The research is all very well but out in the market views are mixed, as Shayla Walmsley reports

Advocates of listed real estate have plenty of arguments in their favour - not least the range of underlying assets and favourable liquidity compared with unlisted. But the
argument that listed real estate acts as a proxy for the underlying market depends on a belief that it is uncorrelated with (other) equities. After all, the appeal of real estate as an asset class for pension funds is diversification of risk. To invest in an asset class presenting the same equity risk would somewhat defeat the object.

Champions of listed might well argue that ‘real' real estate, too, has lost some of its diversifying power. According to Invesco data, IPD UK and NCREIF significantly increased their correlation to equities from a negative position between 2005 and the end of 2008. With deleveraging, the correlation will decrease to its average of 0.3. (There is some correlative diversity - with Asia least correlated and the US most.)

"When you look at the direct market - measured by using the IPD index - the UK property market seems to be more highly correlated to the equity markets than the US property market, measured by using NCREIF," says Robert Stolfo, business development director at Invesco Real Estate. "We think it's because the UK real estate market is heavily influenced by the London market, where much of the economy depends on capital markets. The US market is bigger, more diversified."

In any case, in the recent past the volatising impact of leverage, which has strengthened the correlation between listed property and equities, has increased scepticism over the proxy thesis.

"The asset is the same but there is a higher correlation between equity markets and listed than there is between direct real estate and equity markets," says Stolfo. With a direct investment you normally invest on a lower basis of leverage, up to 50%, in contrast to real estate companies, which often have loan-to-value ratios of well above 50%.

"With listed you have to look at other factors, such as sentiment - it's a share and traded - as you can see from the historical correlation," he says. "Over the last year, the correlation has increased. It's partly to do with leverage and the increased correlation between asset classes."

So does the correlation between real estate and equities rule out listed property as a proxy for bricks and mortar? Some pension funds think so. Philip Menco, CEO of the €1bn De Eendragt Pensioen, the paper-and-packaging pension fund-turned-insurance firm, sees listed and unlisted as "two very different products from an investment perspective". The daily fluctuation of listed makes it volatile - but so do discounts or overvaluation vis-à-vis the net asset value over the longer term. In contrast, non-listed is "a gradually moving investment without much liquidity".

"The long-term return on both products theoretically is equal but, due to the big swings of listed versus its NAV. The shorter term is very different," says Menco. "Therefore, listed is not a good proxy - with the exception of really long timespans."

Real estate and REITs
When is real estate not real estate? When it's a REIT.

Listed property is by definition subject to investor sentiment - hence the damage done to REITs by failing equity markets. Alka Banerjee, vice-president of Standard & Poor's Index Services, points out that REITs fell harder than the broader equity markets globally. S&P data for 2008 show global REITs returns down 45% compared with 42.4% for equities, although there was some regional variation. Accordingly, the REITs recovery is likely to take longer than that of the equity market more generally.

"Between 2000 and 2007 there was a huge bull run, which affected REITS more than equities," says Bannerjee. "They went up higher, and they had further to fall."

Yet she argues that REITs reflect neither the direct real estate market nor an equity investment. "You can't say that REITs are correlated to real estate, although, of course, they are a real estate investment in a sense - because they're highly leveraged and don't have re-sellable incomes," she says. "But they aren't correlated with equities, either. They're a special niche class within equities because more factors influence them than influence other equities. That isn't just about the balance sheet. There is much higher leverage and 90% of the income goes out as dividends to avoid tax."

That could well be one reason why German pension funds have shunned REITs as an investment sub-asset class. "Most think it's too risky - effectively, that an investment in a REIT is an equity investment rather than a real estate investment," says Sandro Cappucci, an analyst at Feri EuroRating Services. Feri research earlier this year suggested that German institutional investors intended to increase their real estate allocations from 9.4% to 10.43% over the next two years. Low correlation - with low volatility and sector expansion - emerged as the most important features. Almost a quarter of those interviewed planned to invest in spezialfonden. There was almost no interest in REITs, nor in property equities (0.2%).

"In any case, there aren't that many opportunities to invest in REITs. They just aren't on the agenda for investors," says Cappucci. "At the moment, there is a high share of direct investment in real estate. But many investors are looking to invest in spezialfonds, which have seen high growth rates. Investors are looking to sell directly into one of these funds. They have a good reputation."

Real estate ‘as it is'
Unlisted - unlike listed - reflects real estate values "as they are", even if there remain questions over valuation, according to Robert Gilchrist, CEO of Rockspring Property Investment Managers.

"We and our clients invest in unlisted because we see it as bricks and mortar. It's the real stuff," he says. "Yes, there are all sorts of questions over valuation but with unlisted you see values of real estate - with no discounts and no premiums."

