With multiple access points, property investors can maximise investment benefits in different markets at different stages of the investment cycle. Joel Cann and Shong Chua report
The four-quadrants model is a way of simplifying the increasing number of access points to property exposure. It consists of two investment dimensions: equity and debt exposure; and private or public access points to investments. Some investors classify debt investing as part of their property allocation; others may describe it as a higher-yielding portion of their fixed income portfolio. Asset-backed property securitisations have fuelled timely and cost-effective financing during this property cycle. Investors are able to access different tranches of asset-backed products depending on their risk-return requirements.
Private property debt market is another traditional access point to property investment. The key players in this quadrant are banks, mortgage providers and mezzanine financiers. This article focuses on equity investing in property, or in other words, the top two quadrants.
Today, property investors have the flexibility to tailor their overall investment strategy to manage diversification, duration, gearing and liquidity against a risk/return benchmark. The development of new investment access points enhances investors' ability to explore and manage various strategic and tactical allocations as opportunities arise. They can now benefit from differences in the timing of property investment cycles within sectors and locations, as well as exploring the arbitrage between private and public markets.
As of end of 2007, DTZ estimates that 82% of the global real estate capital markets were held privately and only 16% listed. However, at first sight, some of these exposure forms may not exhibit similar risk and return characteristics as the underlying property markets. In this paper, we discuss the characteristics and relationship between various forms of ownership, or access points. We will also share the portfolio strategy implications and our experience in implementing the same.
Property access points and portfolio implications
Direct investment: As many studies analysing the benefits of property exposure are conducted using direct property indices, this strategy offers the "true" diversification benefits - if implemented correctly. We believe the main benefit of holding property directly is the ability to control and to manage assets actively - managing income enhancement activities and investments/disposals decisions. We believe, investors should view direct property holding as a means for short to medium-term liquidity. In many cases direct holding of property offers tax transparency for institutional investors.
However, direct property is characterised by large lot sizes, heterogeneity, high transaction costs, high management costs and illiquidity. Heterogeneity creates low correlations and high specific risk in the return performance of individual properties. Clearly this is a constraint that applies most markedly to smaller investors. Research indicates a portfolio needs at least 20-50 assets to largely eliminate specific risk exposure to any given market. Additionally, many investors lack the internal capabilities to implement intensive portfolio and asset management initiatives. When venturing into international markets, investors face informational inefficiencies compounded by differences in regional or local practices.
Private property funds: Another access point is the private property fund market - purpose-built investment vehicles established by third party fund managers solely to place investor capital into the property market through a range of strategies. These funds can take a number of different forms, from specific legal forms (German open-ended funds) to classic private equity structures. The latter are typically closed-ended structures with a pre-defined duration domiciled in tax jurisdiction favourable to intended investors.
From an investor standpoint, real estate funds offer several attractive characteristics:
Diversification of specific risk (divisibility of assets). By pooling investments, the same unit of investment is subject to less risk than if directly invested.
As funds are unlisted, the return pattern of the investment should exhibit a high degree of correlation to the underlying real estate market and, consequently, offer the diversification benefits of direct property holding. This conclusion is supported by comparing the monthly returns of the UK Property Unit Trust index (PUT) with the monthly IPD index (proxy for performance of direct property holding). The two indices are highly correlated (0.97), but the PUT index has a higher mean return and standard deviation due to the fact that the PUT-funds have a degree of leverage (Figure 3).
This leads us to another advantage of property funds. It also provides debt-constrained investors access to the ability to gear an exposure. Of crucial importance, however, is that the diversification benefit to other asset classes is retained when leverage is introduced. Our research indicates that in most countries, the diversification benefit remains up to a leverage of 70%.
Making an illiquid asset liquid is not without its inherent problems, and there has been a tendency for institutional vehicles to opt for closed-ended funds. An open ended structure must be ready to manage potential investor redemptions. As transacting the underlying asset (ie: physical property) can, at the best of times, take from three to six months, the fund must carefully consider how it can meet this potential outflow of capital. One disadvantage with closed-ended funds is the lack of formal liquidity, even the secondary market is still a market in its infancy. The main challenges faced by these closed-ended funds are at exit, when portfolios are liquidated at one time. At this stage, the IRR target of the fund is either fulfilled or not, transparency on actual return during the holding period is vague at best.
Strategy implications
Today, an investor can chose from a mix of direct property investments in markets where information asymmetries can be managed while adding niche private fund investments as satellite investments. For investors lacking internal resources, third-party mandate awards or investment in third-party funds should play a major role in its core strategic allocation. With the information asymmetries and management risk transferred, investors are then able to maximise the benefits of investing in different property markets at different stages of the investment cycle. Heterogeneity between and within markets simultaneously provides choice and diversification.
