Unlike other listed property companies, most REITs do not usually trade at a discount to NAV. And why should they? It is time for European REITs to fulfil their potential, Robin Goodchild says
Not another piece about the credit crunch, might be a typical reaction. The biggest banking crisis since the 1930s has certainly caught the markets by surprise and many of the recent innovations in financial instruments are now causing big problems.
Last year a piece in this journal commented on ‘the avalanche of innovation' in the property market during this decade. Now is an appropriate time to review how those innovations are holding up in the perfect storm from the credit markets.
The three innovations identified were:
All have significantly improved access to the real estate market but are they still performing as expected?
The credit crunch has had, and will continue to have, a significant impact on Europe's real estate market. Contrary to popular opinion, not all the effect has been adverse. The collapse in credit availability and the rapid change in sentiment from risk seeking (greed) to risk aversion (fear) has prevented a speculative building boom, with its inevitable consequences. Even so, the City of London and Barcelona will see rising vacancy thanks to a significant number of projects having been started over the last 24 months. Elsewhere, the lack of supply will ensure that office rents are more stable during the coming cycle than usual and particularly in comparison with the 2000-2004 period.
The main impact of the credit crunch has been on pricing. All parts of the real estate market have felt pain but the REITs have been hurt most. The GPR 250 records a ‘return' of -31.2% for Europe in the 12 months to 31 March 2008 and all national markets show a loss. However, returns were still healthily positive in the medium term (see table).
The rapid collapse in REIT pricing during 2007 preceded the problems in the general stock market and, in fact, European REITs have outperformed significantly this year. One reason suggested for this rapid sell-off, before the credit crunch took hold, was that private funds were using their liquidity buffers. A number of private funds that focus on the retail investor hold REITs and other securities as a buffer from which to meet redemptions. Sales from such funds may have been a material factor in the rapid fall in REIT pricing during Q2 last year.
But this does not explain why some investors wanted to redeem from the private funds in the first place.
A wholly technical factor was a major cause. In the unit trust world, there is a margin between the price at which units are bought and sold - the bid-offer spread. This spread is wider on property funds than for other types of investment because transaction costs (including transfer taxes) with the underlying assets are much higher than for stocks and bonds.
But in this world, when a fund is receiving strong inflows, any investor who sells receives the ‘offer' price because their units can be sold to a new investor. When the inflows subside, the pricing for sellers switches back to ‘bid'.
This is what happened to a number of UK property funds in May 2007. But the media reported the switch as a 6% fall in property values - the difference between the ‘bid' and ‘offer' price. Not surprisingly, many investors were spooked by the headlines and this caused the redemptions to increase significantly. Yet property values were still rising in the direct market. The problem was that, until then, sellers received too much for their units because they were paid above net asset value (NAV). Private funds are intended to be a very close substitute for direct ownership but no direct owner can obtain this premium.
It would be more equitable for all unit holders when inflows are strong, if sellers received a maximum price of NAV and the difference between this amount and ‘offer', went into the fund's reserves. However, this change would make the rules for property funds different from other unit trusts and much of the recent innovation has been designed to achieve the opposite.
The property industry has been seeking to create a private vehicle that combines the risk-return characteristics of direct property with the liquidity of a conventional fund.
This time last year, some people believed that this holy grail had been achieved. Unfortunately, recent events have shown that conclusion to be premature. Moreover, the fund of funds managers have found that the secondary market in private funds has dried up, so their ability to adjust their portfolio's shape is severely constrained.
The derivatives market, at least in the UK, is able to meet this gap but liquidity is very limited and investments are for pre-defined periods. For many investors, and particularly for those that require daily trading, REITs are a much better answer whether through an active manager or passively with ETFs. While returns will be more volatile than direct property, they do closely reflect them over the medium term (see chart). There is always a trade-off between liquidity and volatility in any investment and, for many investors, REITs are a much better solution than private funds or direct ownership.
But there is another reason to have a hard look at REITs today - current pricing. Most companies across Europe are trading at a meaningful discount to NAV, so that real estate on the screen is better value than on the street.
Some equity analysts believe that REITs should trade at a permanent discount to NAV, as taxed property companies did in the past, but they have not absorbed the latest evidence. US REITs have traded on average at a small premium to NAV since 1995, when the modern REIT market first emerged, and other markets have seen similar behaviour on introducing a REIT.
Anyway, why should a portfolio of shopping centres, with gearing and management attached, trade at a permanent discount to NAV when bundled into REIT, while investors have no problem paying NAV if the same assets are in a private vehicle structure? It is nonsensical, particularly having regard to the much greater liquidity of a REIT.
Perhaps the 2007/08 credit crunch will be the catalyst for the European REIT market to achieve its full potential, just as the early 1990s crisis was for today's US REIT market.
Robin Goodchild is head of European Strategy, LaSalle Investment Management