The global case for real estate securities
ver the past decade, there has been strong growth in the real estate securities market. In part, this has been driven by the appreciation of real estate values but, more fundamentally, it is due to the increasing demand for securitised forms of real estate and the introduction of real estate investment trust (REIT) legislation in an increasing number of countries. The structural changes, combined with the market's relatively small size, mean that they have grown at a far more significant rate than the broader equity markets, across global regions.
More and more institutional investors are seeking to increase their portfolio allocations to the real estate sector, due to the benefits of stable income and low correlation with other major asset classes.
Despite the benefits, the main drawbacks for investing in real estate directly are cost and liquidity issues. Investing in real estate securities provides interesting opportunities for institutional investors.
Such securities, whether REITs or REOCs (real estate operating companies), tend to fall half way along the risk and return spectrum for real estate investing, with the benefit of greater liquidity and lower cost than investing in direct real estate.
There are several reasons for institutional investors wanting to build more exposure to this asset class.
On the one hand, established securities investors in Australia, Netherlands and the US are seeking to increase their investments in direct and listed real estate across global markets. On the other, investors from Europe, Japan and other parts of Asia are also increasing their allocations to real estate, and securities are starting to become of greater interest to such investors. These investors are attracted by a series of characteristics including:
■ Strong historical returns - strong real estate fundamentals coupled with structural changes - and the emergence of REIT legislation across many countries mean securities have performed exceptionally well over one-year, three-year, five-year and 10-year periods across all regions.
This performance has been particularly strong in the past three years where securities have generated an average annual return twice as high as that for equities, but it is also
apparent across most markets over the past decade. Clearly, average annual performance of 25% is unsustainable, but the recent strong performance is due in part to the asset class being
significantly undervalued at the start of the decade. Beyond this, the medium- and long-term prospects for the asset class remain robust.
On the one hand, most real estate markets around the world are experiencing a recovery in market fundamentals that drive the underlying performance of real estate securities. On the other, profound changes are taking place across global markets, with REIT structures continuing to be introduced, and securities companies growing in scale and specialisation.
■ High dividend yield - an important historical reason for the strong performance of securities, and their attractiveness to investors, has been the relatively high dividend yields that have generally been above those of broader equities and bonds.
Over recent years, the strong appreciation of securities means that dividend yields have declined, but they remain attractive relative to broader equities. This was certainly the case in North America and Europe but, for both regions, the spreads have narrowed substantially since 2003.
This narrowing of spreads has been driven by strong demand for real estate securities, the benefits of liquidity and diversification, and the expectations of the recovery in real estate market fundamentals across most global markets.
The high yields are a particular feature of REIT vehicles given the requirement to distribute most of their income especially where REIT regimes have been introduced.
■ Diversification benefits - on a number of dimensions. Firstly, correlations between real estate securities and broader equities are relatively low, at 0.39, meaning that securities add diversification benefits to multi-asset portfolios.
Secondly, beyond the scope for global securities to provide diversification benefits for broader equity portfolios, global securities also provide significant diversification benefits across regions.
For example, while rents in the Netherlands and Germany have continued to decline over the past three years, they have soared in Hong Kong and have started gathering momentum in London and New York.
Correlations between real estate markets are around 0.5, contrasting sharply with regional equity and bond markets. Finally, investors can gain exposure to the diversified real estate portfolio by investing in mid and large-cap companies.
■ Volatility - although real estate securities are far more volatile than direct real estate, this tends to be lower than for broader equities. In addition, the level of "global" real estate securities volatility is lower than that of most of the major constituent countries due to the low intra-asset class correlations.
■ Liquidity - The nature of
real estate securities mean there are significant liquidity benefits compared with other ways of investing in real estate. There are two important dimensions to this. First, the trading of real estate securities can be carried out more easily and quickly than direct real estate investment. In most cases, it only takes a matter of days to complete a transaction for real estate securities, whereas direct real estate could take a series of weeks or months. The second important aspect of liquidity is the divisibility of the investments that are made. The scale and lumpiness of direct real estate makes it hard for investors to allocate small sums to particular assets or markets.
■ Costs - As an asset class, real estate tends to be associated with relatively high costs, whether in terms of transaction costs or the costs associated with building a real estate portfolio. In both respects, real estate securities offer investors strengths over direct real estate. Transaction costs for real estate securities tend to be relatively low at around 60 basis points (bps) or less in Asia Pacific and 25bps or less in North America.
■ Investor trends - A number of structural factors suggest that there will be continuing pressure to make significant allocations to real estate. Foremost among these is the continued growth in ageing populations, with more than 20% of the overall population being over 65 years old in Japan, Italy and Germany by 2020,
and dependency ratios increasing across the world. Other factors include the more general trend towards increasing exposure to alternatives, and the maturing of the real estate asset class that increases the options for investors seeking to invest in.
A comparison of some of the strengths and weaknesses of different options for investing in real estate reveals some clear advantages for securities investing, as summarised in figure 3.
For investors, real estate securities provide a series of important benefits which combine with the attractive performance characteristics. Against these strengths, the major disadvantage relates to the volatility of the asset class, and this volatility means that the real estate securities are less attractive to certain investors than direct investing or private real estate funds.
Beyond the overall attractiveness of real estate securities, it is clear that securities markets around the world vary significantly in terms of their maturity and their behaviour. Indeed, these differences are an important factor behind the case for a global perspective on securities investing.
In order to help understand these differences, figure 4 demonstrates the size and the level of maturity in the major global securities markets.
At one extreme, Australia is shown to be the most mature securities market, given its scale relative to the direct market and the search for earnings enhancement. At another extreme, there is a range of countries where the overall capital market is poorly developed with a small scale and immature securities market.
In these countries, such as those in Eastern Europe, India and China, there is little scope to invest in real estate securities themselves.
A more prevalent trend in these less mature markets is for their real estate to be acquired by non-domestic real estate companies listed in countries such as Australia, Hong Kong, Singapore and the UK. Some of the more interesting securities markets fall between the two extremes. These countries, including Japan, the UK, France, and Germany, benefit from the maturing of the securities market. Such markets benefit as individual companies develop greater scale and specialisation, and they also generate the scope for one-off benefits to investors, such as the reduction of tax leakage and the launch of IPOs.
Although there remain important differences in the maturity of securities markets across the world, many of these markets are undergoing significant structural changes. These structural changes, in both the securities markets and the underlying real estate markets, suggest that the global securities market is set to grow in scale and importance to an increasingly broad range of investors.
Henry Chin is global real estate strategist and Peter Hobbs head of global real estate and infrastructure research at RREEF