Current market conditions may mean that listed and unlisted are becoming more similar, but there is still plenty of scope for the two to work effectively together, as Richard Lowe finds
The role played by listed real estate in pension fund portfolios varies across markets and has been the source of debate for some time. Pension funds in the Netherlands, for example, were early adopters and remain heavily invested in the sector, while their UK counterparts remain averse to anything other than direct or unlisted investment.
Some see listed property as being too volatile and too closely correlated to mainstream equities, meaning for some investors it does not represent ‘pure' real estate. There is also the issue that the listed sector provides liquidity that long-term investors do not need and are therefore paying a price for liquidity unnecessarily.
Others, however, maintain they utilise listed property for tactical purposes or see it as a short-term way of gaining immediate exposure to markets that are less accessible. Another argument in favour of property securities is that when analysed over the long term they do in fact emulate direct real estate very closely and are not so closely correlated with the stock market as is often stated.
"There are still many pension funds who don't like listed," says Michael Clarke, head of property distribution at Schroder PIM. "Institutional investors in many countries still have a preference for unlisted funds. That is not the case in the likes of the Netherlands where there has always been a long history of listed sitting alongside unlisted. In the UK you don't see any dedicated listed mandates, it is all part of mainstream equity mandates."
Following months of marked volatility in the listed sector, resulting in many stocks today trading at large discounts to net asset value (NAV), now is perhaps a good time to re-examine these issues. Have recent developments re-ignited the debate or rather confirmed the long-held beliefs of investors?
Günther Schiendl, CIO and member of the board at Austria's largest pension fund, VBV Pensionskasse, is very much of the view that real estate securities have more in common with mainstream equities than direct or unlisted property. He describes property stocks as illusory assets, because they aim to bring "liquidity to an asset class that in essence is not really liquid". Investors that have invested in real estate securities over recent months, he says, "will have realised they are essentially investing in equities".
Meanwhile, when Feri Wealth Management conducted a survey of German investors it found that listed real estate was commonly viewed as a unique asset class, because of its stock market volatility.
Frank Rackensperger from Feri Wealth Management's real estate division says that both private and institutional investors were "quite astonished" that real estate securities and real estate investment trusts (REITs) corrected so suddenly. He admits "it was difficult to communicate" why an asset class relying on "solid values" could behave in such a volatile manner.
As explored in detail in the latest Investor Interview (see pages 12-13), the €950m KBC pension fund in Belgium has been reducing its exposure to listed real estate in favour of direct and unlisted investments as part of its move to a liability driven investment strategy. This has seen the fund reduce its allocation to the listed sector from 90% to approximately 50% of its overall real estate exposure.
"One of the main issues we had with 90% of our real estate accounted for by listed instruments [was] that the correlation between listed real estate and the equity markets is quite big," explains Edwin Meysmans, managing director of KBC Pensioenfonds, citing a correlation of 0.72 with equities as the latest figure he has seen.
However, Clarke believes that this figure can be misleading because it is calculated over a short timeframe. If listed real estate and equities are compared over a 24- or 36-month timeframe, the correlation becomes much less marked, at around 0.2-0.3, he argues.
"It is very clear that it performs like the direct market over time once you smooth out the short-term volatility. Over the long term it provides more correlation with the underlying property markets and if you are a long-term investor you can ignore the short-term pricing movements anywhere."
But regardless of the level of correlation of listed real estate shares with equities, there is a development occurring in the direct UK market that could have significant implications for the whole listed-unlisted debate.
Presented with a dearth of transactional evidence and the knowledge that the listed sector is trading with large discounts to NAV, valuers in the UK have begun to mark down prices based on market sentiment, increasing the volatility of the direct market and bringing it more into line with the listed market.
"The interesting phenomenon in the UK - less so in continental Europe - is that the valuation volatility this time around is bigger than ever before," Clarke says. "You had the fastest falls in history on the IPD index. That is partly down to the willingness of valuers to value on sentiment rather than hard evidence. That in itself is creating additional volatility in the direct market and the unlisted market, creating greater volatility in NAVs."
Volatility in the direct and unlisted markets in the UK could also be increasing because of a changing investor base, with more short-term retail investors taking a larger share of the market and displacing longer-term investors such as life and segregated pension funds that historically have dominated the market.
This was the theory put forward by Rob Martin, head of research at Legal & General Property, at a fundamentals briefing in London in March. "Today's market is more dependent on flows from retail investors," he said, and consequently the market "is more sensitive to short-term investor sentiment".
Tony Key, professor of real estate economics at Cass Business School, does not believe that retail investors are necessarily to blame for the surprisingly sharp correction in the UK. "They certainly helped ramp it up," he says. "But they are still not big enough to really move the market."
