Can real estate equities deliver real estate market performance? It depends on the stocks in your portfolio, as Thomas Körfgen reports
Unfortunately, real estate equities and REITs are still often the great unknowns for many institutional investors. Many investors have not yet internalised that real estate equities are the better shares in the long term, especially for pension funds, or understood why they fall between shares and direct real estate investments in terms of their risk/return profile.
"A good portfolio is more than a long list of good stock and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies", wrote Harry Markowitz in his 1959 article entitled "Portfolio selection: efficient diversification of investments". In it, the Economics Nobel Prize winner laid the foundations for modern capital market and portfolio theory: the combination of different asset class equities.
Asset classes are defined as groups of investments that are comparable in terms of their risk/return profile. Examples include shares, bonds, liquid assets and real estate. In modern portfolio theory, investors will achieve an optimised and balanced investment only by combining all asset classes.
Regardless of whether investors invest in physical property - in a building or in units in an open-ended or closed-end real estate fund - or on the stock market in real estate equities or in a REIT, the basis for a successful investment is the underlying property and its current and future value. For the investor, this means only those who know the real estate markets, who understand them on a fundamental level, and who are familiar with the relevant valuation methods can successfully invest either directly or indirectly in real estate investments.
Back to the portfolio: How can real estate equities be incorporated in the context of an overall portfolio? First, an investor buys shares in a company, with all the related pros and cons involved in such an investment. Share prices do not always reflect the intrinsic value of a company and are subject to volatility and market trends. These effects can be either short- or medium-term. However, shares should in fact reflect companies' intrinsic value in the long term. In the case of real estate equities, this is ensured by the portfolio of properties held.
We are firmly convinced that there is a high correlation over time between yields on real estate shares and the underlying intrinsic value of the assets owned by a company, ie, the properties in its portfolio.
In other words, both expert knowledge of the real estate markets and a fundamental understanding of company analysis are required to successfully manage real estate funds. There are as many different types of real estate corporations as there are different types of properties. There are three basic types of companies: property portfolio companies, property developers and property dealers.
Most real estate companies in Europe and the US are property portfolio companies. What these companies are looking for when investing in real estate is primarily sustainable rental income and property appreciation potential.
Listed property developers, the second category, are often located in Asian countries. By definition, these project developers have fewer properties in their portfolios - and in some cases they can have none at all. Analysing property developers also requires an understanding of the real property markets. This is because the properties developed by these companies have a calculable value on completion that can be determined and discounted to the present.
Finally, some market players also define property dealers as real estate companies. These are companies that predominantly buy and sell properties. This is not a risk-free undertaking for either side. Brokering large blocks of properties successfully for many years is a challenging task, which means that the risk for the investor is correspondingly high. We do not define these companies as real estate corporations in the narrower sense of the term. The reason is that we require underlying assets, that is to say properties, in order to be able to perform enterprise valuations. We cannot and do not want to put a value on pure trading activities in which it does not matter if the company concerned buys or sells clothing, automobiles, or real estate.
For this reason, we limit ourselves to property portfolio companies and developers whose current and future property portfolios are the prime consideration. There is no fundamental or scientific reason to value the properties in different real estate products in different ways. The income method and the discounted cash flow method ultimately lead to the same result - assuming that the underlying assumptions (or properties) are the same in each case.
This has far-reaching consequences for fund managers of real estate equity products. To begin with, they need information on which continents and countries to consider for successful real estate investments. Then they have to clarify which locations in the cities and regions and which types of use (eg, offices, retail, residential, hotels) promise to appreciate in value. Comprehensive knowledge of direct investments on the international real estate markets is required for the analysis and valuation of the portfolios of exchange-traded real estate corporations worldwide.
This is similar to the professional management of biotechnology and pharmaceuticals funds: fund managers can only analyse companies correctly if they have information on illnesses, the medications used to treat them and their mode of action. For this reason, many fund companies in these product areas also have doctors and pharmacists on their teams. Back to real estate: in this arena, top-down requirements are established by the people who buy the properties and develop their own strategies.
The top-down macroeconomic/real estate approach uses the underlying data and forecasts from recognised research houses. The macroeconomic data draws on national and international statistics and the macroeconomics departments of international brokerage houses and organisations. This input is used as the basis for our internal country and sector rankings, which are generated regularly with the aid of our own econometric models.
The basic macroeconomic conditions and future development in a country or region are decisive for the further development of the real estate markets there. For example, analyses demonstrate that the regional economic environment is the main driver behind real estate performance.
