Real estate investors that shun REITs could be missing a trick. Maha Khan Phillips looks at the case for listed property

Global volumes for real estate investment trusts (REITs) in 2011 were higher than they have been since before the financial crisis began. And yet, many institutional investors remain wary of going down the listed real estate route when making asset allocation decisions. Their reasons have been well articulated: real estate securities may be correlated with equities, and volatility is always a concern. But portfolio managers investing in REITs argue that now is an excellent time to re-evaluate the asset class.

"From our vantage point, what we see is that the highest quality real estate is owned by public markets," says Sam Sahn, portfolio manager at Timbercreek Securities. "Whether you are looking at the US or Australia or Singapore, across the board the trend is evident. Pricing in the direct market for core assets have recovered handsomely, but publicly-traded REITs in those same markets are trading at discounts to their underlying asset value."

Alex Ross, senior investment manager of the pan-European property share fund at Premier, argues that REITs offer access to quality assets that are difficult to find elsewhere. "If you look at the top-50 shopping centres out of the 850 in the UK, over half of those are owned by UK REITs," he says. Property has recovered, he argues, with a lot of capital looking for real estate in core Europe. "The stronger quoted vehicles will be the sector winners over the next three to five years because of the strength of their balance sheet."

Simon Hedger, senior portfolio manager at Principal Global Investors, believes that asset quality is key. "Besides liquidity, one of the main advantages of investing in real estate via the listed market is access to the best assets and markets. If you take specific examples like Land Securities or British Land, the asset quality is very high. If you were a smaller institution with $20m (€15.9m) to invest in direct real estate, it would be difficult to access that high asset quality, investing directly in shopping centres or office buildings," he argues.

Sahn says that with heavy discounts in the market, there are plenty of opportunities for investors who want listed real estate exposure. "Companies in the US are trading at 5% discount to NAV, where historically these companies have traded at a premium. In Sydney, companies are trading at the 10% discount range and in Japan it is 15%. These are companies that own really attractive assets in shopping centres, multi-family residential units, and retail assets that are key to large developed world markets," he says.

In the UK, real estate shares are trading at a discount of 13%, and the current value of the discount to NAV is approximately £3bn (€3.8bn), according to PricewaterhouseCoopers (PwC's) Real Estate Valuation Index. The index, which analyses the values of UK listed real estate companies, suggests that property shares could be significantly undervalued, as less than due credit is given to elements such as management expertise, access to acquisition opportunities and finance, as well as the current market conditions. PwC found that between 1999 and 2009, property shares in the UK continually traded at a discount to NAV for the majority of the period. Between mid-2007 and early 2009, commercial property values fell by 44%. They then rallied by 17.7% but have fallen by 1.6% since October.

"In our report we are saying that it is time to look at the manner in which listed REITs are valued and the discounts that have been applied. We don't conclude that the discount applied is necessarily wrong, but that it is worth debating the issue," says Craig Davies, real estate director at PwC and author of the index.

Whether the NAV/discount model works or not, REITs can stand by their performance alone. "The fact is that we have had relatively good performance in the last three quarters on a worldwide basis, which speaks for the sector. People look at the performance and say, I should have invested," argues Helmut Kurz, a fund manager at German bank Ellwanger & Geiger, responsible for REITs.

It is hard to ignore performance, particularly over the long term. In local currency terms, global real estate securities have outperformed broader fixed income and equity markets. Global real estate securities returned 4.51% over the year to June 2012, compared to -1.37% from global equities, according to the European Public Real Estate Association (EPRA). Over the three-year period, global real estate securities returned 17.75% while global equities returned 10.4%, and global bonds returned 4.79%. Over the 10-year period, global real estate securities returned 7.95% compared to global equities, which returned 5.07%, and global bonds, which returned 4.37%. The regional figures varied widely, with North American securities offering the highest returns at 12.69% over one year, 32.27% over three years, and 10.28% over 10 years.

Given the lack of returns being generated by other asset classes, investors who have not considered the role real estate securities could play in their portfolios may be missing a trick.

The role of REITs
Levels of appetite depend, of course, on where real estate securities sit in an investor's portfolio, and whether correlation is a concern. For some investors, REITs are part of their equity allocations. In the UK, because publicly listed REITs have only existed since 2007, investors are predominantly equity investors, says Robert Houston, principal of St Bride's Strategic Advisers.

