Thinking local adds an edge to investing global
As pension funds in Europe broaden their investment opportunity set after the equity bear market of 2000-2002 and historically low bond yields, investment in real estate has been at record levels over the last two years.
Real estate as an asset class has historically generated returns well above the risk-free rate while exhibiting low correlation with traditional asset classes. Within Europe the elimination of currency risk through the introduction of the euro has driven cross-border allocations.
This development, coupled with the lower yields generated from domestic investments, have led institutional investors and local product providers to exploit the potential for investments outside Germany.
The trend towards increasing the global real estate exposure continues as barriers to entry for international real estate investment, such as currency risk and lack of appropriate products, are coming down.
German investors are now thinking more globally than ever and therefore have become more willing to invest in foreign assets. Hence, they must decide on the appropriate level of home bias in their real estate portfolios.
A large number of our clients have an allocation to real estate investments. These allocations vary from a relatively small amount (2-3 %) up to more significant amounts (18-20 %). The degree of allocation depends on different factors. For example, insurance companies and certain pension organisations must follow special regulations if they invest in real estate.
Our clients use different real estate strategies. These may be categorised as income, core, value-added and opportunistic.
In determining an appropriate strategy for the overall real estate allocation our clients have to make various decisions. The first is to determine the desired performance (income, total return) from the real estate allocation. Then they need to lay down their appropriate risk profile.
Finally, a decision is required regarding the structure of the investments. The structure refers to the proportion to be invested in direct holdings versus indirect holdings such as funds (unlisted/listed, open/closed), partnerships, or listed securities such as REITs or REIT funds).
Our German clients review their traditional method of investing in real estate which is buying residential and office buildings in Germany. They are analysing the administration, cost and monitoring of their real estate portfolio. It seems that a growing number of them are moving toward an indirect way to access the global property markets via listed property securities.
The relative disadvantages of investing in unlisted property (direct, closed funds) include:
l Poor liquidity compared to listed property
l Taxation constraints on unlisted property in certain regions
l Management fees might be higher
l Higher administration costs
Nevertheless, we believe that an allocation into unlisted property should be considered as medium to longer term. Most investors can afford to have a portion of their overall asset allocation in illiquid investments. And unlisted property brings greater diversification effects because REITs have a higher correlation to equity markets.
Finally, some investors, especially family offices, still like to invest directly (often together with other investors) in real estate to meet specific return, income and risk requirements through customised portfolios.
Historically, different markets have shown different risk/return profiles. Some markets - for example office markets in eastern Europe - have provided high returns for investors willing to take on the attendant risk.
Others, typically the more mature markets in western Europe have been less risky but also less rewarding. The heterogeneous performance of different real estate markets shows the benefits of a diversified portfolio.
ven European real estate markets have historically not been well correlated with each other. The economic cycles of different property markets offer an extended set of investment opportunities in the long run. As an example, some markets have done well ( Asia, UK, Spain, Paris) and others poorly (such as Italy) during the last years.
The key benefit of investing in a globally diversified property portfolio is the low or even negative correlation with equity and bond markets and between different regional real estate markets. To reduce a diversified portfolio's risk, measured by volatility of returns, it makes sense to implement a global strategy to property investment.
A superior real estate manager should have the proven capabilities to identify those markets which are likely to perform better than others in the future and to implement this in respective portfolio over- and under-weights towards these markets. This should result in significantly increased returns and lower risk.
We believe that the better the property fund manager is the better the sector allocation skills are likely to be.
he major characteristics of real estate returns include sensitivity to inflationary forces, size and visibility of regular income cash flows and the opportunity to exploit valuation inefficiencies in the purchase and sale of properties as real estate markets are not efficient.
A global real estate portfolio provides attractive return prospects, excellent portfolio diversification and a hedge against unanticipated inflation.
Real estate has a lower volatility than equities due to a quite stable underlying cash flow and the fact that the correlation of total returns with equity markets is low. We support allocations to real estate as we are attracted by the favourable risk/return profile of the asset class.
However, REITs, as a special investment vehicle, have a relatively high correlation with equity markets as they are traded on the global stock exchanges and therefore suffer the larger market swings.
As such, the addition of REITs to a diversified portfolio will not dilute the potential return of the portfolio significantly.
Some asset managers view listed real estate securities (for example REITs) as a sub-set of an equity portfolio. Considering the underlying assets are the same, Mercer does not discriminate between listed and unlisted markets in our asset allocation model, because both are real estate.
We suggest that pension funds with only direct real estate exposure should invest in listed global property securities to achieve initial diversification.
Further, the fund must then decide whether a global approach (appointing a manager to cover the full global property universe, utilising one research team) or a regional approach (appointing a number of regional managers or selecting a manager which structures its portfolio and research teams by regions) should be adopted.
roperty securities are generally small cap by nature in their respective markets and are usually less subject to global economic forces compared with other equity securities. As a result, local geographic and economic factors are a significant driving force of property securities returns.
Indeed, property markets and sectors are extremely diverse and the correlation of market conditions between sub sectors, towns, cities, states, countries and regions can be rather incongruent.
Therefore, investments with regional-based teams might produce superior performance for a global property securities portfolio. This makes sense, considering that the required stock selection and research for property securities investments is best accommodated by portfolio managers with specialist ‘street expertise' in their respective region.
Given the infancy of global real estate as an asset class there are limited investment opportunities at present from a global perspective. Nevertheless, we are aware of several existing global property securities products (and managers) and there are more currently in the product development stage.
Merely a decade ago, REITs existed only in a few countries, but now the listing of REITs worldwide has grown substantially. This growth has occurred through increasing penetration in existing markets and expansion into new markets.
We are introducing global REIT allocations in our clients' portfolios. Offshore positions might be 100% currency-hedged. However, we still are conscious of the correlations with the equity markets and fluctuating price distortions caused by imbalances between demand and supply of REITs in different investment cycles. Skilled real estate fund managers make money by buying the right properties at the right time and the right price. Identifying favourable investment opportunities is the key driver for superior returns. The more markets and sectors an investor
is willing and able to invest in, the more opportunities can be found and taken up by an experienced manager. Active managers with a global investment view can make money by finding opportunities in a broader universe. Thus they should given large discretion for their investment activities. If a global manager is used it should have regional-based teams.
In our view the global property securities market is still in its infancy. However, we are aware of some quality providers and we prefer a regional approach even if we implement a global manager.
Mercer won the award for best consultant at the IPE Real Estate Investor Forum & Awards in Amsterdam last June. The trophy