The absence of benchmarking in Continental Europe poses problems for investors in real estate. Nick Leming outlines his views
Property markets are traditionally accused of being less transparent and less well researched than other asset markets. In recent years the UK property market has taken great steps towards overcoming these criticisms.
Some 10 years ago the Investment Property Databank (IPD) started to collect detailed portfolio information from leading institutional property investors and produce regular performance figures for the direct commercial property market. The IPD index is now the accepted industry benchmark. At the same time, Henderson Real Estate Strategy and others have been developing sophisticated models to forecast rental values and total returns for the UK market by sector and region, and also at the town level. Over the years, our coverage has been steadily widened to cover an increasing number of sectors and towns.
The traditional top-down" approach to structuring a portfolio broadly involves the comparison of a portfolio with the appropriate benchmark, establishing the fund objective with regard to return and risk, applying forecasts and targeting properties.
Unfortunately, this type of approach cannot be adopted where benchmarks do not exist, which is the case in many continental European property markets (see below).
How then, in the absence of established benchmarks, can a disciplined asset allocation strategy for continental Europe be developed?
Direct investment in overseas property markets can be fraught with difficulties. Lease structures, transaction costs and tax regimes vary greatly between countries, and detailed local advice is needed to ensure that expected net returns to the investor are actually achieved. This is especially true with regard to the legal and fiscal nature of the investment vehicle used. Furthermore, the advent of EMU will not completely remove the threat of currency risk, as not all countries will be signing up in the first wave. Most importantly, an experienced local presence is required to maximise deal flow, to ensure that the investor has access to the best properties as they become available, whether on- or off-market, and that buildings can be bought and sold speedily and efficiently at the optimum moment. There may be a significant cost implication to the establishment of this local presence, or a significant time delay in locating the right partners.
In our view the correct approach to cross-border European property in-vestment is to select a partner which already has the required expertise in place. The investment structure might be via a specialist sector and/or regional fund or through investment in publicly quoted property companies.
If the route of a specialist fund were adopted, the decision to invest in a particular country and/or sector would probably be more opportunistic, based on knowledge of market cycles and an expectation of outperformance relative to other markets. Once the opportunity was identified, the investor must select the fund which offers the best team in terms of deal-sourcing and active management ability, and the most tax-efficient vehicle. The fund must also offer a disciplined investment approach with a clear focus on fund objectives and investment strategy, supported by detailed research and forecasting of the relevant markets.
An alternative means of investing in overseas markets where an investor has no local presence or first-hand experience would be to consider investment in a regional property securities fund. The principal advantages of this approach are lower entry costs than direct investment and greater liquidity. The growing trend towards securitisation of property will, over time, make quoted property markets larger and more liquid. There is also evidence to suggest that this process may also help generate a period of strong investment returns.
Once again a disciplined asset allocation strategy must be adopted and stocks carefully selected according to strict investment criteria. Our approach favours an active management rather than an index strategy. While index strategies avoid the need for detailed research, they can cause poor performance by leading investors towards unattractive markets. Our approach is "top down", beginning with the determination of general equity market fair value and private market fair value. Liquidity issues need to be assessed, as do general stockmarket themes. The establishment of property share fair values leads to asset allocation by country and/or sector. Individual property companies suitable for investment need to be identified and their portfolios analysed. We prefer companies which are themselves focused in their investment strategy, investing predominantly in their domestic market. This approach has the advantage of tapping directly into local expertise in the markets which appear most attractive. Private market forecasts are made to determine gross asset value and earnings growth, which can be fed into models to predict company specific net asset and earnings growth. An assessment of management impact needs to be factored in, after which valuation analysis and stock selection can take place.
The opportunities for performance in European property markets at present are excellent, but the correct approach needs to be adopted in order to maximise them.
Nick Leming is senior property analyst at Henderson Investors in London"