In an era of prudence investors and managers need reliable data to support their asset allocation and investment decisions, says Cameron McVean
The recent property recession and subsequent rapid recovery have set records and milestones - at both ends of the spectrum - which are unlikely to be broken for some time. Against a backdrop of wild swings in investment returns over the last 18 months, capital flows have dramatically returned positive with £2.5bn (€2.8bn) worth of new capital raised over the final quarter of the last decade.
Volatile market performance, together with an influx of new capital has placed the onus squarely on capital allocators - including investment consultants and end-investors - to adopt a methodical and empirical approach to decision-making. In the last property bull market there was, at worst, a cavalier attitude towards investing in real estate; many investors simply benefited from riding the crest of the yield compression wave, buoyed by the power of cheap borrowing to boost returns.
But as we look to enter an era of prudent investment management, the focus has very much returned to core fundamentals and - as importantly - the adoption of reliable data to support due diligence and, for managers themselves, investment strategies.
Records at both ends of the spectrum
UK commercial property has been through a streak of volatility for more than two and a half years. In direct property markets, quarterly negative returns troughed in the fourth quarter of 2008, with the IPD UK Quarterly Index's only ever double-digit decline of -13%. Exactly 12 months on, the decade was brought to a close with the highest quarterly total return on record, at 10%.
These records were echoed in the performance delivered by IPD's UK Pooled Property Fund Indices (PPFI), with the fourth quarters of 2008 and 2009 recording -18.7% and 10.4%, respectively. Figure 1 shows the correlation between direct and indirect UK property returns: pooled funds outperform the direct market in rising markets, while they significantly underperform in falling markets. At the end of last year, pooled funds outperformed again.
The wild oscillations experienced by the direct and indirect property markets over the last two and a half years act as a reminder of the importance that accurate data plays in helping to define strategic investment decisions.
To help shape those decisions, particularly after a burst of capital inflows, those responsible for allocation decisions need to understand the drivers of performance, the impact of leverage and fees and the track record of managers and their funds in their due diligence.
Capital growth drivers
The volatile returns we have witnessed have been insulated by income returns. Strip away this layer and looking at capital growth trends in the direct market reveals an even more dramatic reversal in the last 16 months. The IPD UK Monthly Index is best placed to illustrate the unique pattern.
Figure 2 shows record rapid capital growth over the final quarter of last year followed by January's more muted growth. This is the reverse of the trend one year ago where, at the end of 2008, the UK commercial property market suffered the worst quarterly capital depreciation on record, followed by a noted ease-off in January 2009. Later in this article, this will be put into a wider context of record fourth quarter capital inflows into UK pooled property funds.
Sentiment notably began to shift in UK commercial property's favour mid-way through last year. By the final quarter of 2009, yield compression together with an easing downward rental pressure, prompted the most aggressive quarterly capital growth on IPD's records, at 8.1% according to the Quarterly Index. There is, however, something counter-intuitive about the present state of the market; namely, simultaneously falling yields and rents. Invista CEO Duncan Owen highlighted this trend at IPD's recent 2009 results launch as "akin to defying gravity".
When markets are operating in an irregular manner, the case for even greater scrutiny on the attribution of performance is clearly stronger, so too is the need for building up a picture of fund level performance across the pooled fund universe and managers' investment strategies.
The perils of leverage
Leverage is arguably the most powerful single variable in enhancing outperformance or in exacerbating losses. Figure 3 illustrates this by comparing a benchmark of the performance of properties in IPD's UK PPFI Specialist Fund Index against the fund level returns, in other words, the property performance inclusive of leverage (and fees), compared to performance excluding these impacts. Specialist funds, which apply the greatest average leverage ratios, have been chosen for this example to highlight both the benefits and dangers of debt.
The gap between vehicle-level and direct property performance, figure 3, is the result of a mixture of leverage, cash and fees. Leverage is the greatest influence of the three. It is responsible for an exponential increase in fund performance volatility as the ratio of leverage increases.
The correlation of leverage and returns is a simple one. But what is the appropriate level of debt that should be applied to compensate for cyclical risks and to deliver long-term performance? Indeed, should debt be applied only at strategic points in a fund's lifespan or during specific periods in property cycles?
In addition to the strategic argument about the cyclical application of gearing, it is important that investors are aware of their manager's track record in applying debt: what are funds' limits; do they stick to them and are they effective in outperforming their benchmark. Knowing a fund's - or manager's - track record is a significant tool to aid investor's decision-making process.
Increasingly, investment consultants and large institutional investors are using IPD's pooled fund database to assist with such due diligence requirements on fund management companies, individual pooled property funds and individual managers.
In addition, the data is used in forecasting models as well as sensitivity analysis including, in particular, stress-testing market scenarios.
With lessons learned since the heady days prior to the credit crunch, in which attractive returns could be achieved by riding the wave of capital appreciation and cheap debt, scrutinising the detail is absolutely critical.
A mini-bubble on the horizon?
This post-recession period is unique for the property market. While there was record growth last quarter, coupled with substantial inflows, capital allocators are still being cautious. Not only is fund manager due diligence on the rise, for both the individual managers and accurate application of intended investment strategy, but so too is increased reporting to investors. Furthermore, fund managers are adopting stricter leverage parameters and controls over capital inflows into pooled funds to avoid having too much money to allocate at any given time.
This puts the events of the final quarter of last year into sharp focus. Yield compression - which returned midway through 2009 - was a buy signal for property investors, and the market responded. Capital inflows into the domestic property market have been considerable, particularly through unlisted pooled funds.
According to the IPD Property Fund Vision Handbook (PFV-H), which monitors 74 UK-focused pooled funds with £31.1bn of properties, £2.5bn of net new investment was raised over the final quarter of last year. This was more than a 10-fold increase on the third quarter's £235m.
Of this total, the seven authorised property unit trust (APUT) constituents in the PFV accounted for just under half of the fourth quarter inflows, at £1.2bn, which is considerable given that they account for less than 20% of the aggregate net asset value of the 74 PFV-H constituent funds. The bulk of the remaining new capital was raised by nine managed property funds, which drew £490m, and 18 other balanced funds, which attracted £563m.
The extent to which funds have attracted new investment is not in itself an indicator of the merits, or otherwise, of these funds in the view of investors. One of the reasons for this is that, in contrast to a year or so ago when funds were deferring redemptions - typically for 12 months - some are now running waiting lists of potential investors. For example, the Standard Life Pooled Pension Property Fund is advising potential clients that new allocations may take up to six months to gain access to the fund, indicating that it has clients on its waiting list with some £260m to invest.
Fund managers are not alone in wanting to trickle their capital into markets to protect the interests of existing investors and avoiding acquiring assets in a forced buyer capacity. Property cycles have proven to be unpredictable in the recent times; from the collapse in capital values following the two financial shocks in 2007 and 2008, to the record recovery in the final quarter of last year.
Investors with capital to allocate, as well as managers formulating appropriate investment and leverage strategies at differing stages of the property cycle, will need to rely on robust analytics, data and benchmarks to measure the impact of their decisions.
Cameron McVean is head of fund services at IPD