Property equities
Listed property companies: Some investors may consider investing into the listed property sector as a means of addressing the obvious disadvantages of direct property ownership. Listed property is priced more frequently, has an inherently higher degree of liquidity, lower transaction costs and lower degree of information asymmetries. Emerging markets also offer opportunities to gain exposure to certain regions, countries and assets in a liquid format.
However, this portion of the listed property sector suffers from taxation issues as the companies pay corporate tax. Additionally, listed real estate has not the same diversification benefits as directly held real estate, at least not on a short-term holding period. It tends to be more volatile than direct investments as the listed sector is priced instantly in a broader equity market environment that can suffer from high volatility. The short-term valuation of property securities is subject to relative sector views from specialist and generalist equities investors, and less directly to the valuation of underlying assets. Due to the thin trading volumes in most property stocks (as most property stocks are classified as small cap stocks), this pricing mechanism allows pricing of the shares to deviate from the value of the underlying assets for long periods.
If the investment holding period is extended, linkages between listed property equities and the direct property market increases. This would indicate that the valuation of listed assets approaches the fundamental valuation over time. However, the correlations are far from perfect and not always evident in all investment markets. The volatilities of listed property and direct investments converge (but do not meet) as the holding period is extended. An explanation may lie in the fact that there are substantial differences in property-type mix, the listed property sector usually adopts a higher level of leverage and undertakes much riskier development and leasing activities.
Real estate investment trusts (REITs): For all intents and purposes REITs, and their relatives outside the US, are listed real estate companies, but with the important difference that they are tax transparent. Thus, the double-taxation disadvantage associated with listed real estate stocks is alleviated. From a portfolio construction perspective however, the more important disadvantage is that REITs offer less diversification than directly held property still remains (depending on the holding period).
Strategy implications
Holding period: Extending the holding period of listed property shares may cause the investment to exhibit higher correlation to the underlying market, although to various degrees and not in all markets. This has implications on the strategy options open to investors regarding intended holding period and also timing the original investment.
Timing differences of cycles between the access points: Capital markets theory would predict that mispricings, which are at times quite significant, would induce investors to exploit the differences in pricing between the two markets. At times when the public real estate is traded at a discount, investors would take the listed property assets out from the stock market, and trade them on the underlying market, thus reducing the discount. At times when public real estate is traded at a premium over private real estate, this would induce investors holding real estate assets to introduce the assets as a listed real estate company, thus reducing the premium on the listed sector. This arbitrage behaviour would force a harmonisation of the pricing of the assets through market forces.
This is also how the market works. In recent years the listed sector has traded at a discount to the net asset values of the underlying assets. This has led to a number of listed property companies in Europe de-listing, thus over time forcing the pricing to return to the fundamental value. The interesting part of this puzzle is that market forces in real estate tend to work with significant time lags.
Use listed sector as a mean of tactical exposure and liquidity reserve, but with an emphasis on retained diversification
To the core portfolio, one may also use listed real estate as satellite strategies and liquidity reserves. Figure 7 illustrates the correlation to the direct market for a portfolio of initially only direct assets, but where an allocation to the listed real estate sector is incrementally increased (blue curve). The effect on the risk adjusted returns is described by the grey curve. The portfolios are equally weighted over four countries, the UK, France, the Netherlands and Sweden. Smaller allocations to listed real estate have a minimal effect on the correlation to the direct real estate market, while the cost in terms of loss in efficiency of return is slight. As the increasing percentage of listed property stocks is added, the portfolio starts to lose correlation against the direct investment market - at a level of 20% listed property; we are still experiencing approximately 0.9 correlations, but at level of 50% listed property, the correlation decreases to 0.7. We believe the correct listed property allocation depends on liquidity requirement from the investors and also opportunities available in the different access points to property investment. We believe a matured property investment programme should not have more than 20-30% of its allocation to listed property.
Property derivatives
Property derivatives are structured to mimic the return of underlying assets. As such they offer the same diversifications as do direct property investments, but at a significantly lower cost, without the management risk. Thus, for an institutional investor, property derivatives may look like a plausible route to obtaining beta exposure. However, one of the major drawbacks is the lack of supply of the product based on direct property market, especially sub-index products. The derivative instruments being applied to the real estate market are usually structured on the basis of a well established index, thus ensuring that there are no moral hazards with the pricing of the underlying assets. Currently, there are limited established indices for global direct investment. Additionally, and unlike the listed market, a direct portfolio often differs in composition to an index portfolio - hence mis-hedging occurs. In this perspective, the market in listed property derivatives, such as ETFs and EPRA index-derived options, is much more developed.
Strategy implications
Property derivatives are a plausible route to exposure to different real estate quadrants, and can also act as a return amplifier (much like gearing). Investors can also apply long/short strategies as well as hedging initiatives based on their underlying exposure.
Joel Cann is director and Shong Chua is head of quantitative analysis at Aberdeen Property Investors
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