Mainstream or not?
The poor performance of major equity markets in recent years and falling bond yields have encouraged greater focus on so-called ‘alternative assets’. Commercial property investment is often conveniently placed in this category, along with private equity and hedge funds. But is such a classification helpful or meaningful?
The term ‘alternative’ is occasionally applied to any asset, such as direct property, that is an unlisted, private investment as opposed to publicly traded, listed equities and bonds. Sometimes the term is simply applied to anything that is new or ‘non-traditional’. Yet commercial property has long been held by many UK life and pension funds, some of which would regard it as a mainstream asset class.
Whilst there is a need to classify investments for various purposes, there is a danger that labels obscure the underlying characteristics of each asset class and, importantly, their interrelationships with each other. This article examines commercial property’s attributes, and the main advantages and disadvantages it offers investors, regardless of whether it is classified as a mainstream or alternative asset.
First we must look at property’s advantages as an asset class:
q Prospective returns Property has delivered strong returns over the past decade. After inflation, real returns have averaged around 8.5% a year. Property has significantly outperformed equities in recent years. It is capable of performing strongly.
Of course, this is no guarantee that future returns will be as competitive. And property experienced prolonged periods during which it underperformed other assets, particularly in the 1980s and early 1990s.
Following strong recent performance, we expect future returns to be lower in absolute terms. However, property should deliver a reasonable premium relative to gilts. One reason for this is property’s relatively high yield. In a low growth, low inflation environment, this is very attractive to pension funds, insurance companies and private individuals.
The chart shows UK property, gilt and equity yields. For much of the 1980s and early 1990s, property yields were below gilt yields. Since the mid-1990s, property yields have been significantly higher than other assets. There is now a gap of some 3–4% between property yields and five-year gilt yields, which stand at around 4%.
q Diversification Property is not perfectly correlated with other assets. It is also less volatile than equities. Property can therefore lower the volatility of returns in multi-asset portfolios.
It is important, however, not to exaggerate its diversification attributes. Some of its perceived diversification benefits are probably over-stated because property returns are based largely on valuations rather than actual prices, which leads to ‘smoothing’ of returns. As a result, historic measures of volatility and correlation with other assets are arguably too low. Various approaches can be employed to ‘unsmooth’ returns series so that they better reflect underlying prices, resulting in higher volatility and correlation measures. Nonetheless, even allowing for such factors, property helps to lower overall portfolio risk.
q Mix of bond and equity Property is an unusual asset class in that it exhibits characteristics of both fixed income and equity. Current rents are contractually agreed and are usually protected, at least in the UK, by ‘upward-only’ rent reviews, forming the fixed income component. This segment is prone to inflation and the risk of tenant default. The equity component of a property’s value arises from the prospect of increases in rental income as rental values rise either through real rental growth or inflation. In some parts of Europe rental income during a lease is linked to inflation.
The proportion of a property’s value attributable to the fixed income component can vary enormously, both between and within different sectors of the market. Bond-type investments – which exhibit a large proportion of total value in contracted rental rents – could be of particular appeal to funds seeking a higher-yielding alternative to fixed interest investments.
This mix of attributes is appealing to investors. It is possible to structure a portfolio with biases towards the fixed income component, or the equity component, depending on the objectives of a particular fund.
These benefits should be set against the disadvantages of direct property.
q Illiquidity Direct property is less liquid than listed assets. Transactions can take several months between the decision to buy or sell and completion. But the key issue is not that property is illiquid, but rather whether or not prospective returns provide sufficient compensation in the form of an implied premium. Funds with long-term time horizons may be able to take advantage of relatively illiquid assets such as property and enjoy higher risk-adjusted returns; for other funds, the implied illiquidity premium may not be sufficient.
q Costs and expenses It is more expensive to transact and manage property than other assets. A combination of stamp duty, legal and other fees can amount to around 5.75% of the purchase price for most UK assets and often higher elsewhere in Europe. Other fees are associated with the management of a portfolio, including rent collection/management, rent reviews and so on. But such costs can be estimated with a reasonable accuracy. The issue, therefore, is whether the net returns, after allowing for these costs, are sufficiently attractive; it is again a question of pricing.
q Valuations The fact that property performance is largely based on valuations (estimates of open market prices) rather than actual transactions is also cited as a disadvantage. This can cause suspicion: differences can arise between a valuation and the price that a property might actually fetch. However, valuation practice in the UK has undergone significant changes in recent years. Most valuations for institutional investors are undertaken by external valuers, often on a quarterly basis, providing greater rigour and independence than was the case in the 1970s and 1980s. More rigorous and transparent analysis of performance takes place, thanks largely to the growth of Investment Property Databank which produces property indices and performance measurement services. Similar trends are starting to occur in the rest of Europe.
q Difficulty constructing diversiified portfolios Direct property is both heterogeneous (each property is different) and, in most cases, indivisible and ‘lumpy’. There is little commonality of ownership between one investor’s portfolio and another. By contrast, equities and bonds can be bought in small quantities, and there is considerable overlap between different investors’ equity and bond portfolios. It is therefore difficult to assemble a diversified portfolio of directly held buildings. Small funds cannot buy directly large assets such as shopping centres, retail warehouse parks or big city centre offices. Even medium and large funds find that the largest properties may skew their portfolios significantly.
However, the growth of property unit trusts and other pooled vehicles, together with the development of multi-manager (or ‘fund of funds’) capabilities, mean that small and medium sized funds can increasingly gain access to property indirectly. This means that market and also manager risk can be diversified more efficiently.
Whether property is classified as a mainstream or alternative asset may be a question of administrative convenience. However, what matters more is that investors understand the characteristics of property – both its advantages and disadvantages – and its interrelationship with other parts of the portfolio.
In a low growth, low inflation environment, property’s high yielding bond-type characteristics are attractive to many funds, particularly given the diversification benefits it brings to a multi-asset portfolio. There are, of course, disadvantages associated with property and so it is important that these are either reflected in prospective returns or in the way in which the property market is accessed.
Guy Morrell is chief investment officer, global property, at Henderson Global Investors