How pure is your real estate?
nitially, let's remind ourselves of the reasons for choosing real estate as an investment in the first place. Property investments are primarily:
■ A source of diversification;
■ A generator of attractive risk-adjusted returns;
■ A potential hedge against unexpected inflation or deflation;
■ A strong cash flow generator
Traditionally, most institutional investors have invested in real estate by holding property, either directly or via non-listed funds, in their home country. In recent years, with the exception of a handful of earlier pioneer investors, cross-border investment via non-listed funds has become more established and this appears to be gathering pace. This development can be attributed to an investor wishing to benefit from one or more of the above benefits of owning real estate exposure. Other potential alternatives to these traditional ways of investing in real estate are via listed real estate companies (including REIT-type structures) and real estate debt, principally mortgage-backed securities.
The alternatives available for investing in real estate can be summarised as follows:
■ Direct property exposure, ie, an investor
actually own property itself;
■ Indirect ownership via non-listed funds;
■ Public equity, eg, listed real estate securities, including REITs;
■ Real estate debt, eg, either as private debt such as commercial mortgages or public debt such as RMBS;
The above mentioned rationales for investing in real estate can all be found in direct and indirect property, but do public equity, real estate debt and derivatives provide the same characteristics and what alternative roles could these investments play?
Theoretically, real estate securities and real estate debt should exhibit similar characteristics to more conventional real estate because their cash flows are derived from underlying real estate investments.
Key players in real estate debt have traditionally been banks. Residential and commercial property mortgage backed securities started in the US more than 15 years ago. They have since also developed and grown into an established investment class in Europe and an increasing number of institutional investors have started to invest in this asset class.
Tradable real estate debt is in most cases structured as bond and because of this it exhibits a higher correlation with the bonds market. Real estate securities as daily traded equities have a higher volatility than directly owned property and with this a higher correlation to general equities.
One could therefore argue that neither real estate securities nor real estate debt can play a property-specific role in a multiple asset portfolio. However, a number of larger US institutional investors, and more recently European ones, hold real estate securities and real estate debt as part of their overall asset allocation strategy. The key reasons for this are probably threefold:
■ They take the view that both investment alternatives provide more liquidity than traditional property investments, which partly offsets the higher volatility of real estate securities and real estate debt;
■ They both allow investors to get exposure to target sectors which might otherwise be difficult to access;
■ There is a short-term tactical play to be made as they may appear attractively priced relative to other asset types.
Investors wanting to invest in real estate on a European platform should be able to access all property types by investing directly or indirectly via non-listed real estate funds, although there might be some potential issues for more specialist asset types, such as residential or healthcare. Internationally, it becomes more problematic to establish a properly structured property portfolio because of a lack of established, non-listed real estate funds, especially specialised ones. Internationally, direct and indirect non-listed real estate are often associated with liquidity issues, lack of transparency and high transaction costs.
This is why international real estate strategies tend to include listed real estate securities to cover certain markets, mainly those outside Europe.
Within Europe, REIT-type structures are not as established as those in the US or Australia and are more broad-based than specialist. However, with the conversion of Primary Health Properties, a UK-based real estate company focusing on primary health care premises, into a UK-REIT at the beginning of this year, there may be hope that more specialist companies will follow suit enabling investors to gain specific exposure to targeted sectors.
Investors not wanting exposure to the rather volatile equity market, albeit based on real estate fundamentals, may consider real estate debt. The key bond-like characteristics are quite different to those of equity, but the underlying is again property. Established real estate debt markets exist for commercial market backed securities and residential mortgage backed securities.
Derivative structures are also worthy of some mention. They have been developed and used to a limited extent in the UK. Currently available structures aim to replicate the characteristics of direct property investment; that is to provide quarterly rental income and annual capital growth. As the market expands the variety of structures may increase to satisfy different needs. While in the UK, there are concerns about property derivatives including short-term liquidity issues and counterparty risk, there is potential merit in their use. In particular, for new or expanding property portfolios, investors can gain instant access to the property market at a relatively low cost while taking due care and attention in evaluating and purchasing appropriate assets. In this way the drag effect of holding excess cash in a portfolio can be reduced. Moreover, these instruments could prove extremely useful for investors wishing to overweight or underweight to certain sectors on a short-term tactical basis. Sector-based derivatives are now available in the UK.
While we are aware of plans to introduce derivatives in such countries as the US and Sweden, as far as we are aware the UK is the only market which is making significant progress here.
Nick Duff is head of property investment consultancy services at Hewitt