Research is a vital ingredient in risk management the pursuit of outperformance - and in the wake of the downturn its importance is all the greater. Henri Vuong reports
The events of the past few years have demonstrated that commercial real estate markets, often described as "safer than equities but more rewarding than bonds", exhibit much greater volatility than trends would suggest. UK commercial property capital fell by almost 15% over the final quarter of 2008, but just 12 months later, a record quarterly total return of 10% was achieved. Both these movements have been recorded on the IPD quarterly index as unprecedented occurrences. With the globalisation of capital movements, the question being asked more and more often is whether such extreme movements are the start of a new trend in real estate performance or are what history will record as the ‘Black Swans' of real estate markets: unpredicted rare events that cause extreme impact.
As global capital flows become more fluid, and real estate markets become ever more synchronised and complex, fund managers need increasingly sophisticated levels of support in their pursuit of investment excellence. While final investment decisions should, of course, rest with fund managers, research expertise and its robust processes can provide valuable insights to help shape investment strategy and improve the search for outperformance.
The process of research involves data and information gathering, and a rigorous process to decipher gathered material and turn it into meaningful advice. Both fund managers and investors understand that, in order to make sense of the regular flow of information, they need ‘stories' that can help them organise this enormous amount of data. This is where the researcher comes in armed with a toolkit of quantitative and qualitative methods and models, and uses a combination of continuous enquiry and new ideas to improve the understanding of the feedback effects between market fundamentals and market pricing.
One of the main benefits of a scientific discipline is that it captures the continual revision of history as well as the emergence of new information, and rationalises it in a way that market participants can understand. Investors in real estate markets recognise that research expertise can enlighten an otherwise relatively opaque asset class where data reporting is far less frequent and comparable data is scarcer than in other asset classes. Fund managers find research a useful guide towards making investment decisions on the basis of evidence thoughtfully and appropriately gathered; they recognise that the greater the importance of the investment decision and the greater its impact, the more important the need for research around it becomes.
When it comes to real estate market analysis, fund managers are generally interested in understanding the past and using scientific theory to predict the future performance of markets and assets. Investment houses generally adopt a ‘top-down' ‘bottom-up' approach, where researchers provide the top-down analysis of macroeconomic and capital market trends in the wider economy as well as local supply and demand influences, to identify opportunities and growth areas. Meanwhile, investment managers perform the bottom-up analysis of opportunities, looking at individual assets and specific opportunities to create value around a particular asset in its local market.
As such, forward-looking market views combined with asset specific views provide fundamental inputs into detailed financial models which facilitate the investment process. Researchers, as a result, ought to work closely with fund managers to discuss their portfolios, their ideas, their themes and investment strategy, in order to advise on how to deliver the best risk-adjusted returns from the structure of client funds. The role of the researchers is to prompt ‘fire-side' discussion and hold constructive debates around portfolio architecture and investment strategy - looking at the collection of market bets in a fund and analysing how they behave in connection with each other, helping fund managers to construct their funds to maximise returns, and/or minimise risk, from a structure point of view.
Proprietary systems developed by research teams can aid fund managers to understand the effect of a bet to a particular market segment in the wider context of the portfolio. For example, increasing exposure to an existing long bet can create an unwanted thematic bias or amplify risk in an outcome which may not have been intended.
On the other hand, exposures to markets moving in opposite directions may have a diversifying effect, meaning that the fund manager can take a larger position without creating significant risk. The researcher's toolkit tests the impact of adding or removing a position on the risk and return profile (predominately based on market segment and lot size) of the fund prior to transaction, thereby assisting managers in the decision-making process.
Researchers encourage fund managers to consider the unintended risks that sometimes develop within their portfolios, which could detract from structure performance. Researchers can work closely with fund managers to add risk cautiously to their fund and increase the market bets to boost performance in rising markets, as well as protecting the portfolio from falling markets. Equally important is that researchers develop the tools to highlight areas where fund managers may need to take more risk in order to deliver outperformance as some funds are positioned defensively, hugging the benchmark, and in doing so may forego potential relative returns.
To reach this level of research expertise a substantial amount of business investment is required. Without the interpretative model of real estate markets that robust research can provide, data analysis, however sophisticated, is mute. Research of any kind, from simple information gathering to the development of sophisticated models, requires time, effort, and money. It requires investment in people and training to ensure that market models are effectively constructed and implemented. Across the industry, real estate professionals recognise that some sort of research is required to support the investment process. The dangers of under-funding research means that fund managers and researchers may begin to accept the potentially subjective work of others without due criticism.
