The events of the past two and a half years have resulted in institutional investors revisiting the listed versus unlisted debate. Fraser Hughes and Alex Moss report

Investors are increasingly debating the opportunities of combining and managing the various capital structures and investment products that have real estate as their underlying component. In this introductory article, which is the first of a series, we focus on:

• The reasons and background for the interest;
• New real estate product launches;
• The relative investment universes;
• Valuation approaches and strategies.
We believe that the interest is a direct result of the following factors.

Convergence of returns has led to a reassessment of risk factors
The convergence of (negative) returns across asset classes that characterised 2007 to 2009 has ended, replaced by a sharper divergence of risk-adjusted returns between asset classes as the global economic recovery continues. This can be illustrated quantitatively by looking at the number of factors driving global equity markets over time, ie, market dimensionality. From 1992 to 2007 this was between 60 and 100, which accounted for divergence of performance between sectors. In 2008-09 this shrank to only 20, but has since doubled.

Put simply, when all asset classes are driven by a small number of factors, then correlations increase, and assumptions regarding historical correlations and diversification benefits are re-assessed. One of the assumptions most severely tested is the perceived lack of volatility in direct and unlisted real estate vehicles. As highlighted previously,(1) valuation methodologies used by these forms of real estate investment significantly underestimate volatility.

Increased importance of liquidity in investment strategies/products: The importance of liquidity within all investment products has been a key lesson of the downturn. As a result, we are aware that a number of managers of unlisted funds have been examining the listed sector to investigate if these vehicles could provide a level of liquidity that unlisted vehicles do not, particularly during periods of increased redemption requirements in their vehicles. The debacle in the German open-ended fund market highlighted this issue and continues to frustrate both retail and institutional investors.

Timing advantages of the listed sector have become apparent: On the one hand, the
speed of the recovery caught investors by surprise. The expected gap between redemptions slowing, cash becoming available for investment and forced sellers providing attractive opportunities for re-investment did not materialise. On the other hand, the listed sector provided investors with a liquid and effective way to participate in the anticipated recovery ahead of the eventual yield compression, which was not available in unlisted vehicles.

Investor demand: While inflows to direct property funds have increased dramatically in 2010, those to the listed securities funds have been nowhere near as marked.(2) Marketing and product development departments are therefore examining how to capture the retail market's enthusiasm for the underlying asset class in a product that can provide acceptable levels of liquidity and risk-adjusted returns.

With a general assumption that both inflation and long-term interest rates are likely to remain low for some time, demand for assets with secure income streams has increased dramatically. The yields offered by both listed and unlisted vehicles are very attractive compared with treasury stock. A significant factor in investor demand is the growth of DC pension schemes; these schemes are the future of pension provision and given the choices investors have (and the speed with which they can move) there is a necessity to have daily liquidity in DC pension options - meaning the real estate pension option on platforms needs to be liquid.

The emergence of debt as an investment option:
There has been increased attention on the ‘other' way of participating in real estate - debt. There is both a listed and unlisted market in debt secured against identifiable high-quality assets, and a number of participants have enhanced returns by trading in debt products. For example, there is a healthy market for bonds of the listed companies in the FTSE EPRA/NAREIT Europe Index. We calculate a $35bn market comprising approximately 150 separate issues, the largest being Unibail-Rodamco's €1.8bn 50-year convertible bond.(3)

Eliminating stocks and asset specific risk: The growth of the exchange traded funds (4) and property derivatives markets has allowed investors to gain exposure to the listed and direct market while excluding stock-specific and timing issues. We believe that a number of smaller and medium size investors are looking for these instruments to form the ‘core' element of a core and satellite approach.

Many mandates already include the option to invest in listed but it is not widely used: Finally, as an example, we show below the investment objectives of a leading UK direct property fund.

"To maximise long term-total return through investment mainly in commercial property. To invest primarily in a diversified portfolio of commercial property, seeking to add value through strategic asset selection, stock selection and asset management. The fund may also invest in other property-related assets, including collective investment schemes, securities, derivatives and debt instruments, as well as government debt, money market instruments and cash." We believe that relatively few institutions that have the option to invest in listed real estate in these structures, or fund of property fund structures, do so actively.

On the other hand, the Thames River Property Growth & Income Trust (5), managed by Chris Turner and Marcus Phayre-Mudge is a prime example of good use of this strategy. The fund's benchmark is 50% IPD UK and 50% FTSE EPRA Europe ex-UK (a direct/listed mix). Currently the fund is skewed towards Europe Ex-UK (listed) given the manager's view on the market. Thames River utilises direct property skills in its local market, the UK, while opting to tap into the management skills and underlying real estate of the listed companies elswhere.

In addition, the TR Property Investment Trust has successfully managed a direct and listed European real estate portfolio since 1995 with a long-term allocation to direct real estate that has ranged between 10-35%.

The main issue the industry faces is to draw together the investment departments of the direct and listed markets. In many cases these are separate, even disconnected, units! There is the need for far more investor education on the subject, a process that investor demand should accelerate.

New product launches
Listed below are examples of new products that have sought to capture some of the themes outlined above.

Debt funds: There are broadly two approaches that funds use to participate in debt: origination and trading in the secondary market. On the latter strategy, either by trading in the existing bonds issued by listed real estate companies or trading the private debt secured against real estate, investors can at current pricing gain equity-style returns taking debt-type low risks.

On the origination side, by either offering to bridge the current gap caused by the decline in LTVs for senior debt provision with new debt finance or by the origination of new senior debt itself, investors can gain an attractive risk return trade-off. This complements existing real estate holdings and is driven by the values of the underlying real estate.

This form of, effectively, mezzanine has been targeted by M&G, Duet and Pramerica. Pramerica secured £150m from a number of investors including APG to invest in directly originated real estate mezzanine finance and debt-like preferred equity opportunities.

