The logic of logistics
Richard Holberton explains why logistics real estate should play a larger role in institutional investors' multi-asset portfolios
We are living in an uncertain economic and performance environment where investors often tilt their asset allocation and portfolio decisions towards defensive assets - those whose future performance is predominantly underpinned by long-term, contracted income as opposed to prospective growth.
Or, put another way, they seek bond-type rather than equity-type investments. This is certainly a strong feature of the current European property investment market. As an asset class, property does not fit neatly into the conventional equity-versus-bond analysis, since its cash flows contain elements of both, albeit to differing extents in different market sectors.
Prime high street retail investments, for instance, that typically trade at relatively low income yields, may be considered equity-type assets since more of the investment reward is composed of capital growth rather than contracted income. Industrial and logistics property, by contrast, generates most of its return through income and may be considered as more of a bond-type investment.
This alone makes the sector attractive to certain types of investor, but the sector's performance history in Europe is also persuasive. Over the past 10 years, industrial and logistics property across the euro-zone has generated an average income return of 7.8% pa, compared with 5.5% for offices and 6.2% for retail (according to IPD).
From a more qualitative perspective too, the sector appears to be finding favour with investors. In the recent CBRE Real Estate Investor Intentions Survey, the industrial and logistics sector emerged as the preferred investment sector in 2012 for 20% of investors. This compares with less than 14% the previous year, and contrasts with declines in the relative popularity of the office and retail sectors.
Despite all this, the industrial and logistics sector still comprises less than 10% of the European investment market, and even this figure is an increase on the proportion that was typical in the mid 2000s. Which begs the question: to what extent should the sector's characteristics affect investor behaviour towards industrial and logistics property? And how does the industrial and logistics sector sit in the context of current actuarial recommendations for different types of investor?
To examine the industrial and logistics sector's credentials more rigorously, CBRE collaborated with consultants Mercer (CBRE is indebted to Stephen Ryan and his colleagues in the real estate team at Mercer for their collaboration in this analysis) to apply statistical and actuarial techniques to its performance record, alongside both other real estate sectors and paper assets. There is little precedent here: the focus of much prior debate and analysis has been on real estate's investment characteristics in aggregate, with less focus given to the specific income and capital characteristics of different property sectors.
Moreover, institutional investors come in many forms and have a range of motives for investing: many are liabilities-driven, while others look to generate returns that match or exceed inflation; others have a primary need for regular income. A multi-dimensional approach is therefore needed.
Four investment dimensions
Institutional investors come in many forms, including pension funds, endowment funds, sovereign wealth funds, private banks, family offices and insurance companies. Across this group, there may be a range of motives and priorities for investing, including diversification and capital preservation.
We approached the issue from four different perspectives:
• inflation-related returns
• efficient total returns
Income-oriented investors will typically prioritise regular cash payments over potential future capital gains. Such investors may need the income to cover regular or future expenses, or may simply perceive income-dominated returns to carry less risk than returns driven by prospective capital gains. This portion of the analysis looked at historic income returns for a range of national markets plus prime yield data aggregated at EU-15 and EU-27 level, and also compared income returns against other asset classes.
Investors who prioritise inflation-related returns are not necessarily seeking exactly the same things. There may be some who seek inflation hedging in the strict sense of the term: that is, an investment that either exactly matches inflation or is guaranteed to give a return in excess of inflation - in the main such investors will be disappointed.
For these purposes, inflation-related returns are intended to denote returns that have a substantial probability of outperforming inflation in the long run. To analyse this dimension we used the correlation coefficient between historic total returns and historic inflation as the test using long-term data from the US and analysis from two other major markets, Germany and the UK.
Institutional investors focussed on liability-matching include insurance companies and pension schemes, although the liability-driven approach may also be used for high net-worth clients such as family offices and those served by private banks. Such investors will need to be able to pay liabilities as they fall due and match, to the extent possible, the interest rate sensitivity of those liabilities.
The key measure in this area is modified duration, which is a measure of the sensitivity of the value of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. For example, a duration of seven years signifies that the approximate expected percentage change in price is 7%, given a 1% yield change.
Real estate does not have "duration" in the true sense, partly because its income is not fixed, and it does not have a fixed redemption date or value. However, sensitivity to interest rate changes can be simulated by assuming a fixed holding period and reasonable estimates of future cash flows.
Efficient total return seekers look to achieve the maximum return for a given level of risk or, conversely, to minimise risk for a given level of return. Return here can mean an absolute return, or return relative to an appropriate risk-free rate. There are several financial ratios that may be used to identify the relative suitability of industrial and logistics assets in this dimension, and this analysis used the coefficient-of-variation, which is a normalised measure of dispersion of a probability distribution. In effect, this measures risk per unit of return, so a lower number is better.
Key findings and recommendations
For income-oriented investors, real estate as a whole does well on income generation compared with equities and bonds, where yields in the 3-5% range are the historic norm (compared with 4-8% in real estate). Comparing the historic income returns of industrial and logistics with that for other real estate sectors in multiple markets, we ranked the three sectors best, mid or worst.
