Fraser Hughes and Alex Moss re-examine the rationale for blending public and private real estate strategies and discover that the debate has moved on
In our paper ‘Finding the right blend’, published in IP Real Estate in 2011, we looked at the rationale for, and methods of, combining listed and unlisted real estate exposure. There have since been a number of developments, both in the market place and also in terms of published academic research that has strengthened the case.
One of the key attractions of incorporating listed real estate securities into a blended strategy is that it offers both liquidity and arbitrage opportunities in terms of the parallel asset pricing of listed and direct property. Therefore, what we would be looking for is clear differentiation over the shorter term between the two markets. As we know, over the longer term the pricing should converge. Let us take then the evidence for the UK.
As figure 1 shows, which plots the movement of the EPRA UK Index (price, not total return) against the IPD Monthly Index (capital growth, not total return), the movement in UK capital values can be described as the gentlest of parabolas, while the performance of the listed sector has offered a myriad of trading opportunities, with movements of +/-15% from the starting point in January 2011.
A number of factors lie behind this relative volatility, but at a time when actual, reported capital values, both from companies and from IPD, have been broadly flat, the movement can be explained by the expansion and contraction of the discounts to NAV rather than material changes in the underlying NAV itself. It is not surprising, given the relative stability of UK, particularly central-London, values and the relative uncertainty of euro-zone capital markets in general, that the relative premium rating of euro-zone versus UK stocks has now reversed.
At their peak last summer, discounts were close to 4%. This represents a normal rate for REITs in market equilibrium. Since then, uncertainty over European values and a forecast modest decline in UK values has served to move the discounts out to a trough of 20-25%. While this may seem like excessive volatility to a direct investor it is worth remembering that the parallel benefit of this volatility is liquidity. The listed market has offered significant opportunities for trading tactically, whereas liquidity in the direct market, particularly in Europe, has dried up completely. To put this liquidity into context, the impact of the uncertainty over the euro-zone has led to a decline of 90% in commercial property transactions in Italy and Spain in the three months to July. In absolute terms, there were only three property transactions registered in Spain during the second quarter - down from 58 the previous quarter. In Italy, the figure was two compared to 56 the previous quarter.
What do the current discounts imply in terms of capital value movements? Looking at the work we did in our previous paper, where we identified the predictive power of REIT pricing, at the current discount of around 14% in the UK and 17% in Europe, then based on an average loan to value ratio of around 40%, current share prices are forecasting falls of around 8% in UK capital values, and falls of around 10.5% in European property values. Using this implicit pricing as a starting point, the value of the listed sector in a blended portfolio is therefore that investors can choose their entry point based on implicit forecasts versus their own. To illustrate this point we have reconfigured the discount chart to implied value changes.
One of the key developments in the period 2011-12 has been the increased urgency with which people are examining the role of listed real estate securities within defined contribution (DC) pension schemes. Over the 10 years to 2010, DC schemes’ share of UK pension funds is estimated to have risen from 3% to 40%, amounting by the end of the decade to more than £500bn (€398bn). This has been largely at the expense of defined benefit (DB) schemes. The Investment Property Forum (IPF), together with European Public Real Estate Association (EPRA), the Institute and Faculty of Actuaries and the Association of Real Estate Funds (AREF), is funding a research project into the topic of real estate allocations within retirement savings schemes.
In addition to listed real estate as part of the real estate allocation, there has been a trend towards looking at real estate as part of a grouping of ‘real assets’ for pension fund purposes. Russell Investments produced a paper which looked at “real assets for the defined contribution menu”, which explored the impact of adding assets such as commodities, real estate and listed infrastructure as a way to help participants achieve their long-term goals. Their conclusions were that target-date funds should include an allocation to real assets in the early working years, and that real assets provide exposure to compelling long-term global trends.
Finally, a recent study into pension fund investment in real estate by Andonov, Eicholtz and Kok of Maastricht University found that larger pension funds are more likely to invest in REITs, whereas smaller funds allocate more assets to fund of funds vehicles in direct real estate. Investing through fund of funds vehicles resulted in substantial underperformance compared to other investment approaches. Smaller pension funds, especially, do not seem to recognise that REITs provide exposure to property returns comparable to external managers that invest in direct real estate - and much better than fund of funds managers but with much lower investment costs.
The paper has some implications for institutional investors investing in real estate. Pension funds should consider the full range of potential investment approaches and avoid extended investment chains. Particularly, smaller funds should consider using more REITs and should re-evaluate their extensive use of fund of funds vehicles to gain exposure to direct real estate. Smaller pension funds can also implement more passive strategies in REIT investments in order to remain cost-competitive with larger funds.
In conclusion, therefore, we can see that since our first article the potential role of listed real estate in a blended portfolio has expanded and that by using our implied forecast model the short-term performance differentials between listed and direct offers numerous arbitrage opportunities to exploit.
Fraser Hughes is a director at EPRA. Alex Moss is head of global property securities analytics at Macquarie Securities Group