Unlike the bond and equity markets in which investments are relatively homogeneous, transparency in real estate markets has always been complicated by the heterogeneity of individual assets and the time it takes to conclude transactions.
Since there are relatively few real estate transactions, in comparison to the bond and equity markets, a fundamental precursor of real estate market transparency must be a common and rigorous valuation standard based upon market price. This has existed in the UK for many years and recent efforts by IPD to expand their coverage of their databank have succeeded in setting up comparable standards in the Dutch and Swedish markets.
Whilst France also has a valuation standard that gradually appears to be working towards a market value, it is not directly comparable to other countries and it is not yet perceived to be a reliable indicator of market value. Both the German and Spanish markets do have standards by which properties are valued but these are not based on current market valuation and so do not add to the transparency of the market.
Investors should therefore exercise a greater degree of caution when investing in markets that do not have a reliable market value based valuation standard. Less certainty as to the value of your investments would suggest a higher risk premium should be applied to investments in these countries. Whilst this is generally the case the German market would appear to be a glaring exception.
However, valuations are not a perfect indicator of true market value and therefore cannot make real estate values truly transparent. In a handful of markets, such as Sweden, real estate transparency has been improved by legislation, which ensures that all transactions are recorded on a national register. In addition a large proportion of valuations are detailed in the annual reports of public and mutual companies, although as yet the legal duty is not to use the new market price based method of valuation
Valuations whilst generally giving an indication of the market value do not provide the investor with the same frame of reference as a stock market index. Firstly they relate to just one building and are normally confidential to the investor. At the portfolio level, real estate investors need to be able to segment the market into elements which are functionally similar and have similar performance characteristics. In the same way that equity investors target high tech stocks or chemicals, in a transparent market real estate investors will want to be able to target specific types of property such a West End (London) offices or Paris industrials. But before this can happen investors need to know the fundamentals of these real estate markets.
As an economist I always tend to focus on demand and supply before looking at any historical precedents which can be used to extrapolate future performance or risks. In the UK, where most of my experience has been based, agents play an invaluable role in making the UK real estate market more transparent. There are number of freely available regular reports which detail take-up, lettings, demand, vacancy rates and development activity in a number of different markets with which investors can quantify demand in relation to supply.
Perhaps not as widespread as in the UK, these type of publications are available in a number of European countries. Although of varying quality and accuracy they form the basis of the next step towards market transparency. A good market based valuation standard will tell the investor what the property is worth now but detailed information on supply and demand can help the investor determine how much it will be worth in the future.
Markets where this type of information is available can enable investors to weight their portfolio towards segments of the market, which they believe are going to perform well. What is missing is a comparative measure of performance, so that investors can assess how well their portfolio is performing relative to the market and how well the individual properties are performing relative to their peers.
The next step along the road to transparency is the property performance benchmark. Rupert Nabarro the co-founder of IPD is well on his way to world domination (of the property market benchmark) with a comprehensive benchmarking service in four European countries and fledgling benchmarks available in a handful of others. The UK possesses the most mature benchmark with performance data stretching back on an annual basis to the early 1970s and a monthly series of mainly unitised fund holdings from 1987.
Whilst comparative measures of the performance of portfolios and individual properties is very useful to the investor now, the data produced by the benchmark is the launching platform for detailed portfolio analysis directly comparable to that undertaken on equity and bond portfolios.
When combined with data from agents reports an investor can rapidly gain an understanding of the differing risk and performance characteristics of the various types of property and the principle factors which drive their performance. Econometric modelling of historic data enable the production of forecasts every bit as rigorous and accurate as those of the equity and bond markets and together with risk modelling allow the construction of portfolios tailored to the investors own risk or liability profile. This type of information also allows real estate to be analysed in the context of the entire asset portfolio in a directly comparable way to bonds and equities, impossible in markets which are not transparent.
It will take some time before the younger performance indices of Ireland, Holland and Sweden can accumulate enough data for this type of analysis to be comprehensively undertaken, but that time is fast approaching.
Despite the fact that the UK benefits from the most transparent property market in Europe, real estate remains a marginalised asset and is significantly under priced relative to both overseas property and domestic bonds. If all of the above were true, then UK property should attract a significantly lower risk premium than German property, before even considering factors such as longer ‘triple net’ leases and upward only rent review clauses.
So what are the barriers which are preventing liquid and transparent markets such as the UK being fairly valued? Despite all the above real estate has a number of fundamental problems; it is slow to transact, it depreciates and being hetrogeneous every property does perform slightly differently. Legislation also has a significant restraining influence on property investment activity. Huge increases in stamp duty on transactions has significantly increased the costs associated with investing in real estate and the ludicrously narrow terms of the MFR has forced many pension funds to abandon real estate altogether.
Psychologically there are also a number of factors at work. The UK is dominated by the equity investment, a market whose performance has outstripped real estate by a very wide margin, albeit based purely on a differential shift in investment yields. In addition, the experiences of over supply and low liquidity during the early 1990’s still play upon the minds of investors many of whose investment horizons are too short to consider direct property investment. Finally and possibly most importantly, the entire property industry has yet to gear itself up to incorporate all the new techniques of portfolio analysis and management and to think about the fundamental characteristics which real estate possesses in the context of other assets.
Mark Long is portfolio analyst with Celexa in London