But Key does believe the unlisted market, particularly in the UK, is increasing in volatility and this is because of the increase in cross-border flows.
"Because there is so much more money moving around the planet between different property markets, you are going to get much more variable capital flows than you used to when Germany was its own market and the UK was its own market, for example. And more variable flows make unlisted property more volatile."
Key cites the recent findings by Real Capital Analytics showing that while real estate transactions have dropped 70% in the US and 40% in Europe, they have doubled in Asia. "This just shows you how much money can slosh around very quickly in the space of a few months," he says.
With cross-border flows representing more than half of the global market, Key believes volatility is bound to increase in the unlisted real estate sector and this will inevitably make it "more similar" to the listed sector.
"I would expect them to behave more similarly both in terms of volatility and in terms of correlation. Obviously, the capital sources are slightly different and the motivations of the investors are slightly different, but underlying it all is the asset allocation of global investors and the recommendations of the global money managers."
Key believes the UK is more prone to this increase in volatility than other markets in Europe because it is the most mature and transparent. However, the fact that listed real estate is now seen as belonging to the field of property asset management as opposed to mainstream equity investments, he thinks there is much more potential for other markets to be affected in a similar fashion.
"It depends on the nature of the unlisted markets," Key says. "Some are much more mature and transparent than others. But real estate fund managers are increasingly running unlisted funds and funds of funds of listed stocks side by side. The analysis and the thinking underlying their readings of the markets is going to be pretty much the same, whereas before it was two completely separate accounts - there were the real estate people who did the direct stuff and the unlisted stuff, and the equity analysts did listed. The two were separated forms of analysis and views on the market.
"But for unlisted markets to behave more similarly [to listed markets] does rely on them having pretty frequent valuations and fairly switched-on valuers, which are things you don't tend to find as much anywhere outside the UK. America, for example, doesn't have either of those things and neither does most of Europe, apart from Sweden and maybe the Netherlands."
Regardless of how it manifests itself, a marked increase in the volatility of the unlisted sector will have huge implications for the asset class and its role in investor portfolios, especially if investors start to perceive a blurring of the lines between listed and unlisted in terms of volatility and correlation.
"If you are in real estate mainly for the diversification benefits and the unlisted sector does become more volatile and more correlated with other asset classes, the balance advantage between listed and unlisted changes. You might argue that listed becomes relatively more attractive," Key says, stressing this is not necessarily his personal view.
The timing of the reduction of KBC Pensioenfonds' listed exposure turned out to be fairly unfortunate. The Belgian pension fund was not divesting its listed investments on a short-term tactical basis, but had it been so it should have made the move sooner, before values starting crashing. This, of course, is the benefit of using hindsight. Meysmans admits: "We should have sold more if you look at the results of listed real estate in 2007."
The €9bn Nordrheinische Ärzteversorgung (NAEV), the German pension fund for doctors in the North Rhine region, on the other hand, recently reduced its exposure to listed real estate to reduce losses. By February of this year it held 80% of its listed allocation in cash and is unlikely to reinvest in the sector before the third quarter of 2008.
Meanwhile, the €217bn ABP pension fund in the Netherlands revealed earlier this year
that it plans to up its investments in listed property, just months after divesting part of its European and US listed portfolio.
Patrick Kanters, managing director of global real estate at APG Investments, the wholly owned subsidiary of ABP that manages all services for the pension fund, said that APG Investments was scouting for "good opportunities" in the listed market. Certainly, with property stocks trading at massive discounts to their NAV, many investors are seeing opportunity in the sector.
These developments highlight the potential for running listed and unlisted property portfolios side by side, so that investors can take advantage of any arbitrage opportunities arising between the two sectors.
"The most interesting thing about the last 18 months is it looks like there has been an opportunity for arbitrage between listed and unlisted," Key says. "In other words, if you had a portfolio of both listed and unlisted and you sold all of the listed on 1 January 2007, and maybe started buying them again now, you would have done very well.
"The last 18 months have certainly made it more interesting to think about combining listed and unlisted. That has made it look quite interesting in the sense that the argument for combining the two is quite strong if they continue behaving that way."
Nick Duff, head of property at Hewitt Associates, says that, despite listed real estate still not featuring "particularly high" on the agenda for UK pension funds, "we see listed real estate as more of a tactical play where you can exploit inefficiencies in pricing at certain points in time." He adds: "What you are finding now is an increasing number of mandates that give multi-managers the ability to invest in listed real estate."
And Clarke admits that while the liquidity that you get from listed real estate is not the "real driver" for investing in the sector, it does still provide access to "top quality real estate with some very experienced property management teams - it just happens to be in a listed format," he says. "There is a very strong argument for having it in a mixed portfolio with unlisted real estate sitting alongside it."