Investors in real estate have been rattled but Paul Kennedy, Eric Tazé-Bernard and Simon Redman explain that the case for the asset class remains sound in spite of recent developments
Developments in the global economy and financial market over the last nine months have led to a challenging environment for all investors. Uncertainty, associated with the consequences of the US sub-prime crises and the resultant slowdown in the US and global economies, has increased volatility and led to a reassessment of required risk premia. Specific consequences include net outflows from equity funds and a retreat from enhanced cash products. Increased volatility, combined with the fear of a prolonged financial crisis, have limited the appetite for equities, despite valuation levels that would be attractive under normal conditions. At the same time, bond yields that are close to historic lows have limited the attractiveness of government fixed-income securities, especially in view of a potential acceleration of inflation associated with easy monetary policies and elevated commodity and food prices.
Enthusiasm for real estate has also been damaged by these developments. Concerns have been exacerbated by an anticipated reversal of the robust performance enjoyed by real estate investors over the recent past and the view that prices in some markets may be excessive. Until the middle of last year, the global real estate market was enjoying a period of attractive returns. The strong performance of the global economy supported robust occupier demand and attractive levels of rental growth. Perhaps more importantly, the increasing dominance of cross-border investors has helped to enhance the accessibility of non-domestic real estate and contributed to the erosion of pricing anomalies.
At the same time, the growth of the unlisted fund sector opened up the global direct real estate market to a broader range of investor groups. The enhanced liquidity associated with this change both increased demand for and altered the investment characteristics of global real estate. In addition, increasing demand for the analysis of real estate markets improved the quality of market data and enhanced investors' understanding of the role of real estate in multi-asset portfolios and appropriate levels of relative and absolute pricing. In turn, this led to yield compression, which further supported interest in real estate as an asset class.
The above changes were accompanied by increasing levels of debt availability and, due to the expansion of the securitised debt market, reduced costs. These changes allowed investors to maximise the returns offered by their real estate investments, thus enhancing profits associated with the structural pricing changes described above.
However, this combination of structural change, supercharged by debt, has led to prices in some parts of the global real estate market which, given the recent reversal of investor sentiment and reduced availability of debt, have become difficult to justify. As a result, yields have already started to soften, particularly in the UK and parts of Spain.
With hindsight, the positive market sentiment of the period up to the early part of last year seems excessive, particularly for secondary quality real estate where risk premia fell to unsustainably low levels. However, there are also good reasons to expect current negative sentiment to be equally excessive. This view is supported both by history, which suggests that markets tend to shift from one extreme consensus to another, and by current pricing in the direct real estate market and in derivatives and securities. This suggests that attractive returns can be achieved even with relatively conservative underwriting assumptions.
While European GDP growth is expected to fall over both 2008 and 2009, we expect the slowdown in the US to be relatively subdued with growth bottoming out by Q3 2008 and gradually moving back towards trend over the following 24 months as the combined effect of substantial monetary and fiscal stimulus offsets the impact of a slowdown in the US housing market and problems associated with household and financial imbalances.
While European economies are likely to suffer from both US dollar weakness and more limited monetary and fiscal stimulae, the turnaround in the US should support an improvement in both occupier and investor market sentiment. When combined with a relatively attractive supply side position, this outlook suggests modest, but positive, rental growth over the next three to five years. On the yield side, our calculations suggest that changes since the middle of last year have either been appropriate or excessive.
As a result, the shift in real estate pricing experienced over the last six months and anticipated over at least the next year, may offer some excellent opportunities to secure quality assets at attractive prices (for example, via forced sales or profit taking). In addition, investors may be able to benefit from an excessively negative approach to the pricing of risk (such as by targeting assets with asset management opportunities or cash flow breaks).
Given the global nature of the pricing changes described above, these opportunities are likely to be available in most markets. However, we expect them to be greatest in markets with marked exposure to the housing market and financial market consequences of the sub-prime crisis (like the US, the UK, Ireland and Spain).
In addition, while the strong performance delivered over the recent past may have been accessible to any investor willing to take bold and rapid acquisition decisions, future returns are likely to be based on the application of more traditional real estate skills of prudent stock selection and innovative asset management. For investors seeking exposure to real estate via funds, this change highlights the importance of selecting fund managers with particularly strong local platforms.
The timing-based opportunities suggested above are augmented by strong arguments supporting real estate's role as a portfolio diversifier. Most surveys* tend to show that, at under 10%, allocations to real-estate in institutional portfolios are lower than recommended by the academic literature* (up to 20%). As a result, the pricing changes outlined above may offer investors an excellent opportunity to enhance their exposure to real estate at increasingly attractive pricing levels. The high allocation to real estate recommended by academic studies* is based on two key arguments: diversification and accessibility.
First, total returns from real estate can commonly be divided into bond and equity components. As a result, real estate benefits from volatility levels between those of fixed income and equity investments. This characteristic limits the correlation of real estate returns with other asset classes and, therefore, enhances diversification opportunities. Real estate's low correlation ratios both with other asset classes and between sub-sectors of the real estate market (such as different countries, types of real estate) are driven by the diversity of real estate markets (for example supply side constraints, differences in occupational patterns).
Using the UK as an example, over the period 1971 to 2006 the correlation between UK equities and domestic real estate was 19%. Over the same period, the correlation between UK gilts and real estate was only 3.5%. In contrast, the correlation between UK gilts and equities was almost 62%. Within real estate, various studies suggest that historic returns from European real estate markets have been between 50% and 60% correlated with those from comparable US markets. (Source: Invesco Real Estate calculations based on IPD data. February 2008).
