Minding the gap
Real estate equities soared in 2006. This strong performance is expected to continue in 2007, driven by improving fundamentals, but also by the structural rebalancing of investment portfolios - whereby European institutional investors increase their property exposure and broaden their property exposure across the direct, listed and unlisted property investment options.
The phenomenal growth of the listed real estate market is forcing institutional investors to evaluate their property holdings to optimise the diversification and returns real estate can bring to their portfolios. (see figure 1)
The need to increase their property exposure stems from a structural underweighting in the asset allocation of portfolios dating back to the 1990s when investors favoured riskier assets than property - and it has yet to be remedied.
According to the European Pension Real Estate Association's 2005 survey of pension funds, 85% of the survey's participants were below their property target allocation of 15-20%. (see figure 2).
The need to rebalance across the property investment options reflects a change in the real estate investment landscape marked by a significant shift in the asset class from a bricks-and-mortar property investment to a liquid and tradable property security. The global market capitalisation of property companies has multiplied tenfold over the last 20 years and shows no sign of slowing.
The capitalisation momentum gathered pace with the creation of REITs, property investment vehicles that accentuate the benefits of listed property companies by eliminating the double-taxation of listed property investments and giving shareholders high payout ratios, sometimes as much as 100% of profits.
In Europe, markets such as France and the Netherlands introduced REITs years ago, while the UK introduced REITs on 1 January 2007 and Germany is expected to follow shortly, as are a number of smaller countries. Along with raising their total exposure to real estate, institutional investors are expected to shift from direct real estate ownership to property securities.
Investors look to holding real estate in their portfolio for its diversification and robust growth. Diversification may take place across countries, regions or real estate segments - such as office, retail and storage. Real estate as an asset class has different growth drivers to those of equities and bonds, so adding real estate to a portfolio can reduce its risk. But the three real estate investment options - direct investment, listed property company or unlisted property fund - differ in their diversification characteristics and in their returns. When making decisions on how to increase and broaden their property portfolios, institutional investors need to weight these real estate investments appropriately to optimise the returns and diversification.
Direct investments - in which institutional investors buy buildings directly - give investors access to the income and growth characteristics of property. As such, a direct real estate investment offers diversification to a portfolio of equities and bonds.
But such a bricks-and-mortar investment suffers from a lack of liquidity, is not tradable, requires a prohibitively high initial investment, is not diversified across segments or countries and tends to come with high transaction and management costs.
The liquidity constraint weighs particularly heavily when an investor wants to draw down the capital in order to fund other investments or liabilities. These constraints make the risk-return trade-off of direct property investments much less amenable.
Listed real estate assets are companies that own and manage real estate directly and give investors access to the income and growth characteristics of property by buying a share on an exchange. In contrast to direct investments, listed real estate is divided into affordable investment shares, such that they are accessible to a wider range of investors. These shares are tradable, liquid and transparent. Because of its divisibility into affordable ownership stakes, investors are able to diversify across property segments, countries or regions.
The major drawback to listed companies is that they are subject to double taxation, as both the underlying assets - the real estate itself - and the corporate profits are taxed. REITs eliminate the double taxation.
While the characteristics of REIT structures vary, there are a number of common traits: first, investors receive a return similar to direct investment in real estate, but they have a different management structure; second, their development activities may be limited; and, third, there is a maximum gearing. REITs also require that a high proportion of the profits are paid out in dividends, precluding the use of these funds for development purposes. In essence, the REITs crystallise value as opposed to creating it. In addition, the availability of REITs in Europe has been somewhat limited until this year, when REIT legislation was introduced in the UK and Germany.
A significant concern about real estate securities is that their shares perform in line with equity markets, and thus do not offer sufficient diversification from equities. Listed property companies become subject to fundamentals similar to those of corporate equities, including market expectations, economic developments, interest-rate changes and the short-termism of fund managers who may have no knowledge of property.
In short, investors trade in listed property companies with little regard for the fundamentals of the asset class and its growth characteristics.
Though there is some correlation between listed property securities and equities, it is low. Moreover, the correlation has fallen over the last ten years, despite the increased securitisation of property companies - which should, in theory, increase the correlation. (See figure 3)
Another concern is the over-valuation of listed property markets. Valuations have increased very strongly in recent years, but much of this can be explained by the catch-up of stock prices to the underlying property values. Property securities are now marginally more expensive than direct property, but this margin can be accounted for by the value-added contributed from property management. (See figure 4)
Many institutional investors are underinvested in property due to these concerns that real estate securities are correlated to equities and bonds - and thus are not a diversifying element in a portfolio - and that they are overvalued. Yet the high costs and heavy burdens of direct property investments are equally prohibitive.
As a result, many institutional investors have sought to bridge their allocation gap with unlisted property investment funds.
Unlisted property investment funds - due to their direct property ownership - offer similar returns of capital growth and regular cash flow as well as diversification from equity markets with the added benefit of being a passive investment. But they are not divisible or liquid, and they are difficult to trade. Some funds offer a degree of diversification with pan-European property ownership or diversification across property segments.
The unlisted route has been a preferred option among European investors, due to the asset class's tax efficiency, the lack of REIT vehicles in the property-rich countries of the UK and Germany and the conservative nature of institutional investors who have been unwilling to venture into the world of listed property.
Over the last 10 years, the number of unlisted funds in Europe has increased from 70 to 473. They are so popular that new funds are cropping up every week. But for smaller investors with limited resources it is difficult to check the quality of each fund thoroughly. And for the few high-quality funds, investors are often put on a waiting list.
Unlisted funds have been less popular in the US and Asian markets, where a tax is imposed on international investors in unlisted funds. Due to the tax limitations in these markets and the scarcity of high-quality unlisted property investment funds in Europe, investors are increasingly looking to funds that combine listed and unlisted property - known in the asset management industry as offering unconstrained solutions. This gives institutions for which listed real estate assets are a mystery a taste of securitisation, as well as allowing them to retain an unlisted property holding, with all the diversification and returns that offers. (See figure 5).
Looking ahead, as institutional investors increasingly choose to combine unlisted and listed property in their portfolios to redress the current underinvestment, any performance differential between the two is likely to narrow as fund managers chase performance.
Another factor is that listed property is likely to garner a greater attention from specialised property analysts, who are likely to make investment decisions in line with the characteristics of the asset class.
As a result, the performance of listed real estate is likely to edge away from that of equities, and closer to that of unlisted property.
As this change in the characteristics of property securities gains momentum, the perception of listed real estate as an equity investment will decline. Instead, listed real estate is likely to be viewed increasingly for what it is, an investment in a separate asset class, as opposed to an equity investment in a sector. As a result, investors are likely to make changes to their investments within property as an asset class, instead of moving in and out of property as though it was a sector rotation. This is likely to result in an even lower correlation between listed property and equity markets.
Remaining committed to diversification does not require that investors stay tied to direct property investments.
Both listed property and unlisted property investment funds offer different diversity features and returns that can be carefully combined and monitored to optimise their investment portfolios.
And for those investors that do venture to add listed and unlisted to their portfolios, they may find that, in time, the performance of listed securities matches that of unlisted counterparts, assuaging any residual concerns of a correlation to equities.
Nick Brugman is Global Product Specialist Property at ABN AMRO Asset Management