Higher gearing can lead to higher share price volatility. This is the single biggest reason why investors view listed property as unsuitable, warns Hugo Machin

As we all know, the real asset of real estate can be held in either listed or unlisted formats.
Currently, there is a belief that listed real estate is more volatile than unlisted real estate.
This is a myth. The fundamental asset is the same whether in a listed or unlisted format.
The reason that unlisted real estate appears less volatile is a time lag between valuations in unlisted portfolios, whereas shares are marked to market every day (and the share market is, by nature, forward looking).

This means listed real estate investment trusts (REITs) have to show, to an even greater degree, that they provide property-like returns not equity-like returns.

It is worth repeating that a REIT in its purest form – high payout ratios and low financial engineering – provides investors with a low-cost way of owning institutional-grade real estate with the benefit of liquidity.

Importantly, it is a good diversifier of an investment portfolio. Whilst there will be points in the investment cycle where low-growth stocks with high dividends appear unattractive, it is vital for the sector that this point of difference is maintained.

Where listed real estate markets have come unstuck is when the business models have changed. Property-like returns managed by experts in a conservative capital structure is a through-cycle truism. A conservative capital structure dovetails well for a further reason why capital would be attracted to listed real estate.

High gearing can lead to higher share price volatility. This is the single biggest reason why investors view listed real estate as unsuitable as a means of diversifying their portfolios. Lower gearing means that the shareholder will receive returns that are a closer proxy for direct assets (due to low financial engineering). It is the age old adage: risk-adjusted returns.

Investors in the sector want to receive high and predictable income streams backed by real assets. Thus, a reduction in volatility greatly aids the argument of listed real estate being a diversifier in a balanced portfolio. The point of being true to label is hugely important.

Returns on capital in excess of a company’s cost of capital will result in share prices being ‘bid up’. Better returns to shareholders will result in the availability of more equity capital, as investors are drawn to the sector. This alternative source of funding is a key benefit of a market listing. Thus, growth driven by better returns will, in turn, lead to a more highly securitised and sophisticated market – the virtuous circle.

A second building block towards a strong share price is that of a suitable capital structure. The question of what is the optimum gearing level is difficult to answer. Generally speaking, investors invest for operational not financial returns. Investors are not, according to Green Street Advisors, universally compensated by better returns from higher gearing, even in a rising market.

The issue is that the higher the levels of financial engineering the less ‘true’ the real estate returns are when owning the shares. It is this point of operational over financial returns that are critical for the property companies to understand. Importantly, high gearing in companies compounds volatility at times of market dislocation and lower gearing levels would alleviate some of this pressure.

For the sake of argument, if we assume that specialist real estate companies are experts at buying, developing and leasing real estate, then it is the capital structure that can often be the critical factor that causes a company to underperform, especially in a down cycle. A sound capital structure is of equal importance to management being financially aligned with shareholders. Arguably, if management are aligned then they would not allow the capital structure to jeopardise the share price. Nonetheless, it is vital that the sector should provide operational returns to its owners.

Asset allocators do not always see listed real estate as a ‘separate’ asset class to be included in their portfolio. Accordingly, the sector needs to become as true to label as possible. Lower gearing will help in this process, by reducing volatility in share prices. This will further provide investors with the cheapest and most efficient way of owning the asset class.

Hugo Machin is a senior portfolio manager at AMP Capital