Shayla Walmsley explains why listed property's underperformance won't result in an investor exodus.
If any steel-nerved investors took comfort from the company-specific drivers of last year's more than 11% drop in European listed property values, Morgan Stanley's forecast of yet more market correction to come will likely have dispelled it.
According to a research note published by the investment bank's real estate team last week, a correction in average property values, including prime, is increasingly likely as more banks suspend new lending. The forecast, based on a historical correlation between performance and restricted loan availability, will also include a narrowing of the definition of 'prime'.
One real estate analyst told IP Real Estate it came down to behavioural factors. When investors feel optimistic, the number of assets they perceive as prime expands. When they feel pessimistic, pari passu, prime assets contract.
The net impact becomes clear when you look at the recent history of market volatility. After the 2008 financial crisis, the market saw a significant contraction in the number of prime assets. The nascent recovery brought with it some recovery in optimism, only for that to be reversed with the recent downturn.
None of the factors Morgan Stanley analyst Bart Gysens said could change the forecast (a silver-bullet solution to the euro-zone sovereign crisis, banks lending more freely or GDP growth surprising on the upside) is especially likely.
Not that Gysens is particularly downbeat. Despite the market consensus that prime will be resilient with broadly flat values for European portfolios, Gysens sees more weakness with a doubling of yield expansion in the UK and an increase of as much as 90% elsewhere in Europe. But he claimed there would not be a significant correction because most companies have refinancing under control. In any case, he said, "not only is a meaningful double dip in property values unprecedented, [but] property yields are relatively robust at around halfway between peak and trough levels."
Whether the underperformance of listed real estate over the past year will have a significant impact on where investors plough their capital is moot. Even when returns are disappointing, real estate equities have one major advantage: liquidity. Disillusion with the performance of real estate equities is unlikely to drive pension funds to sell-up and shift the capital into, say, non-listed funds - simply because the latter will not do the same job.
In any case, we are probably talking about a relatively modest group of pension funds. Where there is no need for daily pricing - in defined benefit schemes, for example - pension funds are unlikely to favour listed for its own sake.
One analyst said: "If you're making a choice between investing in listed real estate and direct investment, you're looking at a discount to NAV."
To be sure, listed has its advocates - Dutch pension scheme managers APG and PGGM both include listed sub-portfolios within their non-listed property allocations - and its champions offer strong arguments in listed's favour, including not only liquidity but also exposure to a broader range of assets than they could conceivably get by investing directly.
Moreover, there is some evidence that REITs, specifically, perform somewhat differently than other property equities. REITs fell harder after 2008, but Deloitte recently reckoned that a pension fund investing in a UK REIT would see a tax-related 35.1% higher return than one investing in non-REIT equities.
Some analysts, such as S&P's Alka Banerjee, have argued that they occupy a niche subcategory within equities because they're subject to more influences, including higher-than-average leverage and a preferential tax position. Likewise, Russell Investments locates REITs firmly within the alternatives portfolio, rather than as an equities subcategory. But even if you accept distinctions between REITs and other property equities, investors in both are primarily concerned with liquidity and diversification, as well as returns.
The likelihood that pension funds that already have some exposure to listed will keep it does not mean there are no alternatives to underperforming equities. Invesco Real Estate portfolio manager James Cowen has called on investors to consider adding REIT debt to their property portfolios to enhance income returns and manage portfolio volatility.
"If you're talking about investors who want to maintain liquidity, most will just opt for listed," Cowen said. "In reality, they can invest in fixed income listed and get a different risk and return profile."
He pointed out that while both volatility and correlation have increased in real estate equity markets over the past 12 months, fixed income instruments, in contrast, have shown a low correlation.
If there is a shift in allocations, he argued, it will be from listed to debt - not to direct. "All investors are different, but, broadly speaking, although some will have the full spectrum, most will have a preference for one or the other.
"If your primary concern is volatility, you don't get that in direct," he said, "so some investors will be willing to lock up all their capital in directly held assets."