Despite radical changes in market conditions, the respective arguments for listed and unlisted real estate have not changed significantly, say Bernd Kreuter and Dirk Dreyer

The main issues in the everlasting discussion between listed and unlisted real estate investment vehicles are liquidity, valuation and transparency.

Units of listed real estate are tradable on a regulated exchange and hence need to be valued on a daily basis. Surely, it is advantageous that investors can diversify by location, size and sector with a relatively small initial outlay. But the unit prices depend on supply and demand, and correlate with the overall stock market. Hence short-term over-reactions are possible. Prices may deviate from the net asset value (NAV) of the real estate and show a high price volatility.

In contrast, the value of non-listed real estate rather reflects its NAV. It delivers a more property-like return, since its value is determined by attributes of the underlying property assets, is less volatile and has lower correlation with other asset classes.
In terms of capital commitment, investing in listed real estate forces the investor to an immediate payment of the full cash amount, thus putting the money to work immediately. In contrast, unlisted vehicles like closed-ended funds are only drawing down capital, once an investment opportunity has been identified. During the investment period, however, each investor has to be prepared to provide the full amount at short notice.

Being traded on an exchange forces the listed companies to be more transparent. Company data and information need to be published according to the exchange's regulations. Compared to the lack of liquidity, the lack of transparency is often felt to be the bigger disadvantage of unlisted real estate.

In addition to the higher reporting standards, the daily available unit prices of listed real estate allow the calculation of indices against which each vehicle can be benchmarked. Due to their low level of transparency, the lack of time series data, and the commitment scheme, unlisted vehicles are harder to benchmark.

Based on these fundamental characteristics, investors have to choose between the two investment types. In addition, there is the question of whether or not the overall market conditions have or should have any influence on this decision.

After years of excellent returns in both the unlisted and the listed real estate sectors, the rally, especially of the listed vehicles, has now come to a bitter end. The current turmoil hit listed vehicles harder than their unlisted counterparts, but is it valid to say that, because of this, investors should shift to unlisted vehicles?

The answer depends on the degree of risk-aversion of the individual investor. Real estate vehicles that can take advantage of the current turmoil and dislocations will be able to seize interesting opportunities. Since the real estate market will face another uncertain year, the flexibility of unlisted vehicles to invest in a variety of instruments, such as debt and mezzanine, as well as the ability to handle unusual situations, like buying from distressed sellers, can create promising opportunities and thus are major advantages of unlisted investment.

Buying real estate with strong fundamentals from distressed sellers at significant discounts to NAV is appealing to a lot of opportunistic investors. The real estate debt market offers a variety of opportunities these days: credit opportunity funds have started to buy undervalued residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). Timing is critical in this segment since funds that started buying too early were hurt by further falling prices.

The lack of debt providers attracts real estate investors that have originally not focused on debt. Due to the current unfavourable cost of public debt capital, private lenders may provide mezzanine financing as well as bridge loans. Due to their longer investment period, unlisted real estate funds may refinance this expensive debt when debt markets are back to normal. This will provide interesting returns for both the equity and the debt side.

The current financial climate has only slightly dampened the appetite of institutional investors for unlisted real estate due to their long-term view, but what about listed vehicles? Has the investor to decide on one or the other of the investment vehicles? It may be worthwhile thinking of a combination of unlisted and listed. As mentioned above, investing in real estate will require deep industry knowledge and fundamental analysis.

The challenge is to identify the most promising real estate companies or sectors and those that are still overpriced. With regard to alternative investment strategies, the application of a typical hedge fund strategy may be promising. Performing fundamental analyses of individual companies and/or segments as well as top-down research will help to identify overpriced and underpriced companies.

Buying (going long) undervalued real estate stocks that have strong fundamentals and selling overpriced stocks without owning them (going short) creates two profit sources along with a potential for risk reduction. Long/short investing in publicly traded real estate securities across multiple real estate sectors using fundamental and top-down analysis can give investors the opportunity to profit even in the current market situation.

In sum, it is valid to say that the general arguments for and against listed vehicles have not been substantially changed by the current market situation: investors aiming at capital growth and price stability should choose unlisted vehicles; investors focusing on liquidity and dividends should prefer listed vehicles paying the price of exposure to stock market risk. In both cases strong fundamentals of the underlying assets are important.

But we have also seen that the troubled market phases we face these days can offer additional opportunities, predominantly for unlisted real estate funds, and thus make them more attractive. Less risk-averse investors, who want to exploit the current dislocations, may have a closer look at unlisted vehicles since they are able to pursue these promising strategies.

Unlisted real estate becomes even more attractive compared with listed vehicles, if their higher flexibility in terms of the deployment of capital is taken into account. Closed-ended funds are not obliged to invest in turbulent times unless there are attractive opportunities in the market. In the absence of the opportunities they will simply not draw down any capital from their investors.

Dirk Dreyer is investment manager, alternative investments at Feri Institutional Advisors GmbH and Bernd Kreuter is head of alternatives at Feri Institutional Advisors GmbH