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How barriers can have benefits

The desire to reduce the volatility of portfolio returns has provided a strong argument in favour of international investment. Foreign markets that exhibit less than perfect positive correlation with an investor’s domestic market can help to lower risk.
However, property investors wishing to invest internationally face barriers that are more onerous and challenging than those experienced in listed equity and bond markets. But for investors able to overcome these constraints, these barriers can also provide benefits. This article explains why.

What are the barriers?
Barriers to international investment are common across all asset classes. However, some are particularly onerous for direct property and need to be appreciated by investors contemplating exposure to foreign markets. The table below is not exhaustive but seeks to highlight differences between listed markets and direct property.
The last issue, portfolio construction, is particularly relevant. The heterogeneity, indivisibility and ‘lumpiness’ of direct property mean it is more difficult to construct property diversified portfolios.
Barriers ...and benefits
Barriers make international property investment more challenging than in listed markets. It is therefore not surprising that exposure to international property is relatively low. We estimate that pension funds globally have allocated around 25% of their total equity exposure to international equities, and around 10% of their total bond holdings to international bonds. By contrast, the exposure to international property is far smaller at around 2% of total property holdings although cross-border capital flows have increased significantly in recent years (JLL report that around €33bn of transactions in Europe in 2002 were cross-border, representing 40% of total property transactions).
However, it is important to recognise that constraints to international investment can also be beneficial to investors who do invest internationally. Barriers make some markets more segmented, whereby they are influenced primarily by local factors, rather than integrated, whereby the return on assets is explained more by international than local factors. And, other things being equal, the greater the degree of segmentation, the greater the potential risk-reduction benefits from investing internationally. Investors who are able to overcome the barriers can enjoy the advantages of segmented markets; the lowering of correlations between markets is positive for those investors seeking reduced risk.
The lack of data in many European markets mean that it is not possible to track correlations over a long time period. However, research by Henderson, focusing on the spread of returns across different countries, has highlighted a generally high degree of segmentation by country. This supports the view that national property markets are driven by local factors. By contrast, in countries such as Germany and France, there appears to have been little differentiation in returns by sector domestically. If such patterns persist in future, this suggests that investors could achieve significant diversification benefits by investing in foreign markets, assuming that the issues outlined above can be overcome.
Some barriers - such as trading costs and tax - can be reflected in pricing such that the net return to investors makes adequate allowance for these factors. Other issues – such as relative illiquidity – are more difficult to accommodate but may be reflected in an additional return premium. Note that some factors can potentially change the return characteristics, volatility and cross-correlation of some markets.

The future
For funds seeking to reduce the volatility of returns, property stands out as being highly segmented, driven mainly by local factors. Barriers to cross-border property investment increase the level of segmentation. By contrast, higher correlation within equity and bond markets reflects greater integration and the increased importance of international factors in driving returns.
Those property investors able to overcome these barriers have the potential to enjoy greater diversification and the possibility of accessing markets that deliver higher returns than would be achieved from a purely domestic strategy.
Pooled vehicles offer advantages to investors venturing outside their domestic market. They can provide an efficient means of gaining critical mass and of dealing with the complex fund structuring issues associated with international investment. Disadvantages can be the higher costs and relative illiquidity associated with some vehicles.
Partly because of the increased availability of pooled vehicles, more property investors are now investing internationally. Whilst the current stock of property assets has traditionally been in domestic ownership, cross-border flows of new money have increased.
Finally, whilst evidence suggests that property markets have shown a high degree of segmentation, this does not guarantee differential performance in the future. Market forecasting and stock-specific analysis are essential. Attention should be given not just to expected returns but also to their correlations and volatilities. Investors should be wary of false diversification strategies, such as investing in CBD offices in major financial centres in the expectation that they will perform differently, whereas they could be subject to similar demand factors and exhibit high rather than low levels of correlation.

This article is based on a presentation to the IPD Property Strategies Conference, Wiesbaden, May 2003, ‘The Segmentation of European Property Markets’. For further information, please email guy.morrell@henderson.com

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