Recent market turmoil highlights the need to track the market and act quickly and efficiently on market expectations, says Jose Luis Pellicer
Pension fund managers have surely heard their property fund managers say things like: "We focus on alpha"; "We work our assets"; "We actively manage our buildings". Traditional property fund managers are experts in managing the specific risk of real estate, ie, the returns on a building-by-building basis - or alpha.
Nevertheless, very few real estate managers ever question market risk - also known as beta - or have a process to manage it. When asked, managers would talk about "timely sales" or "hold sell analysis", which are also "alpha-related" concepts.
But the recent emergence of the property derivatives market could change this. Managing beta requires an expertise in real estate market trends (driven by the general economy and the financial market) and relative performance across sectors/countries.
But property investment management companies do have this expertise in house - the research function. It is time for some researchers to become beta risk managers.Until very recently, the difference between a good and a bad property fund manager was a function of their ability to manage and maximise the alpha component of real estate returns.
This is not an easy job: a good fund manager has to have a feel for a good building, as well as an understanding of the location and specification factors that make a property desirable for tenants. The manager also needs to have a good command of lease structures, tax-efficient vehicles, planning regimes, urban structures, performance measurement concepts, etc. All this requires experience, numeracy, patience, vision and negotiation skills - not an easy job.
Traditional property fund managers tend to make two crucial conceptual mistakes. First, they tend to deny the law of large numbers. As property portfolios grow larger, the effects of active management typically become more blurred - some properties do perform, while others do not, as some tenants can go bust, some re-letting takes longer than expected, etc.
Consequently, as UK balanced funds grow in size, their annual performance tends to look increasingly like the market as a whole (measured by the IPD index). Indeed, the correlation between the total returns on the IPD index and total returns on many large balanced funds exceeds 95%. This is no more than the law of large numbers. Given the above, it is clear that property risks at fund level can almost completely be hedged by going short on a property index - managing beta risk is possible through buying and selling the index.
Second, traditional property fund managers tend to believe that their risks are minimised by having a portfolio with high income yields and high yield gaps (what a trader would call ‘positive carry'). This is, unfortunately, not the case. The main causes of fluctuation of real estate returns are the movements in market rents, market yields and portfolio vacancy.
These are independent of the portfolio yield gap, and more a function of the general economy and financial markets fluctuations. Indeed, the fact that there is a yield gap means that the portfolio is leveraged, which mathematically increases the volatility of returns and the risk. Consequently, managing property risks begins by having a view on the possible fluctuations of market rents and yields.
The current real estate crisis has demonstrated that property fund management is not just about maximising alpha or maximising income. As of H2 2007, many property market participants and researchers indeed expected 2007-09 to be years of poor and possibly negative returns. Yet very few have been able to act on these expectations. How could they? A traditional property fund manager could do little more than brace himself for the downturn, despite the apparent downside risks.
The manager could not afford to sell their portfolio and probably was under pressure to draw down committed funds. Also, the manager could not reshuffle the portfolio, as yields were so low that performance would have been severely dented if substantial new sales and acquisitions had been made.
But some real estate managers did do something. They hedged part of their property exposure using property derivatives, thereby locking in a return of circa 7% for 2006-09. As a result, while many traditional UK property fund managers are expected to suffer total returns south of -15% for 2008 and possibly 2009, the ones that used derivatives to hedge actually managed to maintain part of their portfolio in positive returns.
These few managers have in common a very strong research function where the head of research sits at board level, oversees the implementation of investment strategies and is fully embedded in the management of real estate funds. The head of research is able to recommend (and implement) early enough the use of property derivatives as a way of hedging real estate risk.
However, the research and strategy function should also include risk management. Property research is not just about setting up and communicating investment strategy, or about business development. Real estate research is also about helping fund managers to manage the beta risks of their funds from the top down.
A researcher's expertise relies on linking the general economy and financial market with the real estate returns. A good researcher should both develop a central and downside view on the short-term development of rents and yields across countries and sectors, and the potential effect of these on fund performance in the short to medium term, in order to develop a base and downside fund performance projection from a top-down perspective.
These projections should then be compared with property derivatives pricing on a monthly/quarterly basis. In this way the researcher can simulate the likely scenarios of fund performance - across all property, countries and sectors - and recommend the adequate derivative strategies that could lock in fund performance should the worst happen.
Many property funds already know what risk management is, as many already have a treasury department that manages interest rate and currency risk at fund level. Similarly, rent and yield movements at top-down level also have a strong impact on fund performance that needs to be managed using property derivatives.
Property researchers, fund managers and treasurers need to work together to make this a reality.
The fund manager is naturally long real estate, and property derivatives enable him to lock in a return for the next year in order to avoid the downside risks of rents falling and yield decompressing - indeed, a risk-reducing strategy for pension fund investors.