Frédéric Ducoulombier presents the salient results of a major pan-European survey of institutional investors conducted by EDHEC with the support of Aberdeen Property Investors and Groupe UFG

The forthcoming EDHEC European Real Estate Investment and Risk Management Survey (1) looks at recent developments in the real estate investment industry, reviews academic evidence on allocation to and management of real estate, and analyses investor perceptions and practices in relation to market innovations and research recommendations. The present article is an exclusive preview of the results of the questionnaire-based study of investor practices which EDHEC carried out as part of its survey.

Between November 2006 and May 2007, questionnaires were sent to three types of European institutional investors: end investors (pension funds and insurance companies), diversified asset managers, and real estate specialists (real estate investment managers and property companies). The survey produced responses from 143 investors in 19 countries, with a total of more than €3trn of assets under management and more than €400bn in real estate assets.

Real estate is an asset class of its own that encompasses direct as well as indirect investment
All but one respondent acknowledged that real estate is an asset class of its own. By and large, investors include in this class vehicles for indirect real estate equity investment but have mixed views of real estate debt (see figure 1). The proponents of a restrictive view of real estate investment are in the minority: 4.2% of those who responded to our survey equate the real estate asset class to directly acquired properties and 14.7% believe that unlisted investments alone (through direct acquisition or funds) count as real estate. 72% of respondents acknowledge simultaneously the three modes of exposure to equity investments: direct acquisition of property, purchase of a share in an unlisted fund, and investment in listed property companies. Structured real estate products, investable indices, and real estate derivatives are given a favourable reception, as 67.8% of respondents accept these innovations as part of the asset class. Overall, 38.5% of respondents view real estate debt as belonging to the class, but this average is misleading: 63.2% of real estate specialists are of this opinion, as opposed to 29.5% of other investors.

Real estate investment policy (see figure 2)
Objectives: diversification, performance, hedging
For non-specialist investors, the three main reasons for allocation to real estate are for overall portfolio diversification (appears 27.2% of the time as a top-three justification), attractive risk-adjusted performance (20.5%), and as a hedge for inflation (11.3%). Overall, the various reasons linked to diversification are predominant; the search for alpha is secondary. The excellent performance of real estate over the last few years may account for this situation; in less favourable circumstances, investors may no longer be satisfied with market returns (beta) and may instead take a more discriminating approach (alpha).

Strategic allocation: 10%
Some 74.5% of respondents (excluding real estate specialists) view their investments in real estate as investments in a class of its own, while 23.5% invest opportunistically; the latter are generally smaller investors. The average target allocation - within a range of 5.7% to 13.5% of assets - is 9.9%.

Conventional pecking order among vehicles for equity exposure, marginal role for debt, and modest allocation to new products
The study of the vehicles used by investors for their allocation to real estate shows the limited role of pure debt products (3%), the respect for conventions of long standing among the vehicles for exposure to equity investment (direct investment: 50%; unlisted funds: 24%; listed real estate: 17%), and the still minimal importance of recent offers for structured products (2%), index-linked products (3%), and derivatives (1%).

The equal shares of direct and intermediated investment mask notable differences, as real estate specialists make direct investments with 75% of their funds - that is, twice as much as other investors do. Diversified asset managers put listed real estate ahead of unlisted funds and are more open to new vehicles for exposure.

The study reveals a positive correlation of portfolio size and direct real estate allocation that highlights the problems of directly invested real estate portfolios and identifies unlisted funds as the closest proxy for direct investment.

An absolute return orientation prevails, but relative benchmarks are commonly used for performance measurement
Some 80.6% of specialists and 52.1% of other investors report that they first set nominal or real absolute return objectives. However, 46.7% of the investors who take a mainly absolute approach to performance measurement also use relative return measures. Overall, 68.5% of survey respondents use relative return benchmarks as a primary or secondary gauge of the performance of their real estate investments, a finding that suggests that allocation to index-based vehicles could increase significantly above current levels. (See figure 3)

Detailed analysis of responses shows the appropriateness of benchmark choices: direct indices are used to track the performance of direct investments, property company indices are used to track the performance of investment in property companies, geographic indices are used to track the performance of investment along geographic lines, and so on. The IPD and NCREIF direct property indices enjoy monopolies in the regions they cover. The EPRA family of indices is by far the most popular for the assessment of investments in listed real estate—its only serious challengers are the indices supplied by GPR.

