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Impact Investing

IPE special report May 2018


Best of both worlds

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Real estate used to be one of the cornerstones in portfolios of investors with long term (indexed) liabilities, such as pension funds and (life) insurance companies. Until some years ago the only way to create real estate exposure was through actually buying buildings (offices, shops, industrial, houses, etc).
So, although, the arguments are very strong in favour of real estate it was not always enough. Quite a few investors, and not only the small and medium sized ones, sold off their direct real estate holdings during the early 1990s because relative short-term performance was not good at that time.  
As often this short-term performance issue, turned out an embarrassing way of making a very expensive long-term mistake. Over the last ten years (see table) real estate turned out to be the best performing main asset class. So not surprisingly, in the last two years real estate is as hot as private equity or hedge funds. And that is because there are now more ways to create real estate exposure than before:
o Direct through buying the buildings;
o Indirect, through buying shares in quoted real estate companies;
o Indirect, through participating in a variety of non-quoted vehicles from private equity like partnerships (which are the most interesting in this group) to the open ended German funds and from Property Unit Trusts to joint ventures.
Let us compare these three ways of creating real estate exposure on a few important aspects. On items as market size, liquidity and diversification, we have a mixed picture. The direct market is by far the largest market (institutional real estate in Europe is valued at E4,700bn) and the indirect markets are both much smaller (E75 - E150bn), but growing fast. The most liquid is obviously the quoted market and that applies for ease of diversification as well. In the end it is always easier, faster and cheaper to sell a share in a quoted real estate company then a building or a stake in a partnership. According to most studies you would need at least E100m worth of direct investments before you have just reached sufficient diversification. The figure for the partnerships is at around E50m and on the quoted market less than E1m will do the trick.
If we look at transparency and valuation, it is the quoted market again which sets the best scores. As the quoted market is heavily regulated and there is a whole range of regulators involved, transparency is more or less imposed. Being a public market as well leads to overall good insight. EPRA (the European Public Real Estate Association), active since 2000, does a lot to improve transparency further just as NAREIT has achieved in the US since the 1960s. In the other markets it is much more difficult to obtain information. Yes you will know a lot about your own office building, but do you know who owns the building beside yours? Do you know who is renting it and more importantly what they are paying? And that is only the building next door.
Valuations of direct buildings are a costly affair and because of the labour intensive work – not performed very often. This means that your returns will be smoothed. The advantage is that your real estate investments will appear less volatile than they are, the disadvantage that you can come in for quite a shock next time you have your appraisals done. The partnerships provide regular (every quarter) NAV updates. In the quoted market your investments will be valued every day the stock exchange is open. This has a lot of advantages, but also one disadvantage. Although correlations between quoted real estate companies and the general equity markets have dropped dramatically since the mid 1990s, share prices of quoted real estate companies will still be influenced on the short term if there are sharp movements on the general equity markets.
Costs and ease of use are of course also important. On costs the quoted market is again the big winner. Versus the buying and selling of direct buildings this is rather obvious, but how about the partnerships? Before allocating to these partnerships, not only should you perform due diligence on the investment proposition, but also on the legal and fiscal structure. For most medium sized and smaller investors these costs are too high.
Investing in quoted real estate companies is also very easy in the way you can use your existing structures (such as manager selection, custodian, and the different kinds of reporting and risk management). With the other two ways of investing, however, you would need to develop new capabilities.
The final and most convincing issue should be performance. But here we have a problem as there is no pan-European performance data on the direct or non-quoted market. Looking at the US where we have data going back to 1978, it appears that the quoted market is performing overall much better (2.5 times) than the direct market, albeit with a higher volatility. The reasons for this are the effects of leverage in the quoted market, which does not exists in the direct market. However, much more importantly is the effect of active management of the quoted companies versus the buy and hold attitude of most direct investors.  
Some characteristics of the European real estate securities markets are:
o 160 quoted companies in virtually all European countries spread over the various sectors
o Three index providers (GPR, EPRA and SSB), more than 60 sell side analysts covering the market and more than 30 asset managers (with another 90 buy side analysts) proposing active products
o Nine pan-European investment funds in Morningstar database and first signs of new product development.
What will the future bring? We see that tax efficient structures (like US REIT) are very much in development. In the Netherlands, Belgium and France (just about) this structure already exists. It is important that this happens now in the UK (as the largest country in the index) and Germany (where quoted real estate is penalised versus other forms of holding real estate).
There are indeed encouraging signs that the Euro-REIT might not be too far away. We will also see new product development (passive investments, but also on the other end of the spectrum much more active opportunity funds). When discounts have decreased we might expect a lot of new IPOs, also encouraged by the introduction of the Euro-REIT. Derivatives are being introduced as well. This all will lead to an even more liquid, efficient and diversified marketplace.
So real estate securities are indeed the best of both worlds: the characteristics of real estate combined with all the good aspects of listed equity.
Peter-Hans Budde is director for institutional clients Europe at Kempen Capital Management in Amsterdam

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