In the second article of their series Fraser Hughes and Alex Moss examine the tools and options available for combining or blending listed and direct exposure to one specific property market, in this case, the UK in a simple rules-based strategy

Two specific catalysts have stimulated a surge in investor interest in combining a more liquid, listed element with direct exposure. First, the inevitable move from defined benefit to defined contribution schemes, which have a greater liquidity requirement, and require a form of real estate allocation that can provide exposure to the asset class in a more easily tradeable form. Second, the redemption issues that many property funds faced have led to product developers seeking to capture fund flows by creating a more liquid product.

A recent example would be Schroders creating a high-yielding fund investing in listed real estate. It seeks to reduce the volatility of having to sell illiquid assets to provide liquidity for investors. As a blended property allocation based on the four quadrants approach is new and evolving, research and analysis is still required and it is important to recognise that the level of data and liquidity available for different markets is variable. The table summarises the main features of each form of investment.

The best approach to examine the issue of blending the four quadrants is to select one country and blend just two options initially. We would also emphasis that we are not suggesting that it is necessary to combine all four quadrants across all regions to provide effective solutions to specific product liquidity requirements. At its simplest, listed exposure can be added to enhance liquidity of a product to meet investor requirements, or a trading strategy can be developed to arbitrage between the two areas.

As a first step, we look at the UK direct market - represented by the IPD All Property Index and the UK listed market - represented by the FTSE EPRA/NAREIT UK Index. The UK has the longest time series on both the direct and listed side. In addition, the data sets are widely regarded as most representative of each market. Figure 3 outlines the rolling 10-year performance of the UK direct and listed sector, unlaggeds1 - both capital and total returns. This provides an initial overview of returns, unadjusted for either risk, management costs, or liquidity. The FTSE EPRA/NAREIT UK Index outperforms IPD UK for a significant period of the analysis - 2000-10. On the other hand, IPD UK total return outperforms the FTSE EPRA/NAREIT UK total return. The listed sector trades within the boundaries of the direct benchmark.

While figure 2 shows the ‘raw returns' historically and the stages of the cycle where listed and direct generate superior and inferior performance, we next examine how a simple rules-based strategy can arbitrage between the two markets. At a strategic level, we use a simple portfolio comprising 50% direct property and 50% listed property as starting point. A series of thresholds is calculated around the long-term average discount to NAV (-18%) over the entire period.

This can be recalibrated throughout the course of the strategy. An upper and lower threshold is set at two-thirds of one standard deviation - approximately 9%, either side of the long-term average discount. The weighting to listed property is adjusted 150bps for each month that listed property trades below (or above) the thresholds. For example, if the discount to NAV trades at 20% for a cumulative five-month period, 7.5% extra is allocated to the listed allocation. Once discounts to NAV trades within the upper and lower band, weights revert to 50/50.(2)

By combining the direct and listed market over the period and employing the trading strategy,(3) it is possible to outperform both the direct and listed markets by some margin. Figure 3 shows that the blended portfolio generates much better cumulative total returns than either direct property or property shares. This approach generates an average annual return premium of over 100bps over that on direct property in this 32-year period. The volatility of the returns generated by the simulated portfolio sits between that on direct property(4) and that on listed property.(5) Yunus, Hansz & Kennedy (2010) analysed the long-run relationships and short-run linkages between the private and listed real estate markets of Australia, Netherlands, UK and the US. Results indicate long-run relationships between the public and private real estate markets of each of the countries.(6)

In summary, we are now seeing the first products that seek to combine underlying real estate exposure with the investor requirement for liquidity. Given the importance of liquidity in DC schemes, and their expected growth we also believe that attention is firmly focused on providing a (more) liquid real estate solution for this market, and that listed will play an important role in providing this liquidity.

Fraser Hughes is a director at EPRA; Alex Moss head of global property securities analytics at Macquarie

(1)Yunus, Hansz & Kennedy (2010) - Short-run analyses also reveal significant causal relationships between private and public markets of all countries under consideration. As expected, it was found that price discovery occurred in the public real estate market in that it leads but is not led by its private real estate market counterpart.
(2) This analysis was first published in issue 34 of the EPRA Newsletter - May 2010. The article was written by Martin Allen.
(3) This simulation did not allow for transaction costs, and full allowance for these would reduce the return premium generated. On the other hand, it should also be possible to come up with a more sophisticated algorithm that generates a higher return premium.
(4) Volatility using the valuation-based methodology - we estimate that ‘real volatility' is significantly higher when taking into account significant economic events and low transactions or lack of liquidity.
(5) The market movements experienced by stocks provide an opportunity to buy into property at levels that could never be achieved in the direct market.
(6) The research also states that for all countries, investors would not have realised long-term portfolio diversification benefits from allocating funds in both the private and public real estate markets since these assets are substitutable over the long run.