Fraser Hughes and Hans Op‘t Veld provide a step-by-step guide to building a market neutral portfolio of global real estate stocks for investors who want to take advantage of low valuations

The sharp fall in real estate stocks seen over the past two years, with the FTSE EPRA/NAREIT Global Index down around 50% since 2007, is now potentially opening up interesting opportunities for investors prepared to take a long-term position in the market.The chance to enter the sector during a period of depressed valuations and steep discounts to net asset value (NAV), coincides with the availability of more transparent information and tools to build a truly global real estate stocks portfolio than have ever existed before.

The first step in the construction process is to establish a neutral global portfolio. Many investors will want their portfolios to be a reflection of the global real estate market and the challenge lies in structuring such a model.

The total size of the quality commercial real estate market excluding residential on a global basis is approximately $20trn (€15.8trn)1. Figure 1 highlights estimates of the size of the developed countries around the world. In addition, we have pooled together the estimates of the emerging market countries which comprise approximately 15% of the global total. The estimated size of the markets is shown in the first column. The second column shows the percentages of the regions and countries based on the estimates.

At a regional level Europe makes up 40% of the global total, North America 33%, Asia-Pacific 21%, Latin America 4% and the Middle East and Africa 1%. The remaining columns show: the size of the listed real estate market in terms of total market capitalisation; number of companies; FTSE EPRA/NAREIT Index series free float (investible) market capitalisation and total listed market capitalisation against the total estimated market size.

Adjusting the neutral portfolio
There is a clear case for using these market weights. However, many investors will often choose to implement a growth projection of markets in their neutral allocation as well (which will inevitably allocate more weight to emerging economies). Doing so will allocate funds to those countries with a higher growth rate relative to using current weights.

This typically results in higher allocations to emerging economies (for example, China, India, and Central and Eastern Europe). The challenge facing investors who follow this strategy is that, while future demand for real estate is to be found in these countries, the current investment universe will be very limited. There is a risk that pricing will become too high as investors pile in on a small market. It is therefore sensible to link such a strategy with a measure of relative valuation, to avoid buying into markets which have become too expensive.

Using listed real estate

Figure 2 builds on the neutral portfolio highlighted in figure 1. In this case we use a total portfolio size of €1bn. Using the same neutral weightings for the regions and countries calculated in the second column of figure 1 we allocate proportions of the total investment of €1bn. In addition, within each region/country we allocate capital across sectors.

We allocate across the four main sectors: offices, retail, residential and industrial, using the weightings, 30%, 30%, 20% and 10% respectively. The remaining 10% allocation is invested in other speciality sectors, such as healthcare, hotels and self storage. Investors need to pay attention to a number of issues when constructing a global portfolio:

Time horizons - Real estate is a long-term investment. It should make up a core part of any investment portfolio. Allocations to real estate vary amongst investors and countries. The majority of allocations falling within the six to 12% range. This percentage will be a broad mix of direct, unlisted and listed real estate.

Exposure - Figure 2 shows the basis of the type of exposure investors may be seeking. Weighting the regions and countries obviously depends on investor preferences and what they expect for the certain markets. In addition, sector exposure and type of investment strategy - developer. investor (rental focused) or a mix of the two must be considered.

Exposure will also link to the time horizon of the investment strategy. For example, if the investor sees continued growth in the economies of the emerging markets, exposure may adjust to further developments in those markets over the course of time. On the sector side, exposure to healthcare may increase based on demographic forecasts. Investors may choose to take advantage of real estate development cycles over time. 

Liquidity - Real estate is an illiquid asset, and illiquidity feeds through into the indirect markets. If large changes to the make-up of the portfolio are required, there are a limited number of companies that can offer such liquidity. Therefore, the trade-off between liquidity and diversification benefits will lead some investors to choose from a limited set of liquid companies and others for a broader, less liquid set.

