The performance, diversification benefits and attractive income profile of real estate permit to invest in a multi-asset portfolio, despite its relative illiquidity. Not surprisingly, the asset class is finding increasing favour with institutional investors, especially pension funds.
First, real estate performance has been outstanding when compared to that of other asset classes. Most European countries saw direct real estate outperform both bonds and equities in the three years to 2001. Given the continuing turmoil in the securities and corporate-debt markets, real estate is again on course to outperform generally in 2002.
Secondly, increasing globalisation, coupled with the growth in multinationals, has, in some respects, resulted in reduced portfolio diversification. Today, most portfolios are invested principally in shares and bonds. The challenge facing investors is, therefore, to find new sources to avoid the high portfolio correlation that exists. A movement towards alternative asset classes, such as real estate, that have a different risk-and-return profile will aid portfolio diversification. As an asset class, real estate has a low to negative correlation to equities and bonds due to its lagged relationship with the economy. Furthermore, the diversification benefits do not stop there. Real estate is a local business and by spreading the investments across several countries and property types, investors can reduce volatility and further improve the diversification benefits of their portfolio.
The income profile of real estate is the third attraction, particularly as far as pension funds are concerned. Despite the huge falls in global security markets, the dividend yield on equities in most countries remains below 4%. With government bonds yielding about 5%, the attractions of real estate are obvious when you consider that today’s real estate income yield stands at approximately 7%.

Accessing real estate
Investment in real estate requires not only local knowledge/expertise, but also sufficient sums of capital in order to reap the rewards of portfolio diversification. For the bigger pension funds, providing sufficient capital poses little difficulty. Smaller funds, whose allocation to real estate is below, say, e300 million, would find it difficult to diversify sufficiently. A greater amount of specific risk has to be absorbed in contrast to their larger counterparts.
However, the real estate market has developed over the last four to five years through the increased use of unlisted investment vehicles. Although less liquid than direct real estate, these vehicles provide pension-fund investors with a greater degree of flexibility in their investment approach by enabling them to:
q Pool their investment with other investors. This ‘pooling’ provides a sort of unitisation, as it breaks down lot-size barriers, something that in the past has been a deterrent to real estate investment;
q Enhance total returns by introducing non-recourse debt to their investments. Exposure to such debt is particularly attractive in today’s market when the income from real estate exceeds the cost of borrowing;
q Focus on individual sectors and/or choose managers who are specialists in key product types.

How to allocate real estate portfolio
Real estate offers a wide array of risk-return profiles that can appeal to a multitude of investors. For example, 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, a balanced approach is the optimal way of investing in real estate. The structure should also be flexible in order to take advantage of any short-term inefficiencies that exist in the asset class. We would suggest a five-step approach:
q Step one: portfolio objectives. Determine the portfolio parameters, such as the risk-return target, together with any portfolio constraints.
q Step two: identify the portfolio structure. In deciding any optimal portfolio mix, the objective must be to track the slope of the efficient frontier. For that reason, we would advise a balanced portfolio in terms of sector mix, property types and risk-return profiles. We would also suggest the use of debt in a structured way, as it allows for a portfolio tilt in favour of return over risk. To achieve this, we would recommend a three-fund approach:
l Core Fund – Direct holdings only, no leverage, core country allocations, multi-sector coverage, holding period of seven to 15 years, target liquidity medium-high, established property types.
l Core Plus Fund – Held indirectly via a vehicle, fully geared but to a maximum of 60% leverage, all country allocations, multi-sector coverage, holding period of five to 10 years, target liquidity low– medium, asset profile established to improving.
l Opportunistic Fund – Held indirectly via a vehicle, fully geared but to a maximum of 75% leverage, all country types, multi-sector coverage, holding period three to 7 years, target liquidity low, property types could be distressed assets, developments and/or pioneer locations.
q Step three: optimise portfolio mix across fund types. AXA Real Estate Investment Managers (AXA REIM) uses a combination of historic volatility and future return projections to explain the relationships between the Core, Core Plus and Opportunistic Funds. Our recommendation, based on a real-life example, under pre-defined assumptions, was to have a portfolio mix that consisted of a Core Fund at 80%, Core Plus Fund at 15% and Opportunistic Fund at 5%.
q Step four: define country allocations. Several local factors need to be considered, such as:
l Economic profile of the country (eg, GDP, unemployment)
l Size of real estate market
l Degree of market liquidity and transparency
l Market dynamics (eg, length of lease, property cost relativities, income levels and distribution, type of indexation)
l The historic risk-return profiles’ analysis
l The incorporation of country diversification via correlation assessment.
AXA REIM has adopted two methodologies in scoring the various factors to determine the final allocation between countries – arithmetic and variability. Both methods incorporate a mixture of quantitative and qualitative analysis.
q Step five: determine sector weightings. A similar approach prevails in determining the best weighting for each sector. Main characteristics that are taken into account include:
l Size of sector within each country
l Liquidity of sectors across countries
l Market fundamentals of supply and demand
l Current pricing opportunities.
Once a portfolio has been designed, the implication of the overall structure needs to be assessed. Key areas that should be balanced are the amount of direct versus indirect holdings, geared versus ungeared assets, degree of overall portfolio leverage and the level of diversification across countries, sectors and property types.
Not only does the overall portfolio need to achieve the agreed risk-return targets, it also has to provide a structure that can be practically implemented. This requires a manager who can deliver.

AXA REIM: European real estate specialists
With more than e19bn under management, AXA REIM is a major player in the European real estate arena. Over 340 professionals, operating out of local offices in Brussels, Cologne, Lisbon, London, Madrid, Milan and Paris, are committed to meeting the individual requirements of a broad range of investors: governmental organisations, pension funds, insurance companies, banks, foundations, retail customers and corporations.
They value AXA REIM’s vision and expertise in providing solutions to their individual needs on a pan-European basis. To better serve these clients, a “Shared Resource” team, based in London and Paris, coordinates research, new product delivery and investor relations, which complements AXA REIM’s local expertise.
In the last 15 months, AXA REIM was successful in winning two pan-European and two country-specific separate account mandates and launched several funds raising a total equity of about e1bn, which represents an investable purchasing power over e2.5bn. More than 80% of the equity raised came from clients external to the AXA Group. After the successful launches of several partnerships and ventures between 2001 and 2002, AXA REIM expects to close “The European Office Income Fund” and the “UK Tactical Growth Fund” before the end this year.
AXA REIM’s capability also extends to the application of investment-management techniques to corporate real estate portfolios in order to enhance shareholder value through their more efficient use and ownership. In particular, AXA REIM recognise that, increasingly, corporations are looking for access to alternative sources of equity ownership of their assets, combined with greater real estate operating flexibility.