The case for combining listed and direct real estate is presented by Fraser Hughes, who argues that many pension funds are missing a trick

Pension funds are facing a growing dilemma: how to divide their property allocation between direct and indirect (listed and non-listed) real estate. Their challenge is to wade through the benefits and shortcomings of all types of real estate investment and, in light of the last few years, to re-evaluate the composition of their allocations to the sector.

The total estimated value of high-quality commercial real estate in Europe is around €6trn(1). The GAV of the universe of the FTSE EPRA/NAREIT Europe Index, which contains around 150 companies and REITs, is approximately €30bn; the unlisted funds market, as covered by INREV, is around €260bn, covering 477 vehicles. Together, (including leverage) indirect real estate vehicles own approximately 10% of the total European market.

Equity or real estate?
For years, experts have debated whether the performance of listed real estate is primarily driven by real estate markets or by stock markets. The results of the 2009 study(2) by International Real Estate Business School (IREBS) at the University of Regensburg (see IPE Real Estate December 2009) clearly showed that the medium to long-term performance of listed real estate correlates significantly with the development of direct real estate markets. However, short-term performance is influenced by stock market developments.

In the study the three factors under review were economic growth, the inflation rate and the influence of the money market - which has an impact on the investment climate.
The conclusions derived from the survey were:

The performance of listed real estate in the UK and US(3) is significantly influenced by the development on the underlying direct real estate markets; The longer the time period under consideration, the stronger the influence of the direct real estate market. This escalates to the point where you can deduct with reasonable certainty that the performance of listed real estate over a very long investment horizon will ultimately match the performance of direct real estate ownership; While a short-term study of listed real estate reveals that it is susceptible to general stock market trends, they are definitely driven in the long term by the performance of the actual or underlying real estate held in the respective portfolio.

The report from the University of Regensburg is just one of many showing that returns from listed real estate correlate more closely with those from direct real estate compared to equities for periods over two years (4). In an up-coming report by EPRA and Cohen & Steers, results bolster this position (5). Using one-year rolling returns periods, with a six-month lag, between 1991 and 2009 correlations were:

IPD v FTSE EPRA UK (0.76 correlation) - two-month lag to 2009 trough; MIT/NCREIF v NAREIT (0.70 correlation) - three-month lag to 2009 trough; Hong Kong Offices Private v Public (0.72 correlation); Hong Kong Residential Private v Public (0.65 correlation); JLL Tokyo Offices v Tokyo Public market (0.66 correlation); IPD/PCA v FTSE EPRA/NAREIT Australia (0.83 correlation).

These studies show that listed real estate acts not only as a proxy for direct real estate investment, but also illustrates how this investment approach develops over various investment horizons. It is clear that for an investor wishing to invest in real estate long term, and who has sufficient flexibility, listed real estate is a sound alternative to direct real estate ownership.

Returns/risk profile - apples and pears
There seems to be some confusion in how to evaluate the direct, unlisted and listed markets. The underlying problem with comparing the risk and returns of listed, unlisted and direct property is the methodologies used to price the assets.

Listed is simple - what you see on the exchange is what you get. For direct property, underlying property valuations drive the level of indices, such as IPD and NCREIF. For unlisted funds, portfolio valuations play the leading role in deriving fund value. Throughout a downturn, the over-riding issue with a valuations-based approach is the lack of transactions (or liquidity) to determine accurate values, the infrequency of valuations and the ‘smoothing' effect.

These very different methodologies produce two very diverse sets of results when looking at market returns and volatility/risk, and investors should be aware that if they ignore these differences they run the risk of missing opportunities.

Compare apples with apples
When comparing valuations, the performance of the UK direct market (IPD monthly) and all UK constituents of the FTSE EPRA/NAREIT UK index deleveraged NAV since 1999 track each other, as indicated in figure 1.

Over a 10-year period, the two indices appear to sit tightly together and the resulting correlation is, unsurprisingly, extremely high at +0.90. Interestingly, none of the constituents of FTSE EPRA/NAREIT UK provide data to IPD on a monthly basis, therefore the properties used in each index are all derived from different sources. In other words, the underlying NAV of FTSE EPRA/NAREIT UK is an excellent proxy for the UK direct market. Buying the FTSE EPRA UK index - and its 40 or so constituents - provides the investor exposure to approximately £100bn (€123.7bn) worth of UK commercial property. The introduction of leverage for the listed companies boosted positive returns when values increased and, conversely, exacerbated losses when values decreased.

Alternatively, a transactions-based comparison offers a more accurate insight to market risk. But due to data limitations in Europe (6) on the direct market and unlisted funds - in particular with regard to transactions-based information - the US has to be used for guidance. MIT, Moodys and Green Street calculate indices based on the transactions activity in the US market. MIT calculates a Transactions Based Index (TBI), which is based on the NCREIF index and includes the prices that institutions pay or receive when transacting commercial properties. Moodys uses a similar approach and Green Street uses a ‘hybrid' valuations, transactions and expectations methodology. Figure 2 shows the performance of the indices since 2000. Focusing on volatility in the US as an indication of the relationship between the direct and listed market in Europe, some interesting conclusions can be drawn.

Firstly, volatility in the direct and unlisted market is considerably higher when using transactions data compared against valuations. While we understand that the listed sector overshoots peaks and troughs in the market, investors should clearly understand that the direct and unlisted sector is not unaffected by market events - as indicated in figure 3(7). Listed real estate volatility spiked during the uncertainty in 2008-09 - the NAREIT REIT index jumped threefold and the FTSE EPRA/NAREIT Global Index rose to 2.6x compared against their long-term average. In fact, all readily tradable asset classes experienced similar spikes in volatility over this period - bonds, equities, oil, gold all jumping between 2.5 and 5x normal levels during the crisis.

