Despite dramatic falls in real estate markets the case for the asset class remains strong, with investor attention focused on how they gain access to real estate. Property derivatives have emerged as a strong contender say Daragh McDevitt, Pretty Sagoo and Peter Hobbs
The coming 18 months are likely to represent an excellent vintage for investing in real estate, given the ability to acquire good quality assets, the correction in pricing, and the prospects of a recovery over the following three to five years. In spite of this, many investors have become sceptical about the suitability of real estate in a multi-asset portfolio.
There are three main reasons for this scepticism. First, is the weak performance of the asset class and the prospect that this will continue during 2009 and 2010.
Second, is concerns that real estate has not acted was an effective diversifier through the current downturn.
Third, there have been concerns over the traditional way of gaining exposure to real estate, particularly given the illiquidity and poor governance of many commingled funds.
These concerns, coupled with the denominator effect, could be contributing to a reduction in the appetite for real estate exposure. By latest estimates, 58% of pension fund allocations to ‘Alternatives' were invested in real estate in 2008. This is by far the largest allocation to any single alternative asset class by pension funds globally, but represents a continuation of the steady reduction on the 62% in 2007 and the 66% in 2006.
Although these concerns exist, they warrant more detailed analysis before drawing firm conclusions that could impact asset allocation. In terms of the first concern, that of poor performance, the cyclicality of the real estate market suggests that it is precisely in periods such as in 2009/10 that represent the best vintage for real estate investing. As long as the global economy recovers through 2010-12, then it is extremely likely that property returns will be very strong during the period 2011-13, reinforcing the case for investing when the market is close to a cyclical trough.
In terms of the second concern, real estate's performance has suffered during the downturn, as have the majority of the constituents in a typical pension fund's assets. Within the asset class, while direct real estate has been one of the better performing alternative asset classes over the past year, listed property has performed poorly. The table below confirms the analysis, showing historical performance for a selection of alternative assets based on US markets and over the periods shown backwards from the end of May 2009.
Real estate is traditionally seen as a good portfolio diversifier on two different dimensions. First, in terms of diversification relative to other asset classes and, second, through diversification across different markets or geographies. During the credit crunch, while correlations of all alternative asset classes with equities increased, direct real estate maintained the lowest correlation of returns with equities and other alternative assets. This is demonstrated in the correlation tables that show asset correlations from 1998 up to the start of the credit crisis and during the course of the credit crunch (August 2007 to the present).
In general, correlations between asset classes increased significantly. However, direct property remained below 50% with all but one all of the other assets analysed.
Beyond the continued diversification benefits relative to other asset classes, it seems that there is some persistence in geographic diversification. Although more synchronised than previous real estate cycles, there continues to be significant geographic variation. This is particularly the case for the UK where the correlation in returns through the worst years of the cycle (2007-10) is no higher than 60% against any other market, and lower than 30% for a range of markets including Germany, Italy, France, Korea and Japan.
The UK is a peculiar case, given the severity of the correction in its market, but there are other significant geographic variations. Australia, for instance, is set to be through the worst of its decline by the end of 2009, while returns are not likely to turn positive in Japan and Spain until 2011.
The third concern of many investors relates to the options for gaining exposure to real estate, particularly given the illiquidity of many closed and open-ended commingled funds. During the current cycle, the illiquidity of commingled funds, coupled with the very low volumes of transactions, has posed significant challenges for many investors for whom liquidity has become a specific requirement through the cycle. These concerns over illiquidity have coincided with other weaknesses of commingled funds related to corporate governance and fees, and have led many investors to review the options for gaining access to the real estate market.
It is too early to assess the long-term implications of these concerns over the suitability of commingled real estate funds. It is likely that the largest investors will increase their direct real estate exposure, whether through mandates or separate accounts or through various forms of co-ownership. Such strategies will give the largest investors more control over their real estate allocations.
