Some question property securities' real estate credentials but according to Simon Hedger they have a vital role to play
Institutional and private investors worldwide are increasingly embracing cross-border real estate investments. In recent years, governments across the globe have opened their real estate markets by enabling more tax efficient investment vehicles and this trend is continuing. The proliferation of global property securitisation presents investors with a cost effective means to quickly build a liquid, diversified global property allocation in their portfolio. With this allocation, investors can capitalise upon the rapidly increasing investment opportunity set and take advantage of the diversification and attractive risk-adjusted returns that global property securities have historically provided.
Using the FTSE EPRA/NAREIT Global Real Estate Index as a proxy, this article demonstrates that global property securities:
The diversification benefits
Global property securities provide diversification benefits to a multi-asset portfolio due to their low correlations with global bond and equity markets, as well as diversification benefits to the overall real estate allocation due to low correlations among geographic regions. Looking at the monthly returns from property securities over the past 10 years, Figure 1 displays the low correlations that exist between the index's five largest country constituents.
These low correlations can be expected due to real estate's highly localised nature. The supply and demand of real estate is primarily driven by local market fundamentals; thus real estate cycles across the globe can be at different stages at the same point in time.
This lack of correlation among countries means enhanced diversification benefits for an investor's overall real estate allocation.
Global property securities also provide risk reduction benefits for an investor's overall portfolio. Correlations between property securities and stocks and bonds are historically low as evidenced by Figure 2. In the US public real estate market the correlation to US stocks and bonds decreased over time as the market matured and began to trade as a separate asset class.
In Asia and Europe, property securities' correlations to stocks and bonds in their respective regions have already started to decrease and can reasonably be expected to drop even further over the long term, as those markets become more efficient and begin to trade on the basis of underlying property supply and demand fundamentals.
This could lead to a convergence toward the lower correlations experienced in the US.
The diversification benefits provided by global property securities allow for the construction of a more efficient, multi-asset class investment portfolio. Starting with an initial portfolio comprised of 55% global equities and 45% global bonds, let us look at the historical effects of adding an increasing global property securities allocation illustrated by the following sample portfolios:
Portfolio asset allocation
A - 0% Property Securities,
55% Global Equities, 45% Bonds
B - 10% Property Securities,
50% Global Equities, 40% Bonds
C - 20% Property Securities,
45% Global Equities, 35% Bonds
Using historical returns for all three asset classes, Figures 3 and 4 illustrate how the global property securities addition increased the portfolio return and reduced risk, resulting in a superior return per unit of risk as measured by the Sharpe Ratio.(1) While past performance is not indicative of future performance, the diversification benefits provided by global property securities cannot be ignored.
As shown in Figure 5, over the past three years, the market capitalisation of the real estate public equity investment universe, as reflected by the FTSE EPRA/NAREIT Global Index, increased by 149% from $362bn (€252bn) to slightly over $900bn.
The increasing market size is primarily due to the recent proliferation of countries adopting REIT or REIT-like structures. In 1994, there were only four countries with listed REITs; as of 30 June 30 2006, at least 16 countries had enacted REIT-like legislation, and more are slated to follow in 2007.(2) This rapid securitisation is providing investors with opportunities to indirectly own real estate in areas that were previously inaccessible due to high costs and liquidity constraints.
Moreover, the availability of investor information has increased with the development of performance benchmarks, global industry conferences, increasing analyst coverage, and improving company reporting standards and disclosures. The expanding opportunity set, accompanied by an active portfolio management strategy, has the potential to add alpha by increasing the number of opportunities upon which a proficient stock-picker can capitalise.
Over the past 10 years, property securities have reported a 12.76% annualised return, outperforming both global equities and global bonds with less incremental risk as shown in Figure 6.
While past performance is not indicative of future performance, the Sharpe Ratio for global property securities was substantially higher than the other two asset classes, explicitly showing the superior risk-adjusted return characteristics of global property securities over the period.
(1)Measure of return over the risk-free rate (excess return) per unit of risk. The United States three-month Treasury bills were used as the risk-free rate in this analysis.
(2)UBS Global Asset Management "Real Estate Research: Global real estate investable universe continues to expand and develop."
Simon Hedger is portfolio manager at Principal Global Investors in London