The case for securities
European institutions are reassessing their allocation to European real estate securities. In recent years property has outperformed the other asset classes on a risk/return basis and the performance of real estate securities has reflected this. There has also been the introduction of a widely accepted benchmark. Furthermore, the market is going through a transformation thanks to the expansion of real estate investment trust (REIT)-like vehicles. REITs allow property companies to pass on rents received in the form of dividends to investors tax-free. For institutions looking to gain a property-type allocation, real estate securities offer many benefits over direct real estate. Furthermore, they offer tactical opportunities to direct property investors.
Many institutions view European real estate securities as a proxy for investing in direct property. While the fundamentals of the assets are similar, real estate securities offer investors something different from direct property, including greater liquidity, real-time pricing, a pan-European benchmark, lower purchase costs and a cheaper route to a well-diversified portfolio. However, this does come at a cost, namely reduced portfolio diversification.
In recent years European real estate has been considered a minor asset class relative to bonds and equities. But a number of factors are beginning to move investors towards real estate: the continued corrections and disappointments in equity markets; pressure on pension funds to secure higher yields together with an inflation hedge (most European leases offer some form of indexation or linkage to market values) and recently due to the positive real estate yield margin over the cost of debt (see figure).
Over the past five years, real estate in major European markets has shown superior risk-adjusted returns compared with bonds and stocks. As might be expected of a bond – equity hybrid, real estate’s performance has sat between that of equities and bonds over the past five years – although, in some markets, notably the UK, Netherlands and Ireland it has performed considerably better than both.
On the basis of past trends in IPD-measured markets, we expect long-term returns for European real estate to be around 7-9% a year, based on long-term past real returns of 6.3% plus expected medium-term inflation of 1-2% a year.
In a period of low inflation, returns of 7-9%, suggest that real estate will be good value. In comparison, European government bonds are only showing redemption yields of around 5% a year, with no cover against unexpected inflation. Equities, despite recent volatility, are still priced at dividend yields of 3-4% in European markets, implying 4–6% annual growth to match real estate. This is a demanding target.
After returns, diversification is the most important issue confronting institutional investors, as they are concerned with managing risk in the most efficient manner. Real estate offers a potent source of diversification from equities and bonds for two sets of reasons.
Because of the geographically fixed nature of its business, a property offers truly local exposure to an economy in a way that equities and bonds do not; they increasingly reflect international influences in their pricing and their returns are therefore more synchronised. Real estate largely reflects the fortunes of the economy in which it is situated, and in the case of most retailing and some office functions, this can be down to the level of the city economy itself.
The second source of diversification benefits come from real estate’s form of contract. In continental Europe leases tend to be 10-15 years, with tenant breaks often, but not always, embedded at three- or five-year intervals. In the UK and Ireland longer unbroken leases are the norm, with upwards-only rent review steps every five years. As a result, real estate’s income stream is more predictable than equity dividends. As a result, returns are less volatile than equities.
The form of contract further reduces real estate’s risk to equities and bonds by having a senior claim on tenants’ cash flow, ahead of dividends and bond coupons. It is also payable in advance as opposed to in arrears and in most European contracts is exclusive of insurance, repairs and local taxation, which are the responsibility of the tenant.
The inclusion of real estate demonstrably helps to diversify investment portfolios, and at current pricing would seem good value relative to other asset classes, although this differential is narrowing.
Real estate securities have many benefits over investing in the sector directly. They allow investors access to a liquid asset, with known characteristics, where pricing is on a real-time basis. Purchase costs are reduced as in most European markets stamp duty on equities is less than it is on direct property. This enables an exposure to be obtained much quicker than through the private market. It regularly takes 12-24 months to assemble a direct portfolio. Using private funds is rarely quicker especially given the time taken for committed funds to be drawn down. In the public markets, the bulk of a portfolio can be acquired in a matter of weeks (because there is good liquidity in the large caps) while full exposure for even a E200m investment can be achieved within three months.
Investors can gain immediate access to well diversified portfolios and can tilt the portfolio towards preferred markets through stock selection. Furthermore, the current discount to net asset value that many European property companies can now be bought at means that the public market is a cheaper way to gain access to property than direct ownership. Those NAVs probably do not fully reflect the very hot pricing in today’s direct markets.
Investors gain access to specialised management expertise. This can be beneficial when entering emerging property sectors, but also offers potential economies of scale that larger companies are able to take advantage of and/or when they hold ‘monopoly’ assets, for example, dominant shopping centres.
But there have been problems for investors in this sector as well. For many years Europe has not had an equivalent to the US’s REIT structure or Australia’s LPTs. Some vehicles have existed, for example, SICAFIs in Belgium and the Dutch BIs. However, the tide is now turning.
Another development making securities more attractive to investors has been the introduction of a widely recognised pan-European benchmark EPRA, which allows investors to benchmark their performance on a timely basis.
Robin Goodchild and Matthew Ryall are with LaSalle Investment Management European Strategy in London