In addition to economic data - such as real GDP growth, expected inflation, population and income growth, exchange rate fluctuations and employment trends - a large amount of real estate market data is also included in the models. Notable examples here are trends in the number of office workers, future office space per capita, retail sales trends, forecast vacancies and planning permission for real estate developments. These supply and demand components influence the future development of rental and price trends on the different real estate sub-markets and thus decide the future yields of the properties. In this process, it is important to note that these models are based on forecasts and do not simply analyse the current situation. Since every investment, especially in real estate, is long term and forward-looking, forecasts are indispensable to investment decisions.
The end result of this complex quantitative top-down analysis is the total return (future rental income plus changes in value) for each type of use in each country or region. Countries and regions with above-average expected yields are to be preferred. By contrast, "average" and "below average" countries take a back seat to start with.
The art of equity fund management lies in combining of the macroeconomic and purely quantitative nature of the top-down process with the fundamental bottom-up decisions by equity fund managers. Both quantitative and qualitative factors are included in the analysis process via the fundamental bottom-up decision making processes.
Differing approaches are taken on each continent (Europe, Asia, North America) in line with the environment for the companies' business models. However, the qualitative components of the valuation, which include the quality of the management, the logic of its statements and the strategic development of the company, remain the same.
This qualitative analysis is at least as important as the purely quantitative analysis of a company. In the case of real estate equities, it is also very important to speak with the management of the corporations at company presentations, one-on-one meetings and on-site visits in order to get a feeling for the quality and the regional environment of the properties concerned.
The conventional models in Europe are based on the company's current net asset value (NAV), which is defined as the value of the real estate held minus debts. The added value from future business operations in the form of rent increases, reductions in vacancies and possible revaluations is then calculated and added. The cost of capital and various risk assumptions are then taken into consideration to produce a fair value from the current perspective, which is then compared with the current market price.
The US uses a dividend discount model because most US real estate corporations have REIT status and therefore pay out almost all of their income as dividends. The starting point of the model is the current dividend and its growth rate in the coming years. This data is subsequently discounted by the cost of capital and again compared with the current market price.
In countries in Southeast Asia, simply looking at the intrinsic value in isolation does not help much, since these are mostly based on the size and quality of existing land reserves. In this case valuations need to go a step further and establish how much added value the company can generate between its acquisition of the land for construction and completion of the building.
After this, the top-down analysis must be combined with the bottom-up analysis. The country ranking resulting from the top-down analysis and the valuation of the real estate shares for the country concerned from the bottom-up perspective are combined in a matrix.
From a purely fundamental perspective the top-down view must be more important than the bottom-up view. In contrast to most shares in the broader market, real estate corporations are active regionally and thus dependent on economic developments in their respective country or region. The properties and consequently the real estate companies can only evolve and generate above-average results if the economy is solid.
If a country will produce a below-average total return for its real estate markets (red), the real estate corporations must be very attractively valued (green) for the respective equity funds to consider investing. In contrast, investments will be made if the country is set to record above-average development (green) even though the companies seem expensive at first (red). In a market that is developing positively in absolute terms, a certain premium over and above a company's NAV can be justified by increased corporate profits and the appreciation potential of the companies held.
Management of real estate share products must be designed in such a way as to be independent of the benchmark because the macroeconomic and real estate development of the country and the fundamental valuation of the companies are what drive share price performance. No index takes this into consideration! Only when setting up the portfolio should the fund manager make sure that the signals are appropriately implemented, if necessary against the benchmark. An example: if both the top-down and the bottom-up analyses give the go-ahead for a country, then the portfolio should contain more shares from this country than the benchmark index indicates. In this way, fund managers clearly set themselves apart from most of the competition, who track the index to a greater or lesser extent.
The universe of real estate equities is extremely varied. It encompasses a large number of companies investing not only in different sectors but also in different countries and regions. However, they all have one thing in common: they are part of the real estate asset class but have typical equity features. This means that real estate shares are in no way a new sector or industry. Real estate shares represent properties in the liquid form of shares.
As the underlying real estate markets develop further and become more professional, the markets for real estate equities and REITs will also change in the coming years. The interdependencies between real estate and the capital markets will grow and financial centres will place stronger emphasis on the fundamental valuation of properties. The entire asset class will become more liquid and thus more transparent.
Real estate is the only asset class that has not yet been extensively globalised. Due to the establishment of REITs in many countries, it will be quick and easy in future for investors to increase the proportion of real estate in their overall portfolio, broaden their international focus and hence further diversify their total assets.
In turn, many industrial companies will take advantage of the opportunity and sell real estate that they do not need themselves, thus increasing their profitability. These standalone real estate portfolios are a very attractive investment opportunity, especially for insurance companies and pension funds. This is due not only to the diversification and correlation aspects of direct and indirect real estate exposure, but also to the ability to take account of the special investment criteria and risk restrictions applicable to insurance companies and pension funds.