Getting into position
An increasing number of pension plans and insurance companies are keen to increase their allocations to the property sector, according to an Association of Foreign Investors in Real Estate (AFIRE) survey published last year.
It also seems clear that getting money into the markets is increasingly challenging. Reflecting this, investors are showing greater interest in global strategies that broaden their investment universe, as well as securitisation strategies that facilitate more efficient deployment of capital without increasing the burden on already stressed real estate staff. As a result the flow of funds into global and, indeed, regional securities strategies has grown dramatically.
As a result there are a wide range of issues that investors want to understand before deciding how best to invest in global property securities. These issues include benchmarks, market size and composition, potential diversification benefits, performance differences and relative valuation. Triangulating these variables is challenging, particularly given the speed at which the market moves, but essentially when we speak to our clients, it seems clear that their main reasons for investing hinge on three key factors. First, they value the ability to make quick tactical and strategic shifts in their allocations within the property sector. Second, that they get a return that broadly approximates to real estate. Third, they get the benefit of leverage, corporate management skills and the opportunity to invest in ‘scarce trophy type’ assets.
The most interesting debate we, as managers, commonly face in conversations with our clients focuses on the fourth factor: the ability to consistently add value and alpha. This is, of course, the million dollar question, but the answer is that adding alpha is perfectly possible even in a sector that is increasingly covered and gaining more liquidity every day. The real question is how you do it.
The key to adding value in the real estate securities markets involves being positioned to exploit information imperfections. This sounds suspiciously complex but it is really quite a simple principle. There is a significant lag between real estate market activity and company financial reporting caused by the relative infrequency of external portfolio valuations conducted on property companies’ assets. Access to price setting data, especially if it comes in advance of the valuation professionals and the property companies we invest in, makes it possible to position a portfolio ahead of information becoming widely available. This is a clear advantage which should lead to out-performance.
Another significant source of alpha is derived from the relative level of liquidity in the sector. Although liquidity is increasing as more and more capital and companies come to the market, certain stocks are somewhat less frequently traded than others. This typically means that they are quite frequently overbought or oversold, particularly with increasingly large blocks of capital being allocated to the sector from institutional investors. Again, if you can identify these stocks and identify these volume effects this is another lucrative source of excess returns.
So if we accept that alpha is available, the debate usually moves on to forward-looking absolute returns. The EPRA Europe Index turned in a 49.4% return last year, and 26% in 2005 and 26.9% annualised in the five years to 31 December 2006. That’s phenomenal growth and although some of it is catch-up from a period of very weak performance, it leads many people to doubt the potential for continued growth. This is a more difficult problem to grapple with. As we stand today public real estate certainly doesn’t look cheap when it is compared with the private real estate markets. Earnings yields are not far above local treasury and corporate bond yields and valuation multiples are above their broader equity counterparts.
However, this is not unfamiliar territory from a global perspective. In 2004, very similar conditions prevailed in the US and led many people to sell out of the US REIT market. The reality is that in 2005 and 2006 the private markets continued to see sales price increases as investors’ growth expectations increased on the back of strong US economic activity. Despite this, many appraisers and, importantly, many REITs adopted a more conservative approach to asset values and only assumed increases where they were confident that the increase was sustainable.
With the benefit of hindsight this looks like a sensible move for any fiduciary, particularly as interest rates were increasing pretty rapidly and when one thinks back to the early 1990s and the flak that public property companies caught for aggressively marking their portfolios to market. However, in today’s ultra-liquid capital markets, any valuation lag simply attracts the attention of private equity firms that see both the relatively low leverage on US REITs’ balance sheets and the conservative values as a way to arbitrage the capital markets and generate high relative returns. Hence, we have seen a whole raft of M&A activity in the US REIT market that in turn has boosted REIT returns. Perhaps, then, given that Europe has an uncanny knack of mirroring the US with a lag of a couple of years, we should not under-estimate the potential for a continued European REIT performance.
In practice, if we do track US trends, the European REIT market will be an interesting sector to watch in 2007. For a start, might we expect to see the $39bn (€30bn) privatisation of Equity Office Properties by real estate legend Sam Zell mirrored here? If the biggest REIT in the world is in play then what price the major European property companies like British Land, Land Securities or Unibail? Given the level of global liquidity and the continued evolution of the European real estate public securities markets, it seems to us that 2007 will be another interesting year.
My final comment reflects a slightly more sombre conversation that I had with a client at a recent property conference. The client in question expressed a concern that I think is increasingly important for us all to consider. Corporate activity is an exciting development for the sector but it does have some long-term costs. If privatisations accelerate in Europe, the sector will, all things being equal, contract unless existing companies come back to the market for new equity or we see a significant increase in IPOs.
IPOs and rights issues have indeed been on the increase, although the IPOs have been coming to the market via the AIM. AIM issuance is of course welcome, but the companies being brought to the market are generally smaller, externally managed and are increasingly blind pools focused on emerging markets with some ‘colourful’ fee structures and governance provisions.
Indeed with one or two notable exceptions they have shown weak relative returns compared with the EPRA Index. Although many of these companies fail to make it into most fund managers’ benchmarks, they may dilute the quality of the sector. As stewards of our clients’ money we believe that this piece of the sector needs to we watched closely by portfolio
managers and investors.
Simon Martin is head of research at Curzon Global Partners in London