Second, over the last decade, global real estate markets have undergone a substantial transformation. It is now possible to obtain meaningful performance measurement information on institutional quality real estate in 14 European countries. In most countries, performance data are available for at least one real estate cycle. In some (like the UK), data are available for over 20 years. In addition, Investment Property Databank (IPD) is working to expand its coverage to include institutional quality assets in the main central European real estate markets (Poland, Hungary, Czech Republic and Slovakia).
In addition, the consolidation of the main advisory companies (such as Jones Lang LaSalle, CB Richard Ellis and DTZ) into pan-European and global businesses has been accompanied by substantial improvements in the quality and consistency of prime market data available to market participants. While national conventions remain, it is now possible to produce meaningful pan-European comparisons of variables such as rent, yield, stock, vacancy and take-up. Data are also available on transaction volumes and trends. In addition, the expansion of respected forecasting companies such as Property Market Analysis (PMA) and Property & Portfolio Research (PPR) into Europe has further improved the quality of market data and analysis available to both domestic and overseas institutional investors.
Of equal importance are changes to the European unlisted and listed real estate fund markets. On the unlisted side, there has been a dramatic increase in both the number and diversity of real estate funds available to investors. According to Property Funds Research, the European unlisted funds market increased from 42 funds with a Gross Asset Value (GAV) of around €27bn in 1980 to almost 820 funds with a GAV of in excess of €415bn by the middle of 2007. In addition to enhancing the range of options available to all investors and improving the availability of market expertise, this change has enhanced the accessibility of European real estate to both large non-domestic investors and smaller local investors.
Importantly, the development of the unlisted funds sector in Europe has been accompanied by the generation of fund structures that are favourable to a wide range of investor groups and nationalities and by the establishment of independent industry bodies such as INREV (the European Association for Investors in Non-Listed Real Estate Vehicles), which seek to represent investor's interests, and improve the accessibility and transparency of the non-listed sector (for example, through standardisation). In addition, to cater to an increasingly sophisticated client base, real estate fund managers have developed in-house fund structuring operations to ensure that their clients' investments are optimised for tax and debt. Moreover, real estate investors have adopted increasingly sophisticated approaches to risk characterisation and management that, arguably, may be superior to those applied to the other main asset classes.
Other important changes to the European real estate market over recent years include the development of real estate investment trust (REIT) structures in a number of countries comparable to those available in the US and other parts of the world. In addition, prior to the recent credit crunch, the European commerical mortgage-backed sector (CMBS) market was growing rapidly, enhancing investors' access to real estate debt and increasing the range of available leverage options. More recently, the creation of a real estate derivatives market in the UK in 2005 has contributed to the development of similar products in the US, France, Germany, Australia, Japan and Switzerland.
While the conclusions summarised above are robust, they need to be placed in the context of a number of challenges presented by real estate's characteristics, which limit but don't undermine the case for real estate investment outlined above.
First, the method by which real estate returns are calculated using valuations rather than transactions means that performance is smoothed and, as a result, correlations with other asset classes are probably understated.
Second, while capital growth from equities and bonds can be accessed by selling individual securities, real estate appreciation can only be converted into cash by selling the entire asset. In addition, the "lumpiness" of real estate means that it can often take time to achieve estimated valuations and as a result, investors run the risk of delivered returns with characteristics that differ from those implied by the correlation data.
Finally, real estate investors often use debt to either enhance returns or hedge currency risks. Leverage alters the risk return characteristics of real estate investments and, therefore, may suggest a different portfolio role than implied by the correlation data detailed above.
Having provided detail on the current investment environment and how it links in with the rationale and quantum off allocations to real estate it is important to consider the practical ways this can be achieved. As already mentioned above, real estate has attributes that are compelling in terms of its potential to provide risk diversification in a multi-asset portfolio, but it is these characteristics that cause problems when seeking to execute a real estate allocation.
The key issues are that direct real estate cannot be traded and or easily divided into smaller saleable units. What this means is that, unlike liquid, divisible assets, smaller investors have a restricted number of options. The very largest investors have the widest range of possible options, whereas small investors have a quite restricted and arguably imperfect choice. Furthermore, if different regulatory regimes are also factored in, the ability to implement a strategy can be very restricted.
However, these issues should not put investors off real estate as an asset class because, not only are the investment attributes compelling but, as suggested above, the real estate industry has and is making very significant strides to make it a more accessible asset class through an increasingly wide number of options for investing in international real estate including large-scale, institutional, regional or global opportunity funds, sector specific funds, fund of funds and geographically diversified funds, real estate securities, significant levels of cash and increasingly real estate derivatives.
In summary, despite recent market developments, our analyses point to continued opportunities from real estate in Europe and elsewhere. In some markets (such as the UK), an excessively negative reaction to current uncertainties means that some assets offer attractive risk adjusted returns. Given that real estate has a long-term strategic role in investment portfolios, and that this has arguably been enhanced by improvements to the accessibility and transparency of the asset class, current uncertainty may offer investors an ideal opportunity to increase their current allocations
• Ball, Lizieri and MacGregor, 1998, ‘The Economics of Commerical Property Markets'.
Where Paul Kennedy, Eric Tazé-Bernard and Simon Redman have expressed their own views and opinions, these may change and are not necessarily representative of Invesco views.
Paul Kennedy is head of European research at Invesco Real Estate
Eric Tazé-Bernard is CIO multi-management at Invesco Asset Management
Simon Redman is head of business development at Invesco Real Estate