Sources of risk and performance: primacy of specific risk, importance of sector and geographic risks
Investors view idiosyncratic risks as the main factors behind the performance of real estate investments: for specialists as well as for non-specialists, the risk factor most frequently mentioned is that which refers explicitly to the specific features of the property (location, use, size, age, architecture, and so on). For real estate specialists, the other key factor that is made apparent is also specific - lease terms and tenant creditworthiness. These responses reveal a conventional approach to real estate investment, in the context of which specialists largely view the leverage for added value at the property level. Non-specialists identify property-type and geographic exposures as significant dimensions of risk.
Diversification, both by property type and by geography, is the sole appropriate risk management approach; a pan-European index would be invaluable.
Diversification emerges as the sole suitable risk management approach for real estate specialists and the most useful for other investors (see figure 4). Of the other possibilities, only limits on allocation to real estate find favour among non-specialists; principal-protected structured real estate products are deemed not very useful and derivatives get a wary welcome. Real estate specialists, who are unable to cap the share of real estate in their portfolios, consider derivatives and structured products even less useful.

Investors identify diversification by property type and diversification by geography as the two main approaches to diversification. For specialists, a third approach is grounded on financial analysis; style considerations (growth versus value, core versus value added or opportunistic) are important as well. For other investors, the third approach to diversification is by instrument or by manager, an approach that reveals the particular concerns of those investing indirectly in real estate. Some 65.6% of investors view an investable European real estate index or a derivative of that index as the best means to diversify the real estate portfolio of an institutional investor with a strong home bias.
The majority of the investors have no immediate plans to use derivatives; their investment policies, a lack of training, and the unsuitability of the products account for this figure
The majority (81%) of our respondents have no immediate plans to use real estate derivatives (see figure 5), 5% currently use them, and 16% plan to do so in the short term. Real estate specialists are less interested in derivatives, but their interest increases as the size of their portfolios increases. 50% of real estate specialists consider existing products unsuited to their needs. The other reasons for the failure of specialists to resort to derivatives are the investment rules in force in the respondent's organisation (for 42.9% of those responding) and, to a lesser degree, a lack of familiarity with the products (32.1%). For pension funds and insurers, the lack of familiarity with real estate derivatives is the primary obstacle to the use of these products (55.3%), followed by their unsuitability (34.2%) and by regulatory restrictions (31.6%). For diversified asset managers, internal investment policies are the main obstacle (42.9%), ahead of a lack of familiarity with the products (35.7%) and their unsuitability (28.6%).

The key success factors for real estate derivatives are index quality and contract liquidity
The transparency of the index underlying the contracts is the primary requirement. Investors also deem its representativeness very important -somewhat more so than its breadth. The liquidity/investability of the index is a noteworthy criterion as well, particularly among non-specialists. The main investor demand of the market - far ahead of demand for effective hedges, for cost-reduction capacities, and for a central counterparty to reduce risk - is for contract liquidity. Investors are unanimous in their rejection of indices based on the opinions of real estate agents and report an overall preference for constant-quality transactions-based indices.

The ideal real estate derivative: a medium-term, highly liquid forward contract on the total return of a domestic or international commercial real estate index of all property or of a single property type
Overall, investors prefer futures contracts, but it is swaps that account for nearly all of current market volumes. They are content with total return derivatives and there is little demand for disaggregating rents and capital values.

Real estate specialists have a neutral view of all-property index derivatives as long as residential properties are excluded, consider sector and sub-sector index derivatives somewhat useful, and have no interest whatsoever in derivatives linked to housing price indices. The pension funds, insurance companies, and diversified asset managers with significant real estate investments focus on sector indices of commercial real estate and are also interested in all-property indices; smaller diversified asset managers, by contrast, are drawn first to derivatives of all-property indices, then to property-types.

The bulk of demand is for derivatives at the country level, but there is also a significant interest in pan-regional derivatives; at best, investors are indifferent to the idea of a global real estate derivative.
All investors report high liquidity requirements with respect to derivatives contracts: the

three most frequently mentioned periodicities are monthly, weekly, and daily. Diversified asset managers may report the highest liquidity requirements, but—for their modes and horizons of investment—other investors have surprisingly high requirements.

The one-year maturity garners the most votes from all three types of investors. For real estate specialists, the next two most frequently mentioned are the five-year maturity and the three-year maturity. For pension funds and insurance companies, it is the two- and three-year maturities. Diversified asset managers have a short-term outlook, as their maturities of choice extend to at most one year.

(1)The document will be released at the London EDHEC Alternative Investment Days of November 20-21.

Frédéric Ducoulombier is associate professor at the EDHEC business school in Nice