In every case, industrial and logistics was best (that is, ranked one of three where one is the best and three is the worst). Since real estate ranks ahead of other asset classes, industrial and logistics' position at number one in the rankings holds at a multi-asset level as well. Income-oriented investors who prioritise regular cash payments over potential capital gains should consider substantial exposure to industrial and logistics property.
Life assurance companies active in the annuity market might fall into this category, while the sector might also be of particular interest to endowment funds and charities, or institutions such as private banks that need income solutions for their clients.
To examine inflation-related returns, we used regression analysis performed on a sector-by-sector basis, initially using the NCREIF index from the US, which indicated that industrial and logistics is worse than the office sector, but better than retail. One possible explanation is the long construction lead times in the office sector give rise to supply constraints when material and labour costs are rising, so giving a performance response in periods of high inflation.
Industrial and logistics, with its short construction cycle, low relative construction costs and hence high elasticity of supply, does not have this characteristic and is generally better able to accommodate demand pulses via the supply side.
Findings for the UK and Germany were not wholly consistent with this, but in general it is possible to state that real estate and equity are clearly preferred to nominal bonds and cash on this criterion, and that real estate - including industrial and logistics - is likely to prove strongest over medium-term periods of up to 10 years.
Investors seeking inflation-related returns, such as endowment funds, should generally consider tilting their portfolios away from nominal bonds and towards real estate, within which industrial and logistics is likely to be a core element. Weightings in the other property sectors can then be gauged by analysis of these sectors' inflation sensitivity on a market-by-market basis.
For liability-matching investors, the analysis calculated modified duration for an assumed 10-year holding period, historic income returns for a broad selection of European countries and yield data for the EU-15 group of European countries. On this basis, industrial and logistics has the lowest duration of the three sectors: 6.9 years compared to 7.5 years for both retail and office. Simulations based on a longer 15-year holding period confirmed these results.
Based on this analysis, industrial and logistics is likely to be better suited to shorter duration liabilities. At multi-asset level, too, this broad conclusion also appears to hold: bonds are the clear leader among the asset classes when it comes to liability-matching, and equity has the longest duration.
On this criterion overall, liability-matching institutional investors who favour real estate as a complement to bonds within the matching portfolio should consider industrial and logistics. Very mature defined-benefit pension funds and fixed-term annuity providers, for instance, would fit this category. Industrial and logistics property in this sense should complement rather than replace bonds.
The analysis of efficient total returns began by comparing the efficiency of industrial and logistics with that of retail and office sectors in twelve markets, using the coefficient-of-variation measure described above. Ranking the three property sectors best, mid or worst, industrial and logistics finished with an average ranking of mid (that is, ranked two of three where one is best and three is worst), indicating that overall it was neither the best nor the worst sector in terms of risk per unit of return, measured over the 10-year period analysed.
However, it is worth noting that the industrial and logistics sector emerged most favourably for the UK market. Broadening the focus to include non-real estate asset types, and based on historic risk and return statistics for Europe as a whole, the efficiency rankings are as follows: retail in first place; industrial and logistics in second place; offices and cash in joint third place; equity in fifth place; and bonds in sixth place.
Overall, industrial and logistics achieves a middle-ranking position against other property asset types on this dimension, and real estate in general may offer efficiency advantages over other financial asset classes. Such investors should consider tilting their real estate portfolios towards industrial and logistics assets rather than simply adopting index weightings. This should be of interest to asset allocators working in institutions such as private banks, family offices and sovereign wealth funds.
The application of actuarial-style analysis and thinking to the sector's performance record highlights some clear aspects of its investment rationale, and clarifies how industrial and logistics can make a viable and attractive investment option for a range of different investor types.
One very clear conclusion is that a greater understanding of the sector's investment characteristics and performance features is relevant to a wide range of investor types, and should form a more prominent part of portfolio strategy formulation and management for a broad spectrum of investors.
Clearly, some of these characteristics are well understood - particularly the sector's advantageous income return - but others are less well recognised, sometimes even by investors with existing exposure. With industrial and logistics accounting for roughly 10% of the European investment market, there appears to be plenty of scope to raise capital allocations to the sector.
Overall, we recommend that institutional investors should consider:
• Substantial exposure to industrial and logistics within income-oriented portfolios
• Core element of industrial and logistics to generate inflation-related returns
• Use of industrial and logistics to complement bonds in liability-matching
• Focus on fundamental characteristics of sectors for improved efficiency
A further insight is that market participants in the sector would benefit from ‘speaking the language' of institutional investors. For most this is not a huge change, but may require a shift in emphasis, away from property-level towards portfolio-level characteristics. It is useful to remember that the institutional investor's mindset is accustomed to thinking in ranges rather than single numbers, and focuses heavily on risk awareness, particularly on the quantification of risk and possible downside outcomes.
Richard Holberton is director of EMEA research and consulting at CBRE