Focusing on the direct market, it is clear it was not immune to similar shocks. The black line in figure 3 shows the NCREIF Index (valuation-based) as the smoothed ‘baseline'. At its peak NCREIF was 2x greater than its long-term average. The transactions-based indices all record significantly higher jumps in volatility; between 2.5x for MIT TBI and Moodys to 2.9x for Green Street. It is evident from the US example that the direct market experienced significantly more uncertainly and volatility than indicated by the valuation ‘baseline'. As one commentator said (8): "The idea that real estate is in and of itself more stable than other asset classes is simply wrong. By no means does this have to speak against real estate. It is just to say that investors should approach their investments with realistic expectations."

Building on the US example, the MIT TBI  also calculates the supply and demand expectations of the US market. The demand index can be considered a gauge of market sentiment, at least among the all-important buy side of the market according to MIT. The supply side index gauges the prices that owners accept. What is evident from the two indices is the increase in margin between the two indicators for periods over the past five years. The demand and supply come together in 2005 and eventually invert in 2007. The margin, historically no more than 3-4% up to Q3 2007, exploded into the 10-15% range in Q4 2007 - and there has not been a break from this range in two and half years. The market has gone from buyers' strike to a sellers' strike. These indicators show a serious lack of liquidity on the direct market caused by the inability of buyers and sellers to agree a trading price.

We believe the position in the US market offers an insight into the situation being experienced in Europe. Transactions volumes in both the US and European markets have fallen considerably - the US peaked around $50bn per quarter in 2007 and is currently around one-tenth of that figure. Europe hit approximately $30bn of quarterly volume in 2007 and has stabilised in the $5-8bn range. There is cash out there (the European listed sector is well placed with over €10bn sitting on balance sheets in cash or cash equivalents). But at this moment many potential sellers are afraid to take unforced losses.

Investment considerations
Institutions consider real estate as a long-term investment. Given that listed real estate performance is the same as direct property investment over the medium to long term, an investor's decision-making process in allocating real estate should look something like this:

What is my time-horizon - long term: 10-12 years? What exposure/diversification - city/country/region/global sectors: office, retail, industrial, residential, speciality? What leverage - core, core plus, opportunity? Management quality and alignment? Transaction costs of trading the vehicle? Total expense ratio of running the vehicle? What are the expected net returns? What type of liquidity do I require? Transparency - quality/frequency of information? Pension fund tax position/vehicle tax position alignment? What vehicle best achieves 1-10? Select the best in class.

Patrick Kanters of APG said something similar previously in IPE Real Estate. APG's strategic portfolio, which comprises the majority of real estate assets, includes both listed and non-listed assets. There is no clear difference - they are both real estate.

Trading arbitrage
Theoretically this can be a very attractive opportunity. However, in practice a limited number of institutional investors have the flexibility to play the arbitrage between listed real estate and direct real estate. In the UK, the majority of pension funds still view listed real estate as part of their equity allocation, which may hamper their ability to take advantage of pricing differences on the two markets.

But, in the Netherlands where the majority of pension funds regard listed real estate as a proxy for direct real estate investment, and include listed in their overall property allocation, the opportunity is very real. In addition, a number of specialist property investors have the opportunity to switch between the two types of real estate investment.

Martin Allen, of Reech CBRE, picked up this point in the May edition of EPRA News. Using long-term UK data from December 1977, the direct and listed market are tracked. This example uses a 50:50 split between direct and listed real estate. Based on the strong tendency for property premium or discounts to revert to the mean, weightings to property shares are increased (or decreased) 1.5 percentage points for every month that property shares trade below (or above) lower (or upper) discount to NAV thresholds (9). The results over the 32-year period display a 11.2% annual return - 100bps per annum greater than direct or listed property returns.

In conclusion, the advantages of combining the asset classes - risk diversification, a broader universe to select vehicles, tactical allocation - are clear.

Traditionally, European institutions have favoured private equity investment in real estate over listed real estate or REITs, and recent research shows that this trend is continuing in spite of the liquidity problems experienced with private equity real estate investments over the past two years.

Investors using appraisal-based volatility measures in asset allocation models run the risk of over-allocating to real estate in general and under-allocating to listed real estate. In the words of David Swensen of Yale: "Since the investor ultimately obtains exposure to real estate that underlies either the publicly-traded or the privately-held securities, investors must identify compelling reasons to forego the greater transparency and superior liquidity of public securities."

Along with their medium- to long-term direct real estate performance, liquidity, transparency, access to capital, and experienced management teams, we believe REITs will play an increasing role in long-term real estate allocations, on a global basis.


(1) Taken from the EPRA Statistical Bulletin - May 2010
(2) Full paper is available from
(3) These two markets possess the most robust and longest running data from the direct market.
(4) Based on a body of research, compiled by Morgan Stanley Research - April 2010.
(5) Full report available from in August 2010.
(6) IPD is currently working on transaction based indices in Europe.
(7) Absolute volatility levels are rebased to 1 as at June 2006. Long term average from 2000-2010.
(8) 15 June 2010 -
(9) Thresholds used are equally spaced either side of the -17.8% long-run average discount to NAV over the period from December 1977 to December 2009. The upper and lower thresholds are set at two thirds of one standard deviation, or 9.3 percentage points, either side of the long-run average discount to NAV