Building indices for European property
Property indices generate a surprising amount of passion. For the outsider, this is initially mystifying but some of the issues soon become apparent, particularly if an index is required to benchmark a European portfolio.
So what are the relevant issues? They stem from the heterogeneous nature of real estate and, in the public market, what constitutes a property investment company. Index construction in the private direct market is completely other than in public markets where there is continuous price information for a homogenous entity, that is individual stocks. In the private direct market the equivalent price data has to be ‘extracted’ from transactions in a wide range of unique property assets.
This can be achieved in two ways. One approach is for a real estate service provider to track the rental and capital value of a hypothetical property – a high quality office building in a prime location within a number of cities, for example. A returns index can then be constructed from the capital gains and income. This can be done on as wide a geographic scale as the service provider has market coverage.
There are a large number of such indices for different markets but there is only one that can claim to being pan-European: the Jones Lang LaSalle Office Index, and even that relates to a single property type. In any event, this kind of index is open to two significant criticisms:
q It fails to reflect depreciation because the reference property is always new, and;
q prime properties are a small proportion of the market and not representative of the assets held in investors’ portfolios.
These criticisms are met by the second approach – aggregating returns from actual portfolios to generate universe averages. But, if this type of property index is to be meaningful, all the constituent portfolios must be ‘priced’ at the beginning and end of the period to reflect capital gains accurately. This requires appraisals, preferably independent of the manager. Furthermore, some consistency needs to be achieved in the reporting of net income and capital expenditure and receipts.
Specialist indices of property returns date from the early 1970s in the UK with consistent data series starting in the 1960s, but were given new impetus by the creation of the Investment Property Databank (IPD) in the 1980s. IPD has established itself as the specialist in creating and monitoring property indices based on portfolio data. Through close attention to detail, they have insisted on consistency in data standards while ensuring investors’ information remains confidential. The payback for investors is a detailed attribution analysis of portfolio returns.
But the IPD approach relies on accurate and regular appraisals of portfolios where the individual properties are valued at the price for which they can be sold at the relevant date, that is market to market. This has not been common practice in Europe, apart from in the UK and Ireland.
IPD now produces annual property indices based on actual portfolios for six important markets, but are still some way from having a credible pan-European benchmark. This requires indices for at least Italy, Spain and Switzerland in addition to the countries already covered.
Those investors who obtain their property exposure through the public markets can be forgiven for wondering what all the fuss is about. But there are issues even where there is daily trading.
Constructing a public-property securities index for real estate investors requires defining a universe of companies which is narrower than, for example, the corporates classified as such in the Financial Times. The index needs to be confined to companies that provide property exposure through their ownership of assets because they are the stocks which are the best proxy for direct ownership. This means excluding the service providers and developers, and concentrating on the property investment companies.
In, for example, the US, identifying such companies is much easier because of real estate investment trust (REIT) tax transparent status for property investment companies. Secondly, the European public real estate market is relatively small and comprises a large number of small companies where the free float is limited. As ‘investability’ can be an issue the stocks included need to have minimum liquidity standards.
Even so, it is much easier to benchmark a European property securities portfolio than a direct one. In fact, investors are spoilt for choice because there are six indices to choose from.
Global Property Research (GPR), a Dutch specialist in public property securities, compiles two global indices. The GPR-Life has the widest coverage in Europe comprising all real estate entities with a published trading price and a market cap greater than $50 million ($58 million). However, the index includes a large number of companies that are not ‘investable’ due to either their small size and/or their lack of free float. Furthermore, the German open-ended funds are included but their operator sets the quoted price, not market forces.
The GPR-250 comprises property investment companies with a free float greater than $50 million so it is a truly investable index. It is rebased monthly and the index weights are calculated by free float, not total market cap. As a result, it is now probably the most widely used benchmark.
However, two new indices are likely to challenge its dominance. The MSCI property index has been re-launched this year and, with the prominence of its brand in general global equities markets, may attract a following.
Notwithstanding, we expect that the EPRA index will be the main threat to GPR. This index was launched in July and is produced by the Amsterdam Stock Exchange for the European Public Real Estate Association (EPRA). Its membership comprises property companies, analysts and investment managers. The main attraction of EPRA is that it is a real time index unlike the others which are generally produced monthly. 2001 is likely to see some intense competition between the index producers in this market.
If he uses a securities portfolio to benchmark a pan-European property portfolio, the investor has a number of choices all of which have merit, although we expect EPRA to establish a strong following over the next 12 months.
In the direct markets, the issue is much more complex. The only pan-European product is the Jones Lang LaSalle Office Index which is based on data from 18 cities in 11 countries.
IPD indices can be combined for the six countries they cover but the weights need to be determined.
Clearly there is a way to go before Europe has a robust regional index for its direct property market; but giant strides have been made towards this goal in the last five years and it should be achieved by 2005. The next challenge will to construct indices that measure different investment styles as more investors obtain real estate exposure through specialist funds that have a higher risk profile than core portfolios.
Robin Goodchild is director of European Stratsegy & Research at LaSalle Investment Management in London