined by the end investor’s tax status. This structure brings greater clarity to the true cost of investment and creates opportunities for tax-efficient approaches to property investment.
The world’s property markets are highly inefficient in comparison to major equity and bond markets. This is primarily because property markets are driven by local demand and supply, and regulatory and economic factors. In addition, property markets tend to be dominated by a relatively small number of investors and information flows are poor.
For the skilled active manager, these inefficiencies provide multiple opportunities to add genuine value on behalf of clients by identifying and exploiting promising investment opportunities. This is particularly the case for managers who gain exposure to the market through property equities which, unlike direct property investments, are highly liquid and readily diversifiable.
The performance of property equities is strongly influenced by their attractiveness in terms of risk, return and liquidity relative to other equity markets and direct investments in property. For this reason, property equities cannot be understood or appraised in isolation, but must be considered with reference to other equity and property markets. The successful management of a portfolio of property equities therefore demands an unusual range of investment capabilities and depth of experience in evaluating equity and property markets at the macro and micro levels.
The characteristics of property equities markets around the world vary significantly, and there is consequently no single investment style that can be applied with equal assurance of success. At Henderson we use a variety of investment approaches developed over time to suit the Europe, North America and Asia-Pacific markets. Company research has the potential to add more value in property equities markets than in other equity markets. Indeed, the lion’s share of our performance – between 80% and 90% – flows from the selection and trading of specific stocks on the basis of in-depth, company-specific research that is carried out at a regional level in London, Singapore, Chicago and Sydney. However, outperformance and risk control can also be achieved through the application of top-down views of economies, other equity markets, property markets and sectors. We aim to enhance our bottom-up approach to individual stock selection through an overlay of top-down regional and country allocations.
Property equities are increasingly in demand from a wide range of institutional investors as a result of structural shifts in investment and savings patterns. In particular, the ageing populations of the world’s developed economies are creating greater demand for income, capital stability, inflation hedging and diversification through liquid investments.
These requirements, and the low yields available from equities and bonds, mean that higher allocations to property equities are a natural choice for many pension funds and insurance institutions. Over the past few years we have seen a steady increase in long-term allocations to property among institutional investors, suggesting that property is likely to be a key portfolio diversifier and yield-enhancer for some time to come.