Financing and currency risk must be managed to protect pooled fund returns, says
Cameron McVean

Indirect property investment has come under considerable scrutiny during the economic crisis. In the property bull market of the mid-noughties, a renewed interest in real estate as an asset class emerged, prompting a surge in the number of European pooled property funds - and capital flows followed.

But the downside of leverage, redemption delays and adverse currency movements - not to mention some dramatic falls in capital values and unexpected capital calls - prompted investors to line up at the exit door while returns suffered. More recently, as some European markets have started to recover, notably the UK, capital has begun to return to the unlisted property market; in the final quarter of last year, more than £2.5bn (€2.9bn) of capital came back into UK pooled property funds, according to the latest IPD Property Fund Vision Handbook.

In continental Europe it is a different story. As figure 1 shows, out of the 12 continental property markets for which IPD has published direct market indices, six delivered steeper annual capital depreciation last year than in 2008, while there is still little evidence of capital redeployment in Europe on the same scale seen in the UK. While leverage is typically lower, which is preferable in falling markets, currency swings can erode returns for investors based in countries with strong exchange rates.

Across the whole of Europe, the annual performance of institutional European pooled property funds in 2009 alone varied enormously - by a dramatic 100 percentage points in euro-denominated total return across the 1st to 99th percentiles - at 43.6% and -56.0%, respectively according to the IPD European Pooled Fund Property Indices. By comparison, in 2004 the performance spread was 53.6 percentage points.

Given the scale of the performance spread, it is worth looking a little deeper into what the causes of such variation are at a time when the wider market has, perhaps, been overly criticised. This article will examine the variables that can erode performance and the market environment over 2009, as some markets show signs that the worst - at least in the current cycle - may be behind us.

The truth about leverage
There was a rapid expansion in the European pooled fund sector in the early to mid-noughties. The explosion in indirect vehicles coincided with plentiful and historically cheap debt, financed through complex capital market structures. The combination of these drove up average leverage applied by pooled fund managers.

European institutional pooled funds, as captured by the IPD e-PPFI, show average fund leverage almost doubled in five years - from 14.1% at the end of 2001 to 26.3% at the end of 2006. Of course, this end period is six months before the credit crunch struck, in the two and half years following the mid-2007 turning point, falling capital values sent debt to equity ratios soaring further. Fund leverage, measured as a percentage of gross asset value, soared to a high at the end of June 2009 of 41.8%.

Dicing with debt, though, is a gamble - a distinct financing risk, separate to the core portfolio risks associated with assets, sector and country selection. The positive ‘extra' outperformance of leveraged funds in rising markets should always be considered alongside the compounding erosion of performance when markets nosedive.

The correlation between high leverage and poor performance is clear. Last year, the performance spread among the bottom quartile-performing funds was almost 45 percentage points - with annual returns ranging from -12.1% to -55.8%. These funds applied an average of 63% leverage, which is a huge 30 percentage points higher than the 33% all European institutional pooled fund average leverage. By comparison, performance among the top quartile-performing funds, with annual returns ranging from 6.8% to 43.5%, applied an average of 34.5% leverage. Financing risk, then, can be considerable and leverage without timing does not add value.

Figure 3 shows that leverage accelerated during the noughties. It reveals average leverage in European institutional funds turned the corner in the final six months of the decade, falling by almost five percentage points, at 37.1%, given a combination of improvements in underlying capital values and fund de-leveraging. Reducing the debt within pooled funds has been a considerable focus for the pooled fund community, in response to lower investor risk appetite as well as addressing loan covenant breaches.

Exchange rate problem
Currency risk is another powerful potential erosive influence on returns. Geographic diversification inherently increases the volatility of returns. For euro investors, the impact of currency movements over 2009 was significant for investors in UK-domiciled and invested funds. It was a year of two halves: the first six months saw sterling strengthen against the euro during a period in which capital values were still in decline. Investors, therefore, suffered from negative property performance but benefited from a positive currency impact when returns were converted into euros.

This position reversed in the second half of last year. The euro strengthened against local currencies during a period when property markets began to recover, notably in the UK. Positive property performance was, to some extent, diluted where converted back into euros.

To illustrate this, average returns for all European institutional pooled property funds over the six months to June were -9.1% in local currencies, which improved to -4.2% in euros. In the second half of the year, when the currency effects reversed, a six-month 4.5% local currency total return was eroded to 2.7% in euros.

The influence of currency on performance within the fund databank depends upon the domicile of investors and merits separate analysis. However significant the dangers are pooled fund managers can always hedge currency risk, but high costs can limit the appeal.

Retreat to core and value-added strategies
Return volatility will always be higher for cross-border indirect investments, but the investment appeal is certain to endure - and with good reason. Smaller investors can invest in otherwise inaccessible markets as well as larger lot sizes through a much broader spectrum of investment strategies. And, of course, as markets begin to normalise, the possible liquidity benefits of the route will return.

In uncertain markets, as well as slowly improving ones, there is a natural caution in capital allocation; investors scrutinise their investment options and stress-test potential strategies that bit more rigorously.

Often a part of this more prudent focus is a retreat to domestic markets. But data also play a part in helping analyse past performance, understanding performance attribution as well as in ongoing tactical strategy decisions.

When investing through European pooled funds, ensure currency and financing risk is managed. There is a strong correlation between GDP growth and investment performance, particularly on the downside. That is, where economies are contracting property markets tend to follow, so macroeconomic variables should be a central consideration.

Cameron McVean is head of fund services at IPD