In non-listed real estate, valuations are conducted on a quarterly rolling basis - part of the portfolio gets valued every quarter, adding up to an annual valuation. The contribution of infrequent valuations to the denominator effect - which, because it skews values, potentially leaves pension funds overweight in real estate and therefore over-exposed - has raised questions over property valuation and real estate values.

The problem is not whether valuation takes place but the paucity of transactions, which means there isn't a sufficient comparison, says Andrea Carpenter, interim CEO of the European Association of Investors in Non-listed Real Estate Funds (INREV). "When the market starts moving, it will be different. But if nothing is bought and sold, then there's nothing to compare," she says.

In any case, according to Stolfo, daily valuation wouldn't necessarily help because real estate doesn't change that much. "It's a long-term business and the underlying fundamentals are long-term fundamentals, so the value won't change dramatically over a short period of time," he says. "A quarterly measurement might be useful because it would take into account recent transactions."

Listed real estate may be more liquid, but that doesn't necessarily make it good value - as De Eendragt Pensioen found when it decided to sell off its listed real estate portfolio in favour of unlisted, only to find prices had dropped below the minimum it was willing to accept.

"In listed, you have other things, other characteristics, notably market sentiment," says Gilchrist. "If the FTSE 100 is in a downward trend, the likelihood is that REITs will be too. There is perceived to be liquidity in REITs - important when you consider the ability to exit. But it doesn't come free."

Phil Ellis, head of business development for real estate at Aviva, points out that the choice is between listed and unlisted - not between either and direct. For most (at least UK) pension funds, direct investment is not an option because of the scale and the size of assets under management. To have direct investment, you have to have sufficient diversification in terms of geographical exposure and concentration risk, for example. Ellis reckons that you need a minimum of between £100m and £150m.

Unlisted real estate, in contrast, is a "massive market" because it offers multiple routes to investment. "A pooled funds vehicle is as close as you can get to direct investment in real estate," he says. Pension funds invest in a portfolio of assets within a pooled wrapper, with managers charging fees and possibly using some debt.

"If you only have listed real estate, you increase the equity exposure," says Ellis. "Values don't reflect the underlying assets and they're currently trading at a discount. It shouldn't be investors' only exposure. Pension funds invest in real estate because it's an uncorrelated return."

Overall, he says, there has been more investment in real estate in the second half of the year than in the first because more pension funds are looking at property investment again. They're looking at 10-year lease terms, with prices 45% down from the peak values and higher yields. "Unlisted real estate is attractive both in historical terms and compared with other asset classes," says Ellis. "In contrast, equities are volatile and not as stable as property."

Aviva recommends that investors use listed - like unlisted specialist funds such as shopping centre funds or central London office funds - as a complementary-only option. If a pension fund has 9% of its 10% allocation in the unlisted, it might recommend that it invest the other 1% in listed.

More than that and they increase their risk - and they don't take much dissuading. According to Ellis, most pension funds will keep listed out of their property portfolios - not least because they have equity managers who might be investing in property equities. "We have clients who allow us to use listed - but they're not a majority," he says.

Despite clear champions on both sides, there are good reasons for investing in listed and unlisted. Each has its advantages and disadvantages.

"It depends on what you want from the investment," says Carpenter. "Non-listed real estate offers less volatility and fewer vagaries of investment, because it doesn't depend on market sentiment. But it depends on the type of investor you're talking about. Investors in non-listed are prepared to commit to long-term with less liquidity and volatility. Within one institution you could have the property team investing in unlisted but your equity scheme could be investing in listed - so you're investing in both."

At best, listed makes sense if you time it right - and time it long. Ellis points out that listed property equities are more strongly correlated with equities as a whole in the short term - say, over one to 12 months. Although the availability of global data is limited, long term - say, over five, 10 or 20 years - listed real estate shows the characteristics of the underlying assets. In other words, it's a short-term equity, a long-term diversifier.

Moreover, investing in unlisted real estate has its downside. You need to be a bigger player with more capital, for one thing - in contrast to quoted real estate, which gives smaller investors access "for a smaller bite-size", as Gilchrist points out. Pension funds could invest in listed for short-term tactical reasons, despite the equity correlation. There is a cost advantage compared with direct investment and property equities are more liquid.

Even so, says Gilchrist, "the price of a potential exit in a down market for equities is still worth it, because of their value by mark-to-market on a daily basis. Otherwise, you have to put the asset on the market, find a buyer, and hopefully sell at a price you can live with.

"Unlisted is stodgy and illiquid but it's a stronger proxy for what real estate is all about," he says.