"The problem is that if you are an equity manager and you are choosing to invest in real estate securities you are going to compare that with the perspective performance of pharmaceutical or bank stocks, and you are going to be less concerned about its performance against the IPD index or an unlisted shopping centre fund, because your mandate is to outperform a securities benchmark," he argues.

For the €120bn Dutch pension provider PGGM, however, all investments - both listed and non-listed - are considered to be real estate investments. "The underlying cash flows of the vehicles are real estate cash flows. In the long run, the wrapper is not that relevant. Obviously, in the short run it has more impact," said a spokesperson for the firm.

Fraser Hughes, research director at EPRA, says more investors are allocating the investments to their property portfolios. "A key theme from some recent research we conducted, approaching around 20 big institutional investors in Europe and the UK, is that there is a trend, albeit slow, for institutional investors to view listed property as part of their property allocation, rather than as part of an equity allocation."

For those investors who see REITs sitting in their real estate portfolios but are still concerned about correlations, research conducted by Martin Hoesli at the University of Geneva and Elias Oikarinen at the Turku School of Economics in Finland might help. The study examined whether securitised real estate returns reflect direct real estate returns or general stock market returns using international data for the US, UK, and Australia. The results suggest that the long-term REIT market performance is substantially more related to direct real estate performance than it is to stock market returns. Short-term co-movement between REITs and stocks is stronger than that between REITs and direct real estate, but REITs are likely to provide a similar exposure to various risk factors as direct real estate in a long-horizon investment portfolio, according to the authors.

Wilson Magee, director of global REITs at Franklin Templeton Real Asset Advisors points out that during 2008-09 correlations rose among almost all asset classes. He believes that the volatility during the financial crisis "may not be as statistically important when we look back five or six years". Magee adds: "Volatility has been trending down since investors became more sure that the global financial crisis wasn't going to result in a worldwide depression."

Where are the opportunities?
Experts see opportunities in different places. "It's not obvious to us that the US looks massively cheap," says Paul Jayasinga, senior investment consultant for manager research at Towers Watson. "You could make a case why Asia could be interesting, certainly to UK clients. Many of our clients tend to underweight Asia, partly because there tends to be a domestic bias and partly because there aren't that many core direct open-ended funds in Asia. Asian real estate securities appear to be trading at much bigger discounts to NAV than they have historically."

Others have a different view. "We have a slight overweight to the US," says Hedger. "Currently we still see that being a relatively strong economy. In view of the continuing uncertainty, we are slightly underweight Europe, while in Asia we are market weight because Asia is a region of contrasts. You have good stability in markets like Australia but that is countered by some uncertainty in areas like China."

Other fund managers like China. Svitlana Gubriy, fund manager at Standard Life Investments' global listed real estate team, says Hong Kong is offering opportunities, because of mispricing in the market. "Developers in Hong Kong underperformed quite significantly over the last six months because investors were worried about the slowdown in the residential sector. That underperformance creates an attractive opportunity."

For example, Gubriy points out that Hong Kong might be trading at 33% discount compared to historical discounts closer to 15-20%. She also believes Australia is mispriced, with companies trading at a 15% discount to NAV because of concerns about the economy, even though real estate securities income is driven by contractual rents, which are not expected to fall to the same degree as other sectors. "This creates a lot of arbitrage opportunities."

Magee also likes China. "We started investing in companies with almost pure exposure to China last year," he says. Magee is encouraged by the long-term prospects of markets like China and Brazil. "These economies are transforming themselves, they have a growing middle class, a growing wealth, and there is a tremendous need for quality housing."

Most managers are underweight Europe, with a few exceptions. "It is difficult to make predictions about Europe, because there are macro headwinds," says Jayasingha. "The valuations appear to be cheap in some markets relative to history, but it is difficult to be overly positive, and many of our clients already have direct exposure to European real estate."

One manager who is positive on Europe is Larry Antonatos, director and product manager for global equities at Brookfield Investment Management. He argues that while there has always been a mispricing between the public markets and the private markets, European stocks are in general being painted with a broad brush. Because investors are nervous about Europe, opportunities are being lost.

"We view Europe as the single most important opportunity across the globe for everything we do," Antonatos says. "We are long-term positive on Europe. There is a lot of high-quality property available, generally in the southern European markets, where there is concern about sovereign debt and about the possibility of debt restructuring and the euro-zone.

"Our view is that countries exiting the euro-zone is a relatively unlikely event. So when we see great properties trading in a ‘risky' market, we will take modestly sized positions in select high quality companies. We are running a prudent portfolio, but we are paid to take risk in a prudent and measure way to generate excess returns."