Successful researchers are those that receive meaningful support from their organisation, seniors, and peers. Employing good researchers but allowing them to become de-motivated by neglect, under-funding, lack of client contact, and lack of development and back-up resources would hinder the natural evolution of established research skills while suppressing the source for new approaches and new insights. Therefore, an investment in research is also an investment in the minds that develop the tools for analysing investment opportunities.
Real estate research has progressed from guiding fund managers to which pond they should fish in to identifying what species of fish are in the pond and recommending which would be the best catch. Research gives the fund manager the material with which to perform his job; it provokes thinking and offers direction, though ultimately the fund manager has the final say on investment decisions and implementing investment strategy.
Sometimes, however, fund managers are criticised for their apparent disregard of strategic research in favour of making investment decisions based on intuition and rules of thumb. Fund managers using instinct and intuition instead of hard research can fall into the trap that our brains set for us, because of various heuristics and biases. Behavioural economists would argue that "when people are free to do as they please, they usually imitate each other", and "that markets are plagued by herding behaviour and group thinking; and that individual choices can frequently be affected by how prospective decisions are framed". This is especially true of real estate markets in the last property cycle when there was aggressive buying of inflated assets followed by a mass exodus.
In addition to being disregarded, raw research findings sometimes do not make it externally, either through mis-interpretation or fear of controversy, whether for marketing or transaction purposes. For reasons of confidentiality and sensitivity, raw research findings can sometimes be censored or held back from the public domain. However, as the poet Johnson once said: "All knowledge is of itself of some value. There is nothing so minute or inconsiderable, that [he] would not rather know it than not."
Research in the real estate sector is becoming increasingly sophisticated; a forecast is no longer a single number, but an assessment of risk. Following the recent recession, risk management has become even more important in global economies, financial systems and real estate markets. Fund managers may well have a ‘good feel' for markets in which they operate in, and a good understanding of the drivers of property returns, but unfortunately they have no means of scientifically assessing the risk implications of their actions.
Increased market volatility calls for a more disciplined and refined approach to risk management. Market participants must recognise that, in order to evaluate the idiosyncrasies of property, they require bespoke risk tools to quantify the factors that drive the risk and return profiles of real estate investment. Such tools can help analysts and fund managers to understand the impact of a particular property factor on an asset's risk and performance, and subsequently allow users to assess the effect of the asset on portfolio performance and risk.
The conceptualisation and development of such systems are often research driven, either through the investigation of new approaches or through re-active research - reacting to the changing nature of real estate investment. Research is fast becoming the beating heart of an organisation and plays a vital role in the development of structured systems that help to eliminate investment biases based on emotion and help market participants move away from the herd which, in turn, can enhance risk-adjusted return on investments.
The author, Sir John Harvey-Jones once said: "The contribution which the human mind makes to work and business is very much one of picking up information from tiny, seemingly insignificant trifles, and relating them to new ideas or concepts." If research techniques can help forecast so-called ‘long-tail events' such as the substantial capital value movements seen in UK real estate markets recently, then research mechanisms which recognise the possibility of similar events just a bit earlier, or when surprise is unavoidable, can help fund managers to react more quickly to help to mitigate the losses that result from misjudgements during periods of mis-pricing.
In addition to providing analysis and strategic investment insight for fund managers, research also helps enhance a client's understanding of his fund. Researchers also spend time explaining the research process to consultants. This work is often a powerful source of explanatory evidence to consultants as to how fund managers think about portfolio strategy and risk.
Researchers must expend time on giving presentations both internally and externally, to provide in-depth insight into portfolio construction. It is also a great opportunity to show the market that researchers are there to help fund managers preserve and maximise fund performance, as well as to offer valuable advice on the most appropriate investment strategy based on a measured view of risk and investment outcomes.
Research cannot answer all the questions, but the process can ensure that all available information is taken into account and rationalised in a way that investment risks can also be scientifically measured. For research to be taken seriously it needs to be objective and completely independent. Research explores new areas of innovation and creativity, not only supporting existing processes but looking towards future ideas and developments, and is therefore a crucial engine in the machine that drives market leaders.
As Bertolt Brecht, the German playwright said: "The aim of science is not to open the door to infinite wisdom, but to set a limit to infinite error."
Henri Vuong is a property research analyst at PRUPIM and vice-chair of the Society of Property Researchers