But, as shown in the table, they suffer from a series of limitations including their costs and the limited scope for diversification. Most investors have relatively small amounts of capital allocated to real estate and, for such allocations, it is difficult to avoid the risks of asset concentration without having exposure to some form of commingled fund.
Relative strength of different modes for investing in real estate
These fundamental challenges in gaining diversified and cost effective exposure to real estate means that for most investors the commingled fund will likely continue to be a preferred method for gaining exposure to the asset class. But the challenges of the fund model mean that many investors are likely to look at other options for gaining access to the asset class. The benefits of real estate securities or REITs are well established, and there is likely to be a resurgence of interest in this asset class as the market improves over the coming 18 months or so.
Beyond the benefits of REITs, a new option for gaining exposure to real estate has emerged over recent years - that of property derivatives. The property derivative market is at a fascinating stage of its evolution. On the one hand, there is a series of forces likely to hold back the development of the market, including investors' desire to avoid complex and structured products, concerns over counterparty risks and the still relatively low liquidity of the derivatives market.
Against this, there are a series of trends that suggest that the property derivatives market could eventually be set for a period of strong and sustained growth due to a series of advantages including: the ability to ‘short' the market, either speculatively or to hedge a given portfolio for a certain time; the elimination of the onerous documentation and due diligence required in the physical market; the ability to trade property within specific slots of time periods, perhaps not starting your exposure to the market until three or four years from trade date; the avoidance of property taxes and agency fees; the ability to express a view with immediate effect; and the ability to arbitrage different property assets -equities, CDOs, CMBS, RMBS and so on.
The emergence of the property derivatives market
Property derivative profits and losses, as their name would suggest, are ‘derived' from the physical property market. The gain or loss on the contract is calculated by referencing the terms of the contract against a specific property index calculated by an independent third party provider - for example, Investment Property Databank (IPD) in the UK or France, or the NCREIF index in the US. Investors and hedgers can trade against the future evolution of a property index by agreeing to exchange known fixed cash flows at specific points in time (typically annually) with payments that are derived via an agreed formula utilising the index. This formula is flexible but the most common variant is for the contract to pay the year-on-year return from the index versus annual fixed payments.
We show a schematic of this structure called a ‘total return swap' on property, in the diagram Schematic of cash flows in a 3y maturity total return swap on the IPD UK Index.
In the structure, a counterparty that wants to gain exposure to the IPD index agrees to pay a fixed rate per annum established when the swap is transacted, in return for a receipt of the index performance at annual points. The index performance is measured from December to December, and actual payments occur at some time after the reference points, to allow for the index values to be published.
The characteristics of the derivatives market mean they tend to be used for three broadly distinct purposes:
On the basis of the inherent attractions of the derivatives market, increased interest from investors and a series of regulatory changes, there has been a surge in the growth of the UK IPD derivatives market, with an outstanding notional of around £8bn (€9.4bn) as at the end of Q1 2009. The UK is the most liquid market with the French IPD, German IPD and US NCREIF NPI index also trading in smaller size, giving a total global notional value of over £9bn.
The turmoil facing the real estate asset class means many investors have raised concerns over its suitability in a multi-asset portfolio. Despite these concerns and the loss of value over recent months, this short article has demonstrated that, in reality, the asset class has performed relatively well through the cycle, both in relative terms and as a diversifier against other asset classes.
A potentially more profound impact of the current turmoil relates to the concerns over the suitability of commingled funds due to their illiquidity and governance. As investors look for other options for investing in real estate it is likely that co-investment and separate accounts will benefit, as will the REIT market.
Beyond this, it is the property derivative market that could be one of the main, if surprising, beneficiaries of the current turmoil.
Peter Hobbs is head of global real estate research, RREEF Alternative Investments;
Daragh McDevitt is global head of inflation and property derivatives structuring, Deutsche Bank; and Pretty Sagoo is director, pensions and insurance structuring, Deutsche Bank