Toes in the water
By providing high yields, capital gains and diversification from equity and bond markets it is no wonder real estate is proving attractive to institutional investors still reeling from the after-effects of post-2000 market falls and low debt yields.
And the US property market, the largest and most liquid in the world, is high on European investors’ lists to diversify into, both directly and through listed real estate investment trusts (REITs).
The US commercial property market is valued at $4,630bn (e3,695bn), of which $2,240bn is in institutional hands, according to Emerging Trends in Real Estate 2003 by the US-based National Association of Real Estate Investment Trusts. Foreign investors make up 11.6%, or $260.7bn, of this institutional total, although Jay Hyde, vice president of communications at the association, says there is no way to quantify how much came from European institutions. REITs had $155bn under management at the end of 2001, with institutions holding 58% of the total, he adds.
Market rises have helped boost this figure. The REIT association said total returns were 38.5% in 2003, with the last negative year in 1999. The 10-year average return was 10.3%, of which 70–80% was in the form of cash dividends and the rest capital gains, according to Datastream figures used by the International Herald Tribune.
Returns for direct real estate are harder to calculate as the indices that exist measure appraisal value of properties rather than transactions, according to Alexa Auerbach, press officer at Ibbotson Associates, a specialist US-based asset allocation research house.
Institutions also tend to prefer holding direct real estate over Reits, she adds. Intuitively, they believe holding the actual properties means returns are less correlated to the stock market and therefore provides a better hedge. Using appraisal figures confirms this view.
But research by Barry Feldman at Ibbotson on a transaction-based direct real estate index, NCREIF, used by the REITs association, found that the correlation to the markets is comparable. Using both asset classes is complementary, producing more efficient portfolios. Feldman’s research found the ideal real estate weighting was 7%, as this added up to 27 basis points in returns.
Relatively few European pension funds asked by IPE, however, combine both direct US property and REITs in their portfolios. Raymond Satumalaij, real estate strategist at the €7bn Blue Sky pension fund in the Netherlands, says the group plans to start buying direct US real estate again after stopping in 1999 in favour of US Reits.
This is because the group had finished its analysis of the characteristics and returns of both asset classes, he says. “Risk-adjusted returns in private property were a smoothed 10%, whereas public-listed real estate’s returns were 12.5% but more volatile.
“Direct investments cost 200–300bps but REIT fees are 40–50bps, although exposure to that market does not take into account transaction and tax costs. Now we have looked at the results and it was beneficial to have private real estate and we want to do something again but are looking at how much and currency risks.”
Blue Sky has 12.5%, or €900m, of its fund in real estate, of which half is in non-listed private real estate and half in publicly listed properties – and of that 25% is in US REITs.
Dutch pension funds were the most keen on US real estate, partly because of their size.
Theo Jeurissen, head of asset management at the €20bn BPMT technical and metalworkers fund, the largest private sector fund in the Netherlands, says 13% of its portfolio is in real estate. Of this, a quarter is in the US and a similar share in Asia; the other half is in the home country and the rest of Europe.
Says Jeurissen: “Like most Dutch pension funds we have built strategic asset liability studies and this recommended 10–15%. This figure has not changed for three to five years. In the US, two-thirds is in direct real estate and the remainder in REITs.”
Other big pension funds across Europe are expanding their property investments. Michael Nielsen, head of investments at the €36bn Danish supplementary state pension fund ATP, says the scheme is increasing its property portfolio to include real estate outside the home country and that this might include the US after 2005.
“We have a large, directly owned Danish portfolio of 120 properties worth €1.5bn. A few years ago we revised the investment strategy and started investing in real estate outside Denmark and into Europe. It is now a 4% allocation, worth €200m but building to €600–800m by end -2005. Then we expect to revise the strategy.
“Europe, first, then we will look at a mature market with information available, legal system and lots of buying and selling. The US has this. I do not know about Asia. We will use our existing consultants to analyse properties, with REITs an option.”
Knut Riesmeier, managing director at MEAG Munich ERGO Asset Management, which has €12bn under management in real estate, €1bn of which is in direct US real estate, out of total assets worth €135bn, agrees. “Insurance companies and pension funds traditionally hold real estate investments in their home countries.
“This attitude still applies for some companies but over the last couple of years the attractiveness of other real estate markets has led to an increasing regional diversification to maximise returns and to lower the risk. Within regional real estate asset allocation the US is playing an increasing role.”
Deborah Reidy at the €9.6bn National Pensions Reserve Fund of Ireland says the scheme is looking to expand its allocation in real estate to 2% from 0.5% and has appointed two consultants to look at US and European property. It is too early to say more, she says, but an initial meeting has been held to define mandates and search for managers.
The size of many pension funds, however, means the costs of diversification are too high. Gerry Ryan, company secretary of the €2.8bn Eircom fund in Ireland, says there is less than 0.5% exposure to US property and that comes through REITs. “Scale is a problem and also getting sufficient information. It is hard to justify expenditure if it is not a huge proportion of assets.”
But if size is a hindrance, quantitative rules on pension fund investment also skew managers’ choices. Andre Ludin, chief investment officer at Novartis, says 30% of assets have to be invested in Switzerland, which makes buying US real estate difficult for all Swiss funds. Also against investing in the US property market is the fact that houses in the US are made of pressed wood rather than stone, as in Europe, and so of lower quality.
A senior employee at a UK scheme says his previous history was investing in direct US properties. The scheme is now focused on UK real estate, as it is “simpler and comparatively easy to sell”. Before, it had bought US farms and property but had to set up a US company for the audit and administration and it was difficult to get out of legacy properties, he says.
And there are concerns about current REIT valuations. Satumalaij at Blue Sky says: “REITs are expensive compared to non-listed real estate; premiums are close to zero but the NAV is 17% above the normal 10% range.” He adds, however, that equity markets are uncertain and US interest rates could rise. This would affect bond prices and yields and could lead people back to REITs for lack of alternatives, maintaining prices above NAV for some years – as happened in the 1990s.
European pension funds are, on balance, increasing their investments in property and US real estate in particular but risks remain, along with volatile currencies, and for some schemes the rewards in diversification are not worth the costs.