How will investor views of real estate affect the size and the structure of the real estate allocation and how does this influence the structure of a multi-asset portfolio? Monika Ward reports

Over the past decade, institutional investors have become increasingly risk-averse - reducing, in particular, their allocations to equities. This has manifested itself in a desire for income, as opposed to growth, implying a higher value being placed on the former.

Plain government bonds initially met that requirement, but as their yields fell so did performance prospects, and institutions have increasingly sought alternative low-risk products. Subsquently, the commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS) markets mushroomed, with the latter encompassing, towards the end of the period, the sub-prime sector.

Similarly, the boom in demand for property may have been perceived as a desire for high performance (and for some investors it certainly became irresistible on that basis) but it was initially driven by a desire for income, and the growth arose out of the re-rating of the asset class's income in a period of unusually low interest rates.

The case for real estate in a multi-asset portfolio
Combined with its comparatively strong returns, real estate's low volatility has maintained its attractive risk-return characteristic over the past 15 or more years. Benefiting from a low-correlation with other asset classes, it presents a significant diversification opportunity and, according to the IPF (1) (on the evidence of the 16 years to 2007), historically portfolio risk would have decreased dramatically by adding real estate to a core asset mix, more so than including the remaining alternative asset classes.
Even putting aside the global downturn of the past two years, the argument for institutional investors increasing allocations to real estate remains strong (and, indeed, the need for secure income makes the argument for higher real estate allocations even stronger).

The case for increasing the allocation to property is made by theoretical capital asset pricing (CAPM) portfolio modelling. The output from such an exercise suggests that investors with a plain vanilla risk requirement should apportion 10-15% (2) to real estate. Interestingly, this level of capital allocation remains fairly constant at all levels of portfolio risk, unlike government bonds and large cap equities, which dominate low-risk and high-risk portfolios respectively.

But the reality is that size (of the property universe) does matter
Unfortunately, the reality is that the size of the commercial real estate investment markets is limited by the amount of occupational demand. In the western world and, in particular, the more mature markets, 2000-09 was a period when occupational demand did not increase significantly - reflecting the nature of the modest economic growth. As demand pushed prices higher, institutional demand could, therefore, only be met by investing outside the domestic market - ie, by enlarging the universe.

As an example, the appetite of UK pension funds for property is expected to grow. IPF has estimated (3) that funds' allocation to real estate is expected to increase from 6% to 8% over the next three years. However, this will also be restricted by the depth of the market. To put this into perspective, the potential wall of money from pension funds looking at real estate is too much for the market to absorb through direct property transactions alone. We estimate that UK pension funds had £204bn (€246bn) allocated in real estate at the end of 2009.

Assuming that this is solely UK property focused, the pension funds would need to be the successful bidders in all direct commercial property transactions over the next two years (using the long-term average volume (4) ) to increase their allocations to 8%. If they wanted to increase their allocations to 15%, this would take nearly a decade.

Of course, in the upturn, investors in many other countries were trying to achieve the same thing at the same time. Frequently that was not possible within their domestic markets, which have often been of insufficient size to absorb their capital - and they have been obliged to look abroad. While they certainly achieved diversification in doing that - which is clearly a benefit - the size of the investment pool relative to the amount of investors looking to allocate has remained limited.

Development adds to the asset pool but, as property players will attest, this was not the decade of the developer, simply because occupational demand did not reach such excess levels that it could not be met from existing stock. Hence yields were bid down and prices rose.

This in turn led to a convergence of yields across markets despite the risk profile of the structures (in the way real estate investments were accessed via leverage and in some cases different currency) and markets being different.

How do you overcome this hurdle?
Institutional investors can only increase their allocation to property if they are willing to compete it away from other investor groups. But there is a problem with property that does not exist with, for instance, equities. Equities come pre-packaged with gearing. All investors are on a level playing field - as you cannot buy a share in a choice of a geared or ungeared form.

Not so for property. The gearing is external to the direct asset. Investment theory says that gearing increases returns (over the long term) and, therefore, it makes sense to have gearing. (One could, of course, have an interesting debate on the optimum level.) But institutions find themselves in an impossible position. They are investing in bonds, which are a form of fixed-return asset. To borrow money is the mirror image and it does not make sense to do both (invest in fixed interest and borrow money on a fixed interest rate) - you might as well lend the money to yourself.

But many other property investors do not have the same restrictions and can gear their assets. Theoretically, these investors can afford to pay a higher price than the institutions for the same assets, to achieve the same (post-debt) returns. Of course, there is no reason to suppose that the various investor groups have similar return requirements.

However, given that the other asset classes can form benchmarks for property's relative performance and that they are generally not susceptible to external gearing (to any great degree), it is almost inevitable that an equalisation of net returns develops.

