A reliable index is essential for benchmarking any investment portfolio. Without an index of past performance, asset allocators are not surprisingly reluctant to permit investment in assets that do not have a definitive track record. Real estate now has reliable indices for most of the main national markets in Europe. However, there are still gaps.
There are three ways for pension funds to gain exposure to property - by direct ownership, through private funds or via the public markets. The availability of specific indices is most comprehensive for the public markets, closely followed by direct ownership. There are no indices for investment in private funds currently but INREV (European Association of Investors in Non-Listed Real Estate Vehicles1) is working to create such a benchmark. At the present time, therefore, investors in private funds need to use indices derived from the direct market, or seek absolute returns.
The public markets
There is a plentiful supply of return indices for a European real estate securities portfolio. There are currently six different indices that can be used, each with its own idiosyncrasies. At LaSalle, our preferred benchmark in Europe is the EPRA index. EPRA is the European Public Real Estate Association and like INREV is an association of property companies and investors. Its index is produced in real time by Euronext in Amsterdam.
A company must satisfy four main criteria for inclusion in the EPRA index:
o Free float > €50 m
o Minimum quarterly trading volume >€25m
o 75% of EBITDA from property ownership
o Set of accounts in English
There are some large property companies in Europe that have only a small proportion of free float because they are effectively controlled by minority shareholders. Furthermore, there are a number of companies where the trading volume is very low so actual investment is difficult. The EBITDA criteria ensures that the benchmark relates to ‘pure’ property companies and not conglomerates or construction companies. Thus the companies in the index are as good a proxy for direct property ownership as possible.
Investors choosing to get their real estate exposure through the public markets and use EPRA have a robust benchmark which is ‘investible’. It is possible to get full exposure to 95% of the EPRA index stocks in 10 trading days, assuming a market weighted portfolio of €50m and that the daily volume in any one company does not exceed one-third of its daily average trading volume.
The benchmark should be adjusted to accommodate withholding taxes, etc for individual investors. No Euro-zone institution is tax exempt yet in all jurisdictions, so any pan-national benchmark that combines a number of national markets will need to reflect the client’s tax liabilities.
Big strides continue to be made in benchmarking direct property performance across Europe and this is due virtually single-handedly to one UK company, Investment Property Databank (IPD). Since IPD’s foundation in the early 1980s, their indices have steadily transformed the property market. This occurred first in the UK and now extends to most major European markets.
IPD require a number of conditions to be met before they can produce a national index. The conditions are:
o A significant proportion of property owners who want to make their market more transparent
o Property portfolios that are appraised to market value at least annually and preferably on 31 December
o A sufficient number of transactions in the direct market so that appraisers can provide credible assessments of market values (the best price a property would sell for).
IPD has built its business by providing property investors with performance analysis services and, at the same time, creating market benchmarks. The service took 10 years to gain wide acceptance in the UK but the provision of benchmarks has had a significant effect on how property portfolios are managed. Managers, whether internal or external, are no longer able to hide behind poor performance because before no-one knew what that performance should be. Moreover, asset allocators and CIOs have more confidence in property because they receive the same information they see for the other asset classes. A further benefit is greater market liquidity. Managers have to be much more rigorous in identifying whether they wish to hold or sell properties to beat the benchmark. This has had the effect of increasing turnover as properties are no longer held ‘for ever’. Annual sales receipts have increased within the IPD UK Universe from 3.5% of portfolio value in 1985 to 11.5% in 2002.
Now the operational pendulum may be swinging too far: managers are so focused on beating their benchmark they may be taking more risk than is appropriate for the mandate. It is very difficult to beat the index just by holding prime properties all let on long term leases. Outperformance is obtained by seeking risk whether through buying more secondary, higher yielding properties, taking letting risk or using leverage. All these strategies can be appropriate in the right environment, but a manager should not adopt a more risky strategy just to beat a benchmark.
IPD has started to make real progress over the last few years in developing its indices in continental Europe. The lack of regular, market-to-market appraisals has been a hindrance but benchmarks are now available in 10 of the 15 EU countries as well as in Norway. Furthermore, indices are in the course of development in Italy and Switzerland. An index for Italy is particularly important because then there would be a national benchmark for all the larger economies of western Europe and a credible regional benchmark could be constructed for the first time.
The credibility of the continental European indices is generally high. The Swedish index has just had the ultimate accolade. Barclays Bank is offering a derivative instrument which will pay the investor an annual return equating to the Swedish IPD for either a three or five year period. This is a tribute to all concerned in that the production of that index, where portfolio valuation standards are much more closely scrutinised than, for example, in the UK.
The same cannot be said unfortunately for the German IPD index. The sample of properties that goes to make up the annual index is only 30% of total German institutional property holding. Moreover, the actual results are difficult to accept. First, the annual return has been extraordinarily stable since the first results were published in 1996, varying between 3.5% and 5.9% only. The next most stable market in Europe over this period is the Netherlands where annual returns range between 8.8% and 16.1%. Second, the stability of the returns is not consistent with data from other sources. Offices comprise 60% of the IPD German index, the largest sector component by a significant margin. The data in the chart contrasts the office rental growth series reported by IPD with an index constructed with the same city weights from Jones Lang LaSalle prime rents. While the two series are not absolutely comparable, more correlation would be expected than is displayed. The lack of change in the IPD series is extraordinary.
Notwithstanding, the indices published for the other European countries, which are of course also based on appraisals, do not give rise to the same concerns and are generally regarded as good indicators of the performance for their underlying markets.
Once there is complete national coverage of Western Europe with robust direct market indices, the next steps will be their extension to central Europe and the accession states. IPD’s collaboration with INREV will also be important in the creation of private fund benchmarks that can distinguish between different styles of investment. This latter innovation will be especially welcome so a manager can have a benchmark that properly reflects the risk profile their client expects them to pursue.
Robin Goodchild, European director research and strategy, LaSalle Investment Management in London
1 INREV was formally launched in May and is an organisation supported by investors and managers/ fund promoters, but controlled by the investors in non-listed vehicles (see article page 8).