To obtain their exposure to real estate, Australian pension funds prefer listed property securities. In fact, just under three-quarters of all real estate exposure by Australian pension funds is obtained by investing in real estate investment trusts (REITs) or listed property companies.
While initially focusing on the domestic market, pension funds ‘down under' have been strongly allocating to global listed property mandates over the last eighteen months and it is now a recognised asset class. This allocation shift to global mandates has been driven by a desire for more diversification, higher income and better liquidity, particularly as the baby boomer generation moves into retirement.
For those investors who might be interested in benchmark weights, global real estate indices have between a 40-50% exposure to the US REIT market (depending on the preferred index). With this potential exposure to the US listed real estate market being quite high, some Australian investors have expressed concern about recent developments in the US sub-prime mortgage market.
Overall, the US residential real estate market has slowed significantly over the past year. The S&P/Case-Shiller Housing Index, which measures the market value of single-family homes, shows a 2% decline in US house prices over the last year with the average house price now $209,000 (€156,000).
While the flat housing market is a drag on US GDP growth (which will have a broader impact on the real estate market), more recent concern with US housing has focused on the sub-prime mortgage market.
Sub-prime mortgages are mortgages marketed to less credit worthy individuals whereby lenders are compensated for taking greater credit risk by charging higher interest rates.
Deterioration in loan performance is concentrated on adjustable rate mortgages (ARMs) as the interest rates are reset to higher levels in the current environment. By way of contrast, the performance of sub-prime fixed rate mortgages (as distinct from ARMs) has not worsened substantially.
Some important facts to note are as follows:Sub-prime ARMs account for only 6% of the total US home loan pool, while the total sub-prime market is 8% of the total US home loan pool; The national foreclosure rate on ARMs is 4.5% while the delinquency rate (defined as over 60 days late) is 13.3% (foreclosures are also included in this delinquency number); These foreclosures are concentrated in the ‘rust belt" states in the Midwest, areas affected by the continuing woes of the US auto industry. Ohio, Indiana and Michigan were the top three states for foreclosures; The national delinquency rate for all loans is 2.6%, and those classed as seriously delinquent (greater than 90 days late) represent 2.2% (one is a subset of the other). The national foreclosure rate for the entire mortgage market is 1.2% (this number is also included in the delinquency rate) and more than half are resolved before the borrower is forced from the home.
Sub-prime lending tends to be close to 90% financed. The flow effect of these foreclosures has seen the bankruptcy in March 2007 of one sub-prime mortgage broker, New Century Financial, based in Orange County California. In our opinion, this bankruptcy was primarily due to lax underwriting standards and a lack of diversification in their business.
Property is a localised game. Not only does it have low correlations to other asset classes, but there are also very low correlations between, and within, countries. This is a result of the differing business cycles between regions and more generally, different microeconomic influences.
Correlations between different countries typically range between 0.2 and 0.4. To offer an example, Germany is emerging from a 10-year recession and Japan from a 15-year recession, while the UK, Australia and the US are much further along in the real estate cycle. Strong GDP growth rates, most notably in the Asian region, support continued increases in property prices. It is this importance of local features to the earnings potential of the underlying property assets that results in low correlation levels across regions at such low levels.
These low correlation effects directly apply to the US residential market, where employment and wage prospects and in turn, dwellings and mortgages fundamentals, vary greatly across the 50 states. Indeed, Class C apartment REITs in the US are beginning to see a benefit from sub-prime issues as some previous home owners are forced back into the rental market. (As an aside, private equity activity in this sector in May 2007 has also fuelled stronger prices.)
However, it is important to note that the fundamentals driving the commercial real estate market, the primary source of underlying assets for most US REITs, are very different from the residential housing market. The US currently has 4.4% unemployment and continuing GDP growth of 2.5%. Retail spending remains robust and corporate profitability is strong. These solid economic fundamentals are driving increasing occupancy and rents in commercial and retail space, which is the basis for continued earnings growth in the US REIT market. In particular, Manhattan, Washington DC and parts of southern California remain among the most attractive real estate centres worldwide.
The effect from the sub-prime mortgage fall-out has been well contained in the directly affected markets. It has had virtually no effect on the US commercial real estate market. In fact, economic fundamentals in the US continue to support stronger real estate earnings. Given that the US property market has very low correlations to other property markets around the world, the effect of US sub-prime issues on global REITs is negligible.
All statistics are taken from the Q4 2006 National Delinquency Survey from the US Mortgage Bankers Association
Stephen Hayes is managing director at Perennial Real Estate Investments in Sydney