In today's market, indicators of real estate performance are more keenly sought then ever before - but how effective are they? Paul Mitchell reports
The Investment Property Forum's (IPF) Consensus Forecast has provided an indication of the outlook for the UK commercial property market since 1998. Arguably, variations in the prices of the listed property sector/REITs can also provide such a measure. The emergence of an active property derivatives market in the UK now provides an additional measure of investor expectation. But how do these various indicators of property market performance relate to each other in practice and how useful are they?
These questions were addressed in two pieces of research undertaken for the European Public Real Estate Association (EPRA) and the Investment Property Forum (IPF) by Dr Shaun Bond of the University of Cincinnati and myself. The EPRA research asked the question: ‘Who is the best "forecaster" of IPD total returns, the IPF UK Consensus Forecast or the property derivatives market?' It should be emphasised, however, that it is debatable whether or not property total return swaps should be priced on the basis of forecast IPD returns. We abstracted from this debate and instead extracted, using the techniques widely employed by the property derivatives community, the IPD Annual Index returns implied by property derivatives prices. Further details of the methodology are in the reports.
The IPF research looked at the relationships and influences behind the IPF Consensus and the IPD returns implied by derivative market pricing, and also their relationship with the UK listed property sector. The thought behind this was that the direct market - specifically the property valuations embedded in the IPD performance indices - was slower moving. By contrast, the listed property sector might be thought to react more quickly to events that potentially affect the real, underlying value of property. Central to this, and characteristic of equity markets, are changes in ‘sentiment' - in particular risk pricing.
Looking first at the historical forecasts of IPD returns against the subsequent outturns, neither the IPF Consensus nor the property derivatives market has a good record. Both the IPF Consensus and the derivatives market at the beginning of 2006 under-predicted the year-end outturn, while they substantially over-predicted the outturns for 2007 and 2008 at the start of each respective year. Largely because of its better record in 2008, the derivatives market has been the superior short-term forecaster to date. This conclusion could well change when the 2009 IPD outturn (likely to be around -3%) is confirmed - figure 1 shows that the derivatives market started 2009 in an even more bearish mood than the IPF Consensus.
Regarding medium-term forecasts of IPD returns, figure 2 suggests that the IPF Consensus had the better record for the three years to end-2008. The IPF Consensus's three-year record is likely to be emphasised once the 2009 IPD outturn is available, although the derivatives market will be proven to have rightly downgraded its medium-term views very sharply in the second half of 2007.
What is behind these respective records? With respect to the one-year forecasts, the main source of error in the IPF Consensus for 2006 and 2007 was its inability to anticipate the risk premium, which property investors were (implicitly) pricing - this fell by more than the IPF Consensus was anticipating in 2006 and then rose more than predicted in 2007. For the one-year forecast for 2008, the IPF Consensus did not anticipate the large rise in yields in turn associated with a massive downgrading in expectations of future rental growth. This is somewhat excusable given the corresponding revision in economic forecasts during 2008.
It clearly is not possible to ‘look into the mind' of the property derivatives market. However, the derivatives market in the second half of 2007, and then again in autumn 2008, responded very aggressively to worries over the credit crunch, the banking crisis and the prospect of economic recession. It did this much more than the IPF Consensus. This is evident from figure 2, which shows relatively sharp downgrades in the derivatives market's medium-term views at these times. Furthermore, figure 1 shows how the derivatives market's gloomy view on 2008 was formed well ahead of the IPF Consensus.
More sophisticated analysis reveals that derivative pricing is generally more sensitive than the IPF Consensus forecast - when economic and rental growth expectations are being downgraded, the derivatives market changes its view more and similarly when ‘hurdle rates' and the risk premium are being revised.
Turning to the relationship with the listed property sector, past research has tended to find that the listed sector is the first to respond to events affecting the outlook for property and that this response then filters down to the direct property market. How does this work for property derivatives?
The listed sector's price was, up to the end of 2008, compared with the rolling five-year prospective IPD return implied by derivative market pricing. Somewhat surprisingly, what was found was that the property derivatives market led the listed sector in its pricing, meaning that the derivatives market reacts to factors affecting the perceived outlook for property ahead of the listed sector. This emphasises the earlier theme that the derivatives market reacts relatively quickly to events and in particular sentiment.
In conclusion, neither the IPF Consensus nor the property derivatives market has a good track record in anticipating IPD returns. Derivatives market had, on balance, a moderately better record than the IPF in anticipating short-term returns up to 2008, but 2009's experience is likely to undermine this record.
Using either the IPF Consensus or the property derivatives market as an indicator of short-term IPD returns is unlikely to be successful. For the IPF Consensus, this reflects the inability to predict sentiment. The derivatives market is prone to greater swings in this respect - something which helped in 2007 and 2008 but disadvantaged its view at the start of 2009. Anticipating and then accounting for the ‘real' impact of economic recession has been difficult for both.
Indications so far have been that the property derivatives market leads the UK listed property sector. It will be interesting to see if this trend continues.
Paul Mitchell is the founder of the Paul Mitchell Real Estate Consultancy