Robin Goodchild examines to what extent style analysis can be applied to real estate investments
Property as an asset class has infinite possibilities for investors, offering every range of risk-return options. Yet real estate is too often viewed as a dull investment. So what can be done to add ‘style’ to property investing? LaSalle Investment Management believes that ‘style analysis’, as the term is understood in equities, is not applicable to real estate as an investment approach. Instead the ‘style’ emphasis should be on risk-return profiles.
The critical characteristic of real estate that most distinguishes it from the other asset classes is its heterogeneity. The pricing of each building is unique so there can be no public trading. Thus, when an investor analyses a property investment, he doesn’t know the price at which the asset can be purchased. Furthermore, it is difficult to implement a tactical strategy to target a specific market because owners of properties in those markets who are willing to sell always have to be found. Experience has shown that it is generally better to wait until an owner decides to sell to secure the best deal. This lack of liquidity can therefore inhibit trading strategies.
But the concepts of ‘value’ and ‘growth’ are applicable in property. Within LaSalle Investment Management, we identify whether locations are correctly priced by their specific market so that we can identify those selling at below ‘fair value.’ We are especially attracted to locations with good medium- to long-term growth prospects which can also be acquired at below ‘fair value’ (see Fig 1).
Such assets would be located in the ‘value/growth’ quadrant of the LaSalle Investment Management Grid. Assets located in the ‘cyclical’ and ‘momentum/growth’ quadrants can also be worth acquiring, but there is no point in buying assets that are ‘over-priced’ and in low growth locations.
Some property investors have done very well by focusing on ‘value’ assets, which are usually high yielding. Others have prospered by building a land holding in a special location and retaining it, i.e. acting as growth investors. But both strategies can be adopted within a portfolio-- they are not mutually exclusive.
Investors are often characterised as having ‘top-down’ or ‘bottom-up’ strategies. In real estate, a top-down approach concentrates on the economic fundamentals that determine the demand for property and on weighting the portfolio toward sectors that are expected to perform best. A bottom-up approach focuses on the performance of the individual assets with less regard to the overall shape of the portfolio.
UK research evidence from Investment Property Databank (IPD) indicates that a bottom-up approach has greater impact on performance than top-down because returns from individual properties within the sector can be highly variable (as a result of heterogeneity). However, IPD also points out that the best performing property funds are those where decision-making is good at both ends, i.e. the individual properties did well and the overall shape of the portfolio enhanced performance too. So, again, investors need to combine both approaches to be successful.
‘Style’ in property investing, as far as LaSalle Investment Management is concerned, relates to risk profiles. Real estate offers a very wide range of risk-return opportunities from AAA net leased buildings and ground leases to speculative development projects in a variety of property types – hotels, leisure and industrials as well as offices, retail and residential. Moreover, the cash/income return available varies significantly so that high-income yield portfolios can be created where the risks relate to tenant covenant default and reletting/tenancy roll-over (see Fig 2).
In recent years, opportunistic returns have been comparatively easily obtained from real estate recovery plays. Paris offices during 1996-8 were a good example of a market in which opportunistic returns were achieved through a combination of distressed sellers, rising occupier demand and cheap finance. Once markets have recovered and distressed sellers become scarce, opportunistic returns can be achieved in established markets only through taking on significant development and letting risk. Some claim that opportunistic returns can be obtained in emerging markets, such as within Europe, in Poland, Hungary and the Czech Republic. Even there, however, investors have to accept significant development and letting risk because there are few existing investment grade buildings that can be acquired.
At LaSalle Investment Management , we favour ‘Income & Growth’ style returns at the present time, i.e. Internal Rates of Return of 14-18%. These returns can be obtained in Europe today without committing to speculative development and excessive leverage though some reletting risk is absorbed. Given the general lack of development activity in most European markets today, reletting risk is more quantifiable than when significant new construction is coming on stream.
‘Income’ and ‘high-yield’ style portfolios are also very attractive now because real estate yields are materially higher than bond yields across the continent. Institutional investors used to having high exposure to bonds should find property especially attractive now as statutory return targets are increasingly difficult to achieve from traditional fixed income assets.
One draw-back for investors in real estate is the lack of benchmarks. Reliable national indices are only now becoming available in Europe thanks to the work of IPD. However, it is apparent that a single, national index is only a first stage. Investors want benchmarks which compare portfolios managed with similar risk tolerances. IPD’s UK index measures portfolio returns for a variety of investor types. The bulk of the data is provided by insurance companies and pension funds that generally have a similar risk profile. Recently, though, more quoted property companies and specialised funds have joined the index. This has tended to increase the overall index average return because these investors are taking on more risk through having less diversified portfolios and a greater exposure to development.
Institutional investors have responded by comparing their performance against a bespoke, custom-made benchmark rather than the ‘All Property’ average. These bespoke benchmarks are based on the average for the portfolios of a comparable group of investors usually controlling for portfolio size. But this is not a long-term solution. It would be better if ‘style’ benchmarks were also available so that returns from portfolios with similar risk profiles could be compared.
Liquidity: an alternative ‘style’
All investors in real estate are concerned with liquidity to some extent. It can be argued that relative liquidity should be a third dimension to the risk-return profile of an investment. Alternatively, it can be viewed as part of the risk exposure.
The rapid development of the Real Estate Investment Trust (REIT) market in the US during the 1990s has encouraged investors to re-examine European property company securities as a means for obtaining real estate exposure. The traditional view is that property company returns are much more highly correlated with equities than with direct property. The latest evidence shows that the correlations are lower where there is a special vehicle that can distribute rental income tax transparently, i.e. like a US REIT (see Table). Furthermore, even where there is no REIT-type vehicle and the average correlation with the equity market exceeds 50%, as in the UK, that correlation is not stable over time. As significantly, the correlation with the direct market is greater than expected, when a lag is allowed for the delay in appraisal-based indices reflecting market realities (see Fig 3).
At LaSalle Investment Management, we believe that property company securities are a suitable vehicle for obtaining real estate exposure, either as a substitute for direct assets, especially where the planned investment is not sufficiently large to diversify specific asset risk, or in combination with a direct portfolio. They provide obvious advantages in terms of liquidity and can also allow tactical flexibility, e.g. by using the net asset value discount/premium as a signal for switching between public and private markets (see Fig 4).
Generally, portfolios that include property company securities are towards the left-hand end of the risk-return spectrum, but private placement programs -- where capital is injected into a company to enhance its valuation -- offer a higher return.
Style investing in real estate is in its infancy and the concepts used in equity markets are not appropriate for direct transfer. Within LaSalle, we believe that the risk-return profile is a more practical indicator of style for our market.
Dr Robin N Goodchild is director of European strategy & research at LaSalle Investment Management in London.