Pan-Europe route to diversification
The world is experiencing an increasing trend towards globalisation. Recent cuts in interest rates in the US, a dominant force in this area, have been replicated around the globe. An alignment of global monetary policy is a strong precursor towards this trend.
It is therefore not surprising that security markets in most developed countries are all highly correlated. The adage “follow Wall Street’s lead” has some strong bearing. For the investor, equity markets could display characteristics akin to the ‘domino effect’. When one market falls, the others follow suit. 2000 was a case in point.
Real estate’s participation in a multi-asset portfolio should surely not be in question. Its low volatility, low correlation and diversification benefits are justification enough despite its relative illiquidity.
The asset class is characterised as a hybrid of fixed interest and equity, similar to a convertible stock. Most of its return is obtained from the secure, stable and predictable income streams underpinned by contractual lease obligations. As a tangible asset it has the potential to be actively managed to enhance capital value. It is the blend of these two characteristics that act to dampen extremities in performance that leads to its low volatility, as seen in the figure. The differential is more pronounced, particularly over the past five years (to 2000), where UK real estate volatility is below 4% compared to double-digit figures for UK equities, UK bonds and overseas equities.
Not only is real estate affected by the economic cycle influencing tenants to increase or decrease space, but also by the investment and development cycles. Capital will be attracted to areas where investors can see attractive arbitrage between risk and return. Developers will build where there is the greatest opportunistic profit in economic imbalances between supply and demand of space. The interaction of these three cycles, economic, investment and development leads to a real estate performance profile that lags the other portfolio asset classes. Different peaks and troughs are incurred which results in a low correlation to that of other securities.
Diversification benefits are enhanced further as various forms of real estate can offer a wide array of risk return profiles appealing to a multitude of investors. Prime property in prime locations with annual indexation in rental income carries a risk return profile considerably different to that of speculative developments where higher risk ensues in the form of letting, construction and financing.
For the investor, greater diversification opportunities are opening up across Europe. According to Jones Lang LaSalle, cross-border real estate activity almost doubled reaching e19bn in 2000 compared to e10bn in 1999.
Increasing pan-European real estate investment activity is being facilitated by many factors:
q The introduction of a common currency, the euro, being the initiator of events.
q In contrast to the UK or the US, unemployment rates are relatively high in most of Europe. Anticipated reforms in labour markets are expected to have some bearing on the total stock of real estate required, where it will be located and how it will be used.
q Outsourcing by both corporates and government is changing the way real estate is both owned and operated. There are two major forces. The first is a strong desire for organisations to be flexible. Competition remains fierce, therefore adaptability is key in what is a fast and changing world with new technologies. Secondly, capital markets are affecting the way real estate equity is being employed. Organisations are continually influenced by accounting considerations where capital needs drive some corporates to restructure balance sheets. There is also a recognition that professional external real estate portfolio management can contribute to shareholder value.
q In relation to the above, capital markets are also influencing the real estate investor through the prudent usage of debt in appropriate financial structures. This is leading to an increase in investment return.
q There is a strong trend towards indirect investment with growth in specialist-focused vehicles. This has led to a widening of the investment spectrum from institutional to private equity type returns. Critical mass is created by investors grouping together to target specific real estate opportunities that would have once been outside the investment spectrum if they were acting alone.
q The attraction of pan-European real estate is further enhanced by its relative performance profile. Volatile equity markets are finding it difficult to move out of negative territory, particularly after the fall-out from the technology stocks. Low bond yields, largely as a result of the low inflation environment and in the case of Europe, convergence, has led to low yielding nominal returns. In contrast, real estate across most pan-European markets have enjoyed healthy double-digit total returns.
Furthermore, the medium term investment fundamentals remain attractive. Consensus forecast of European economic growth (GDP) for the next two years is expected to be above its historic trend, supported by an environment of reducing interest rates and relaxation’s in fiscal policy.
From a supply prospective, there is a limited amount of good quality space with current vacancies at historic lows. Some development activity is on the increase, although there is also a considerable time lag, as planning and build times delay the availability of product by approximately two years.
From a pricing perspective, rental values are rising strongly. Most of the activity has been concentrated in prime locations. This is now beginning to filter out to the secondary and periphery areas. Property capitalisation yields are stable and in most cases exceed the cost of borrowing (plus margin). This makes real estate a self-financing investment, in contrast to the other asset classes. This advantage will increase as the yield differential is expected to widen further as interest rates fall.
However, not all real estate markets are synchronised across Europe. Countries such as the UK and Spain are ahead in the property cycle while others like Germany, France and Italy lag. This creates different degrees of opportunities across pan-Europe with the differentiation providing further diversification benefits.
As with any asset class research, investment and risk management processes are key. Management should have pre-defined investment policies within both strategic and tactical asset allocation in order to optimise the best control of risk management.
Real estate not only has global influences but also micro such as local planning regimes and demographic effects. Good management of real estate will be highly dependent on existing, local businesses with experience and focused expertise. It is very important to have established infrastructures with large investment networks that provide access to the right product. Proven in-depth market knowledge with strong track records are prerequisite features.
Real estate is already an established asset class in a multi-asset portfolio. However, in light of increasing globalisation its relative position should be examined with consideration being given to increase weightings. It offers diversification benefits in many ways. None more so, than when viewed on a pan-European basis.
Kiran Patel is director of European research at AXA Real Estate Investment Managers in London. This is based on a presentation to the European Asset Management Congress in Frankfurt