Integrate or differentiate?

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Is listed property managed as part of investors’ real estate allocations? A survey by Property Funds Research and Consilia Capital for EPRA strikes at the heart of the matter. Alex Moss reports

There has been a significant amount of research in recent years, produced by both academics and practitioners, that has focused in particular on two areas. First, much attention has been paid to the merits of listed real estate as part of a mixed-asset portfolio; and second, academics and investment firms have explored the relationship between the performance of the listed sector and both direct real estate and unlisted real estate funds.

The conclusions of the research are broadly consistent, as follows. First, REITs can act as both a return enhancer and diversifier in a mixed asset portfolio (Lee, 2012), and adding listed real estate to an unlisted portfolio can enhance returns as well as liquidity (NAREIT, 2011).

Second, while listed real estate returns do not reflect direct or unlisted real estate returns in the short run (one to two years), listed real estate and direct real estate are more correlated or co-integrated over the medium-to-longer term (three and more: see, for example, Hoesli and Oikarinen, 2012).

Third, listed real estate performance appears to lead direct market indicators by around six months (Cohen & Steers, 2009), although whether this lag is capable of being exploited to deliver abnormal or excess returns is questionable (Baum and Hartzell, 2012).

The first and second of these findings suggests that listed real estate should be attractive to investors, especially pension funds interested in the longer term. The global financial crisis of 2007-09 and the associated price and liquidity collapse of illiquid real estate assets over that period should arguably have led to an increase in listed real estate allocations at the expense of privately held assets. However, no significant change in behaviour has been observed. There may be many reasons for this, some of which are likely to be behavioural, or institutional, rather than purely based on rational economics.

Until now, however, there has been little work published on the behavioural or institutional aspects of incorporating listed real estate into an investment strategy. To rectify this we have undertaken two pieces of research for European Public Real Estate Association (EPRA). The first, published in March 2013, ‘The use of listed real estate securities in asset management’, examined both the different strategies and the various fund types available to investors who are prepared to use listed real estate, citing a number of examples, and how listed real estate is or may be combined with other types of real estate and real assets. These other assets include internal and external unlisted funds (the product of the investor or a third-party asset manager), derivatives, property debt, direct property, and real assets such as infrastructure and commodities in their various forms.

This second piece of work is a logical extension of the first paper, and concentrates on survey evidence examining whether or not listed real estate is managed as part of the overall institutional real estate allocation. Our starting point is as follows. If there is a strong rational case for including more listed real estate in multi-asset or real estate portfolios, and if there is little evidence that this is happening, then there may be an explanation that has to do with the organisational structures or investment processes employed by investors or sub-contracting asset managers. Hence, while we might recognise the apparent benefits of listed real estate noted above, it is important to understand and capture the organisational processes that determine whether European investors do include listed real estate in their real estate portfolios – and, if not, we would like to know why not. To the extent to which investors do use listed real estate, we would like to understand what (if anything) limits the weight they place on listed real estate.

Structure of the survey
As a precursor to this study, the EPRA research committee designed a pilot survey with the following objectives:
• Identify potential organisational issues limiting the exposure of European institutions to listed forms of real estate;
• Support the development of some hypotheses that can be properly tested;
• Generally support the design of a comprehensive research study of this issue.
The research was designed, and semi-structured interviews were undertaken, by Alex Moss, Andrew Baum, Fraser Hughes and Karen Sieracki on behalf of the EPRA research committee.

Following this pilot study, which was undertaken in Autumn 2012, a further, more extensive study was undertaken in Spring 2013. This increased the number of respondents from 20 to 56, and also took care to distinguish three categories of respondent: investor, asset manager, and investment consultant. The rationale for dividing the respondents in this way was to determine if there was a significant difference in approach and strategy between performance-driven investors and consultants on the one hand and fee or profit-driven asset managers on the other. To this end, different questionnaires were designed for the three different categories.

We held interviews with individuals representing 56 organisations, of which 16 were pure investors (self-managed pension funds, sovereign wealth funds and endowments, not apparently motivated by fees or profit) or consultants, while 40 were asset managers.

Survey findings
For the investors and asset managers we interviewed, we were told simply whether listed real estate stocks were managed as part of the real estate allocation. Consultants were asked whether this was an approach they recommended. Combining all three interviewee types, we found that only eight of 56 interviewees, or 14% of our sample, claimed to have an internally integrated approach to the management of listed and direct/unlisted real estate. It is profoundly disappointing that 86% of our sample has failed to develop or recommend the integration that the performance evidence we summarise in the introduction and background seems to support.

Behind this headline, we find another surprising result. Only a bare majority of interviewees (30 against 26) regard listed real estate as part of their allocations to this asset class. Among the 30 who do, only eight have an internally integrated approach; 22 either sub-contract the management of the listed real estate allocation to another manager, or use a different team within their broader organisation. Combining the 22 who sub-contract with the 26 who do not include listed real estate as part of their real estate allocation, 48, or 86%, do not have an integrated approach to building a real estate portfolio, including listed, unlisted or direct real estate.

For some European investors and managers, listed real estate is clearly part of the equity allocation. For others, there is some evidence that pension funds and consultants regard (or would like to regard) listed real estate as part of the real estate allocation. However, there is strong evidence to suggest that asset managers (with their greater experience of execution as well as a propensity for business unit separation) may not have developed a satisfactorily integrated investment process.

In conclusion, even though our sample of 56 institutions might not be representative of the full universe of investors, it is disappointing that 86% of our sample has failed to develop or recommend an integrated approach.

Change is in the air, however, and the key drivers of sentiment that we uncovered appear to be as follows.

Compliance and risk regulation. Compliance related issues can limit the appeal of the securities markets to a private real estate manager. Changes to solvency and other investment management regulations could have positive or negative effects on the attractiveness of listed real estate as the relative importance of volatility risk and liquidity play out.

Globalisation is an apparently irreversible trend. While we may see more investors confining themselves to domestic (and private) real estate, the majority are more likely to continue to seek exposure to global markets. While the lack of control afforded by a listed exposure is a real problem for many larger investors, access to global markets is probably a bigger factor. Coupling this factor with the much smaller lot sizes available through listed markets suggests a strong positive drive towards the listed sector.

Education and skills (or a lack thereof) currently inhibit the use of listed real estate.
Traditional real estate teams are not familiar with the different performance characteristics of listed companies and how to use real estate market research to choose between listed securities and private assets.

Peer-group pressure. As hybrid schemes combining unlisted funds with listed portfolios gain assets under management it seems probable that more asset managers will seek to develop and offer similar solutions.

There is clear confusion regarding the importance of volatility and the relevance of the investor’s investment horizon. In theory, most institutional investors have a long-term investment horizon, so the annual volatility of listed real estate securities (and their short-term correlation with other equities) should not matter – but it does because performance is reported annually. It is by no means clear that this problem will go away.
Finally, liquidity is another positive for listed real estate. The move towards defined contribution pension funds from defined benefit schemes requires more liquid and daily priced assets, promoting listed real estate over its private equivalent.

On balance, the wind is behind the increased popularity and use of listed real estate as part of an investor’s real estate allocation.