Derivatives - The expanding range of products linked to real estate indices provide investors with an extremely useful toolbox. IPD over-the-counter and exchange listed products provide investors with effective exposure to the direct market. Pricing methodology is based on underlying property values. FTSE EPRA/NAREIT futures contracts offer listed real estate exposure, and FTSE EPRA/NAREIT exchange traded funds are another useful alternative to gain effective and simple real estate exposure.

Credit markets/debt ratings - There are times in the cycle that debt can be used effectively to enhance returns for investors. Alternatively, there are other times that companies with high levels of leverage will be penalised by the market. Investment solely in REIT structures, for example, may limit investors debt exposure due to restrictions placed on REITs either by regulation or the market.

Currency risk - When building a global portfolio, investors must consider currency risk. A euro-based investor holding the portfolio in figure 2 would incur approximately 75% exposure to non-euro currency movements. Of course, these currency movements can be hedged providing a contract is readily available. Looking at the list of currencies that our theoretical portfolio is exposed to in figure 3.75% of the portfolio can be hedged using three forwards contracts: euro/US dollar, euro/yen and euro/pound sterling

Legal and fiscal issues - Investors want to achieve attractive returns. However, a return realised locally is not necessarily the same return when repatriated. Taxation remains an important issue, preventing investment from some jurisdictions being repatriated into other jurisdictions. or severely curtailing net returns. Much can often be done to mitigate these issues - for example, through bespoke structures).

Passive versus active management - A key question in implementing the allocation is whether to do it passively or by following an active strategy. If the choice is to adopt a passive strategy, a (customised) benchmark will dictate the allocation. However, when choosing an active strategy, the challenge will become to time markets and to acquire the information that will lead to outperformance. Real estate is a cyclical business and if investors can time cycles this will benefit performance.

Correlations - A clear understanding of the correlations of the real estate allocation versus other asset classes in the total multi-asset portfolio is a prerequisite. The investor should also understand the correlations of the different regions, countries, investment type and sectors within the portfolio. By understanding the correlations of the overall portfolio and the markets within the portfolio an investor can better gauge the diversification possibilities.

Correlation with equities
One of the most strongly debated issues in the bricks and mortar investment world is the extent of correlation between real estate stocks and general equities. which of course affects the usefulness of listed property for asset allocation and diversification purposes in investment portfolios.

Some analysts, particularly in the non-listed world, argue that returns from property shares track those from broader equities much more closely than they track those from direct property. However, research on the US market done by Pagliari (2004)2 showed that, in the longer run, property shares generate returns in line with the underlying asset returns (when controlling for factors such as leverage and sector).

New research from Morgan Stanley now also indicates that the returns from property shares correlate much more closely with those from direct property than with those from broader equities over periods of over one and a half years.

Furthermore, there is no material difference in the correlation of returns from property shares with those from direct property and broader equities over periods of one-to-three years. Property shares only exhibit a significantly higher correlation with broader equities over periods of less than one year.

The analysis looked at monthly data from across 23 years taking capital value movements for UK commercial property as measured by the IPD UK Monthly Index, between January 1986 and December 2008. It also looked at monthly data over the same period for movements in UK property shares and the broader UK stock market.
Morgan Stanley calculated rolling returns for all three asset types over periods of one, two and three quarters; and over periods of one to 10 years.

Then, for each rolling period of time, they calculated the correlations between the returns from property shares and those from direct property and broader equities, respectively.

The results of the analysis support the conclusion that real estate shares are a good proxy for direct property. This is relevant for asset allocaters who are looking for an indirect play on property, and believe that real estate shares offer a good alternative to unquoted property funds for all but the shortest-term investor.

Fraser Hughes is research director at EPRA and Hans op ‘t Veld is head of listed real estate PGGM
1. Figures are based on countries GDP. For more information on the calculation methodology read: "Size of the Total Real Estate Markets" research on
2.Pagliari. Scherer. Monopoli. Public versus Private Real Estate Equities: a More Refined Long-Term Comparison. Real Estate Economics