Listed real estate is a powerful predictor of the direct property market as, Scott Crowe reports
Most real estate investors recognise the benefits of owning real estate securities: liquidity, transparency and exposure to a number of commercial real estate sectors for a relatively small capital outlay. Now investors and market observers can add one more to the list - real estate securities can forecast direct property performance.
Cohen & Steers analysed performance data for direct and listed real estate returns, and confirmed what we had learned in more than 20 years of market observation: in markets with reliable performance-data collection methods, such as the United Kingdom, the returns of listed real estate securities and direct property are positively correlated, but with listed real estate securities' performance leading private property returns by about five months.
We began by comparing the returns of the UK listed and direct property markets for the 10-year period ended December 31, 2007. Not surprisingly, as property is the underlying asset of both, there was a strong correlation between the two, as shown in figure 1. There were interesting distinctions, however. The listed real estate market led the direct market by six to 12 months. It also demonstrated greater measured volatility; direct property's appraisal-based measurement has a tendency to smooth returns.
We believe that the major reason the two return streams appeared to be out of sync is liquidity. Exchange trading means that current events, market sentiment and capital market conditions are quickly absorbed into listed share prices. Direct property, on the other hand, is valued less frequently, most reliably by way of a sale; and between sales, through occasional appraisals. The result is a slower transfer of information about a property's value.
To compensate, we moved listed property returns back six months, reasoning that it takes that long, on average, to buy or sell a commercial property in a healthy market.
The results were illuminating.
Introducing a six-month lag to the listed property returns resulted in the two streams moving more in line with each other, as shown in figure 2. It also confirmed our long-held thesis that listed securities can be used to anticipate direct property's returns.
Understanding the relationship between listed and direct property provides several options for investors. Chief among them is the potential to anticipate private property trends from public market behaviour. That is, investors can use the predictive difference between public and private property markets to generate returns in excess of either one alone. For a theoretical investor, with knowledge of when markets reach their peaks and troughs, the results would be compelling.
To illustrate, we compared a static property allocation (50% listed/50% direct) with one that uses the methodologies' buy and sell signals to switch between 100% property securities and 100% direct property. When listed property securities hit a bottom, the investor holding direct property at or near a peak would sell, and buy real estate securities with the proceeds, and vice versa. In our example, our theoretical investor's portfolio outperformed the static one by 607%, as figure 3 illustrates.
In reality, of course, perfect knowledge (and perfect market timing) does not exist, and it would be all but impossible to generate those returns—barring astonishing good luck. An investor operating in real time (and the real world) cannot be certain that a spike or a decline represents a true market top or bottom, and not a minor correction.
The listed markets can nevertheless provide useful information for tactical real estate investment decisions, such as increasing or decreasing property weights, timing strategic allocations or allocating between listed and direct real estate. For example, figure 4 shows that the listed property market was a better indicator of direct returns than Investment Property Forum (IPF) forecasters - a sample of 27 experts' predictions of direct real estate markets. In particular, the listed property market predicted the 2007 downturn more quickly than did the IPF forecasters.
There are limitations to this methodology, chief among which are the time needed to make direct real estate investments, the variability of direct market valuations, the composition and activity of listed real estate companies and the challenge of recognising a peak or trough in time to allocate between listed to direct real estate efficiently.
Limitations aside, however, we believe investors can take advantage of the relationship between listed and direct property returns to strategically and tactically manage their public and private real estate holdings and enhance total returns.
Scott Crowe is global research strategist for Cohen & Steers' global and international portfolios