The European property share market is quite large when we look at the number of property companies existing today. We track about 240 European property companies, which compares to a figure of 650 property companies we follow worldwide. However, a large proportion of these companies are very small indeed. Only 10% of the European property companies have a market capitalisation of over e1bn.
It is clear that the average size of quoted European property companies is still very limited. The combined market capitalisation of the GPR General Quoted Europe Index (a market capitalisation-weighted property share index following 133 European companies) is €80bn, translating into a €600m average market capitalisation per company.
The very small average market capitalisation creates liquidity problems. Institutional investors will not buy shares in the smallest companies, because the shares are very difficult to purchase. Larger companies enjoy the interest of a wider range of investors and analysts tracking these, which arguably leads to better pricing of the shares relative to the net asset value. This enables the larger companies to attract capital, especially equity, whereas the smaller companies find it increasingly difficult to attract capital. Smaller companies often end up being better off going private or by being acquired. The combination of larger companies with access to capital and smaller companies trading at deep discounts for a long period is one of the key reasons why consolidation in the European property share markets started a few years back. The average market capitalisation of European property companies, small as it may be, has grown substantially over the past five years. The current trend towards consolidation suggests that we will see a smaller number of larger property companies in the future.
Investors also have a need for relatively large and liquid property companies. The number of institutions investing internationally in property companies has been very limited. Because of currency risks most investors only held domestic private real estate investments in their portfolios. However, this is changing rapidly. Investors are moving out of their domestic private investments to a diversified portfolio of European property shares. By doing so, diversification benefits can be achieved and performance can be boosted.
To be able to invest outside their home country, investors need reliable information as well as liquidity in the property share markets. Both items were very hard to get up till now. Analysts have always concentrated on the largest companies in the business, and due to a lack of information many investors can not evaluate the potential of the smaller cap companies. Moreover, annual reports often are not available in English and disclosure is poor, in particular for the smallest companies in the market. Smaller companies lack transparency and therefore liquidity. Taking a look at the way liquidity has evolved in the European property share market, it is easy to find that the liquidity is skewed towards a small set of larger property companies. Figure 1 shows the average daily turnover, measured as the total value of all purchases in million euros, of the 15th and 25th most liquid property company in the European property share market. In 1995, the 15th most liquid property company in Europe had an average daily trading volume of e1.8m. In 1999, this figure was e6.6m. However, the company ranking 25th in 1995 had an average turnover of e1.1m; in 1999 this was e3.5m, or only 55% of the company ranking 15th. It shows that, although liquidity in general is getting better, the gift of liquidity is only bestowed upon the top 15 companies in the European property share market.
Limited availability of liquid property companies clearly puts a constraint on the creation of real-time indices and derivative products. There only is value in a real time index if there really is something to measure. As is shown in Figure 2, liquidity drops dramatically if a set of 25 stocks rather than 15 stocks is tracked within an index. Obviously, this is getting worse if the set of stocks in the index grows. This is why the existing GPR indices (ie, the GPR 250 with 88 European companies and the GPR General with 133 European companies) are not suited to serve as a basis for the real-time index. The lack of liquidity would cause most of the price ticks to include only noise or currency movement, and the price shocks would be large, due to infrequent trading. Furthermore, less liquidity means it becomes difficult to hedge the index (derivative), which is of obvious importance when creating a market for derivative products.
This alone warrants the creation of a new index, which carefully balances broadness and coverage on the one hand and liquidity on the other. The GPR 15 Real Time Index is such an index. The GPR 15 covers 38% of available market capitalisation in the European property share market, although it only follows the 15 most liquid companies. More important, however, is the correlation of the GPR 15 Index with the broader property share market, because it is supposed to be reflecting the performance of this broader market. The GPR 15 serves as a very good approximation for the performance of the broader market. Figure 2 compares the returns of the GPR 15 Index with the returns of the GPR 250. The correlation between the two turns out to be 97.5%, which is almost perfect. From this it is safe to conclude that the GPR 15 can serve as a tool to hedge or gain exposure to the European property share markets, which is immensely important for it to become accepted.
Another reason why existing indices do not meet the requirements to serve as a starting point for derivative products is the way in which these indices are set up. The index needs to be replicable without having to go through complicated calculation methods. All property share market indices available today have flexible constituent weightings, which will not work for the purpose of creating derivatives. The GPR 15 Europe Index is constructed by assigning a fixed number of shares to every company in the index. The country weights within the GPR 15 are determined by looking at the market capitalization of a country in the GPR 250 Europe Index. The number of companies in each country is determined by the weight of the country in the index. Currently, this leads to a rather strong tilt towards the UK and French property share markets, which are by far the largest in Europe today. Within the country, each company gets assigned a weight according to its free float market capitalisation (with a maximum of 17.5% for each constituent company). Constituents will change once a year, or whenever a company drops out of the index. Of the 15 member companies of the index, nine are British at the moment, and two are French. Some investors might argue that this composition is not practical, as a position in this index forces the investors to invest 60% of their portfolio in the UK. However, the strong weight of the UK market is a fact of life in the European property share markets, and it is quite conceivable that it will change in the future, as more markets will see securitisation of real estate in the form of quoted property companies. Because this will take a considerable amount of time before the market gets there, GPR is also in the process of constructing a Euro-zone real time index.
This brings us to the question whether the markets are ready to construct derivative products on the GPR 15 Europe Index. We feel that the conditions for such products will be met in the near future. By creating a tradable real-time index, the first step towards derivative products has been made. Now it is up to investors to create demand for the product. To do so, an understanding of the product is needed. This will take some time. However, history has taught that innovations in the financial markets will always happen, and in most cases they will happen quickly. With increasing liquidity and investor demand in the quoted property markets, the GPR 15 Europe Index is a stepping stone to more sophistication in the property share markets.
Hans Op ‘t Veld is a partner with Global Property Research in Amsterdam.