Therefore, for many periods, institutions find it almost impossible to compete property assets away from other investors. To do so, they would have to pay a price which, for them, would give inadequate returns for the risks involved. There are, however, two periods when they can make this work.

Firstly, when it is possible to capture a relatively greater proportion of the cyclically high return from property. As we know, property has a long slow cycle - at least compared with equities - and there can be clusters of years when the annual returns are strongly positive and strongly negative.

Institutional investors can afford to be less discriminating on timing given the long-term nature of their investments. They can purchase at a time when the short-term lower returns or the lack of debt finance can raise the barriers to entry for other investors. The past couple of years are a good example of the window of opportunity for them.

In practice, it can be difficult to match that window. Some in the UK have questioned whether the recent pick-up in interest in real estate from institutional investors has been too slow off the mark. Inevitably, such times are periods of higher risk, and this requires even more due diligence. This can delay the entry.

The second way is for institutional investors to play the risk/return game to their advantage. Property companies are not as refined and will not push on property opportunities where returns are below their target returns. Institutional investors, whose outlook is long-term will, depending on their risk profile, welcome low returns where the risks are also low.

Another solution for investors to gain further diversification was to follow the development into the emerging market. This has typically meant focusing on the less-developed Asian markets and, closer to home, the central and eastern European property markets. Since the peak, the pricing readjustments in some of these markets have been deeper and faster than the more established markets, which have lagged but have not been sufficient to restore confidence to pre-recessionary levels.

The global nature of the current recession has meant that geographical diversification has offered less protection than in previous downturns, especially in the emerging markets. There is currently a feeling among both investors and consultants (5) that geographical diversification can be better achieved through other asset classes, such as hedge funds and equities, severely questioning the benefits of property diversification.
To test this belief we undertook

a case study to see whether diversification benefits really exist, focusing on Dutch investors and their home market specifically. We analysed the combination of historical total return figures and future return projections to explain the relationships between Dutch properties, European properties, and European-listed companies factoring in the historical volatility and return relationship between the three assets.

Applying depreciation to our total return forecasts, our analysis produced a projected total return at 7.8% annually for Dutch properties, an 8.8% annual total return for European properties and a 10.4% annual return for Europe-listed property companies over the next three years. The volatility calculated for each of these property types was 4.8%, 7.6%, and 25.8% respectively.(6)

Assuming a total maximum portfolio risk of 5%, there were two results for the optimal allocation. Both results highlighted a heavy weighting in the domestic market.

The first allocation would assume an 85% allocation to Dutch properties, 10% in European property and 5% invested in European listed property companies (assuming a portfolio return of 8% at a risk (volatility) of 4.9%).

To attain a portfolio return on 8.1% at a risk of 5%, the allocation to Dutch properties would be marginally less at 80%, with 15% in European direct property and 5% invested in European listed property companies. The conclusion of this analysis is that limited geographical diversification is required for Dutch investors.

However, this might not be the case for other European property markets. There are still very strong arguments that going cross-border adds to diversification. Short-term similarities should not be confused with long-term differentials.

Risk aversion continues in 2010
Given the more difficult borrowing environment and increased nervousness of investors, there is a movement by investors to work more closely with their fund managers. This can manifest itself in a number of ways, with investors frequently insisting on investor committee inclusion and participation. A large part of this increased focus is to ensure that no management style drift occurs, whereby managers move up the risk spectrum to achieve the required returns.

Property nevertheless is still an appealing asset class, but increasing allocations especially in direct property are not as easy as theory would suggest. Also, despite the growing appetite for property in a multi-asset portfolio, institutional investors are still risk averse, an aversion they show through more control over their investments. But they also need to be conscious what risk profiles they accept when investing overseas.
As we have seen, if everybody is doing it and doing it in the same way (with leverage and going up the risk spectrum), cap rates converge and the spread of returns between low risk and high risk narrows, thus making the case for overseas investment more difficult from a portfolio balance perspective.

The additional return and diversification benefits that overseas investments can bring can get too small for the risk being taken. In the example above, this was clearly the case and resulted in a high allocation to the domestic market. Overseas investments may therefore have their limits.

1 IPF ‘Asset Allocation in the Modern World', July 2007
2 In practice, nobody would accept this at face value. Issues such as pricing (valuation) accuracy lead asset allocators to question real estate's claimed low volatility.
3 UK Institutional Investors: Property Allocations, Influences and Strategies, IPF Research Report July 2010.
4 The long-term annual transaction volume in the UK is GBP33bn (DTZ, Investment Transactions Database).
5 UK Institutional Investors: Property Allocations, Influences and Strategies, IPF Research Report July 2010.
6 The volatility figures are a result of standard deviation of total return figures between 1995 and 2009 based on IPD/PMA and EPRA (for listed property companies).

Monika Ward is senior property analyst at AXA Real Estate