Derivatives funds: Following the success of Reech AIM Iceberg funds in which they have combined property derivatives with REITs, a new property derivatives fund has been launched. The InProp Fund will offer returns linked to the IPD Index through the use of swaps and futures contracts. Seeding investors are reported to be Scottish Widows, PRUPIM, that are pioneering users of the property derivatives market, and the Skandia Property Fund, advised by ING Real Estate.

Four quadrants strategy: This model effectively divides real estate investment into the classic four quadrants:

• Public equity (REITs, property companies)
• Public debt (CMBS, RMBS)
• Private equity (JVs, private equity funds, and direct investment); and
• Private debt (commercial loans originated by banks).

Hermes Real Estate is the latest fund manager to announce that it will be implementing this strategy. The fund has invested in debt and public equity as well as the more traditional private equity.

In addition to the four quadrants, derivatives can be overlaid onto this strategy.
Liquid property replication: Pacific Real Estate Capital is the latest firm to develop a vehicle that will invest across capital structures within real estate. The fund is called the Liquid Property Fund and will invest in REITs, CMBS and RMBS, and direct property derivatives, on a global basis. It aims to invest tactically, allocating capital into liquid real estate instruments without attracting the same levels of fees, charges and taxation leakages as holding a direct property or a fund of funds portfolio.

Relative investment universes
One of the fundamental issues to understand is the relative size and structure of the listed and unlisted markets. In terms of the listed market, we have used the Macquarie Global Property securities Analytics database, which encompasses all listed real estate companies globally. As at the end of September 2010 this comprises 1987 companies in 66 countries with a combined gross market capitalisation of £1,098bn. The regional breakdown is shown in figure 2.

Having identified the investment universe, the next stage is to establish the relative size and importance of the listed real estate sector compared with the domestic direct property market and equity market. Using EPRA statistics, we can see that the global listed sector equates to 5% of the global direct market, and 2.7% of the global equity market.

Finally we need to examine the investment opportunity set of the listed sector versus the unlisted sector. For the unlisted universe we have taken data from Property Funds Research. As figure 3 shows, the major differences are the relative importance of listed in Asia, unlisted in Europe, and the number of dedicated global unlisted funds. It should be noted that in this simplistic representation the scale of the listed universe is under-represented as we have taken market capitalisation rather than gross asset value of the unlisted sector.

Relative valuations
As can be seen in figure 4, the US ex-industrial remains the region with the lowest dividend yield and currently trades at the most significant premium to analyst estimates of NAV. Conversely, J-REITs and Australian LPTs currently offer much higher yields plus discount to NAV in the range 0-10%. South Africa is the highest-yielding market, trading at approximately 15% premium to analyst estimates of NAV.

One of the key areas to address in combining listed and unlisted is to correctly assess where the listed sector is trading relative to the trend of the underlying direct property market. We have therefore attempted to produce another global snapshot, this time reflecting the momentum of property values, and comparing this with the upside/downside to our target prices for the stocks covered in that region. The top-right quadrant in figure 5 shows regions where the property market is improving and there is most upside to a target price and the bottom-left quadrant showing where the fundamentals are declining and there is believed to be downside from current prices.

Correlations
Research carried out by EPRA/Cohen & Steers highlights the lead/lag relationship between the direct and the listed market. While listed remains a proxy for direct real estate investment in the medium to long term, the listed market offers a directional indication of underlying real estate values.(6) The report concludes:

• Listed property companies tend to lead the returns of direct real estate by approximately six months. Interestingly, the lag has decreased to around three months for the US and UK market since 2007;
• While the listed performance is directionally accurate, the returns tend to overstate the eventual reported direct market moves;
• The propensity of listed markets to lead the direct markets may be related to the inefficient transfer of information in direct markets;
• The stronger the factors that delay information transfer in direct markets, the longer the gap between the markets' return series.

Conclusions
We believe the trend towards combining different financial instruments that have exposure to real estate is likely to continue, and could well enlarge the universe of potential buyers of both listed and unlisted vehicles. Understanding the relationship between the two markets has useful and important implications for investors - even if an investor is only investing in, for example, solely public or private equity real estate they need to be aware of the pricing of other parts of the market. For example, by using listed property returns as a leading indicator of direct real estate performance, investors can meaningfully improve their asset allocation decision-making process.

Specifically, there are the following uses of listed real exposure within an existing unlisted fund structure:

• Exposure should be more tactical than strategic, given the differences in valuation and methodologies in calculating risk and lack of pure sector exposure in most REITs;
• The ability to enhance income returns of a portfolio immediately via quarterly dividend payments from listed REITs;
• The ability to access geared sector exposure ahead of a recovery in values;
• The ability to acquire assets at various stages in the cycle at below market value;
• Overall, if properly used there will be an improvement in risk-adjusted returns and liquidity by adding listed exposure to direct or unlisted exposure.

1- See Fraser Hughes, ‘Joined-up investing', IPE Real Estate, July 2010, p20-21
2- 2009 saw considerable inflows into regional and global listed funds. In addition, the constituents of the FTSE EPRA/NAREIT Global Real Estate Index raised over $60bn in 2009.
3- For a full list of FTSE EPRA/NAREIT Europe Index constituent bonds see the latest EPRA monthly statistical bulletin, p 61.
4- There are 10 separate liquid ETFs on the regional breakdowns and Global. Full list and information available from www.epra.com
5- See www.trproperty.com for more information on strategy, investment and performance.
6- See EPRA/Cohen & Steers Report - July 2010. Available from
www.epra.com.

Fraser Hughes is a director at EPRA and Alex Moss is head of property analytics at Macquarie