Building real estate into portfolios
The euro has changed the scope for property investors very significantly. Even though national market characteristics are important, and will remain so for the foreseeable future, property investment managers can now pick assets from a much wider range of cities without currency risk exposure.
Property markets are generally viewed as illiquid but some types of property are more illiquid than others. In general, major city office buildings are one of the least illiquid. The euro improves investors access to a much greater number of such markets which has important portfolio benefits for both diversification and for strategy. As the chart shows, the major national markets across Euroland have produced very different returns since 1981.
Property can play three roles in a multi-asset portfolio. These are hedge against inflation, diversification, and cash yield.
Inflation hedges may seem less important in today’s economic environment but times change. Property values in the medium term are a function of construction costs so do provide some ‘real’ protection. Furthermore, portfolio income growth has exceeded inflation in the UK.
But there are other inflation hedges available to investors. Property is more likely to emerge from an asset liability modelling exercise because the pattern of its returns are poorly correlated with those from equities and bonds. It is therefore an excellent diversifier. Often, if the allocation to property is unconstrained, the ALM indicates a property weighting well above current average exposures. In consequence, the result is put down to data problems and disregarded. Most property returns series are based on appraised values, not on transactions, so generally understate volatility. The data series can be statistically ‘unsmoothed’ which increases the volatility. However, this does not materially affect the (lack of) correlation with other assets and this latter factor is more important in determining the allocation to property.
Property cash yields are now higher than bond yields in every Euroland market. This results from the convergence of the fixed interest markets plus the low expectations for inflation. This higher income return not only makes property attractive in its own right, it also allows investors to use a property portfolio as a substitute for fixed income securities, given the right type of assets. It is quite common today for property to provide 20% of a pension funds income but comprise only 10% of the portfolio assets.
A diversified property portfolio needs a minimum of 10 individual assets and preferably over 15. This assumes that all the properties are of a similar value, so the specific risk associated with large individual lots needs to be carefully monitored.
Within this framework, a variety of portfolio strategies can be pursued. Risk averse investors can focus on well let properties in prime locations where the income stream is secured through long term contracts. Those seeking higher returns have a number of options. They can target quality properties with some letting risk, either because of current voids or short term lease expiries. Alternatively they can buy more secondary stock where the yields are higher but the perceived liquidity is lower. Opportunistic returns can be obtained from financing developments which in-volve both construction risk and letting risk. The risk profile, for any of these strategies, can be further refined by using leverage.
But building a property portfolio across Euroland still requires cross-border investment. The property investment manager needs to have a presence, on the ground, in the main markets to access the best deals and manage the assets thereafter. Furthermore, expert tax and legal advice is essential to ensure the net of tax returns can be correctly assessed in advance and that tax loss is minimised.
As a result, most pension funds today want to invest in property either through company securities or through indirect vehicles. They eliminate the day-to-day administration involved in direct ownership, albeit at the expense of some loss of control. In any event, the minimum size for a diversified segregated direct euro-land portfolio is not less than E100m.
A property company securities portfolio can be precisely benchmarked and gives much better liquidity than from the direct market. The downside is some restriction on the investment universe as there are very few quoted property companies, for example, in Germany. Furthermore, the pattern of returns is not precisely in line with direct property.
Indirect vehicles do provide direct property returns but may not be available at the time of the investor’s choosing, being dependent on a promoter. More particularly, the quality of the management with any indirect vehicle is crucial because early liquidity can be problematic. An indirect property vehicle should have a focused investment strategy with a pre-defined exit and a tangible alignment of the manager’s interests with the investors’.
Anyone embarking on building a property portfolio across Euroland should have regard to the following:
p Establish clear performance/ benchmark objectives;
p Devise a robust portfolio structure based on country and sector weights;
p Ensure that there is the local capability to deliver the strategy;
p Do not under-estimate the complexity of taxation and legal issues; and
p Insist on high standards of reporting and market research
Robin Goodchild is director, European Research & Strategy, at LaSalle Investment Management in London