The debate as to how best to invest in real estate continues. Julian Schiller and Jamie Goss explain the case for unlisted funds and derivatives
Indirect investment is a means of gaining exposure to real estate, without actually investing directly in ‘bricks and mortar'. There are a number of routes to gaining indirect exposure to real estate, whether it is via listed securities, derivatives or unlisted investment funds.
Indirect real estate products are rapidly becoming an important component of pension funds' overall real estate portfolio allocation. For example, in the UK the current total real estate allocation of pension funds averages 8-9%. Increased investor interest in unlisted vehicles has contributed to an exponential growth in the market over the last five to seven years. This interest has been driven by the advantageous characteristics of unlisted products. Derivative products are a more recent phenomenon, but they are also rapidly increasing in popularity as a means of quickly gaining diversified exposure to real estate performance.
The component proportions of direct or indirect holdings are dictated not only by an investor's sentiment to the sector as a whole, but the relative merits and drawbacks in holding real estate directly and indirectly. Furthermore, an investor's current portfolio weighting and particular position in the market will influence an investment decision into either type of holding.
Direct ownership gives an investor total control over the assets and allows the flexibility to directly initiate value-adding strategies and asset management initiatives.
Additionally, direct investment provides the investor with the opportunity to tailor a bespoke portfolio that meets his exact requirements (providing resource, expertise and capital are of no issue). Lastly, the adage of owning old fashioned bricks
and mortar should not be overlooked.
That said, investors are familiar with the shortcomings of direct property ownership.
Firstly, the high costs of trading physical assets (real estate transfer tax, agents and legal fees) are well known. In addition to this, the resource required to manage direct portfolios (particularly internationally) is extensive, and without suitable resourcing there is the possibility of error and poor performance.
Secondly, the typically large lot size of direct ownership can often result in considerable exposure to a single asset and indeed sector, which can be a limiting factor on portfolio diversification.
Why invest in unlisted funds and derivatives? Essentially, unlisted investment funds and derivative products provide many of the benefits of direct ownership, without the drawbacks of owning ‘bricks and mortar' directly.
Further, these vehicles have additional advantages:
Outperformance: Careful selection of funds, with specialist asset managers exploiting a unique investment strategy within particular markets, allows an investor to invest in those funds which show the potential for outperforming the market. This is not an opportunity available through derivatives per se, although trading at a certain price means that it is possible to lock in returns which are guaranteed to outperform the IPD indices, which many funds track (in particular in the UK).
Product availability: In recent years there has been a dramatic increase in the number of unlisted fund vehicles available for investment by institutional investors. With such a variety of product the investor has the ability to select one that is best suited to their portfolio/ investment criteria, although this will often require the assistance of a specialist adviser to track the ‘fund universe' for a suitable, quality product.The availability of derivatives is a function of how much of the product is traded. The UK should see some £8bn (€10.6bn) worth of derivatives trades for 2007, and this amount looks set to continue growing rapidly. As more trades take place, there are more counterparties with whom to trade and more banks are willing to make markets, hence making the product more available and liquid.
Access to market: Unlisted funds provide investors with the opportunity to invest in markets that may otherwise be inaccessible due to multiple barriers to entry. This is exemplified by the vehicles exploiting markets such as Russia and eastern Europe, where, without the presence of a local partner and structured investment vehicles, the issues of direct ownership, let alone the hurdle of sourcing quality product, would be too great for investors to obtain exposure to these markets.Similarly, the growth of international derivatives trading is gathering pace, as more global indices are compiled. Investors are able to gain synthetic exposure to foreign real estate markets through trading these indices. British companies have this year carried out Italian, Japanese and Australian derivatives trades, thus artificially ‘buying in' to those markets, avoiding the costs and risks associated with bricks and mortar investment. Furthermore, in times of uncertainty, when trading volumes in the direct and unlisted fund market are thin, the derivative product particularly appeals due to the constant presence of indices.
Access to management: Unlisted investment funds are usually managed by highly-specialised teams of investment professionals, experts in their market, with on-the-ground presence and relationships with local occupiers. Such management teams have the ability not only to source product, often ‘off-market', but also the ability to work assets and drive value. Investing into a fund vehicle takes this management-intensive drawback to direct ownership away from the investor, while allowing him to retain a share of the upside that such management strategies create.While active management of assets is not a feature of the derivatives market, an increasing number of independent market advisers are able to pinpoint the best opportunities and pricing within the market, bringing skills often associated with equity markets, to the property world.
Costs: Unlisted investment avoids the up-front costs of direct ownership such as stamp duty. The upfront costs of indirect ownership are lower, and indeed the secondary trading of units comes at a significantly lower price than those incurred when trading physical assets. However, it is important to note that the costs of physical ownership are inherent to any fund and will therefore have some impact on fund performance. An additional consideration when exploring the opportunity for indirect investment is the asset management fees a fund manager will demand, which can vary considerably between funds.Derivatives avoid these costs as no direct property is involved in the transaction. They only incur an initial fee for arranging the trade, and in most cases this fee also pays for any advice given with respect to the trade.
Liquidity: In most markets the direct property market is deep and there is always a ‘reasonable' price at which a transaction will occur. The unlisted funds market, however, suffers from some illiquidity; in bull markets it is difficult to obtain exposure and over-paying for stakes in up-and-running vehicles is required, while in a bear market finding purchasers at reasonable prices is challenging. That said, when purchasers are found the speed of doing a deal can be remarkably quick.Derivatives prices (for main indices such as IPD UK) are available from around a dozen counterparties on a daily basis. As such, trading opportunities are readily available and quick to execute, on both buy and sell side. However for the sub-sector indices in the UK and indices outside of the UK, the derivative market lacks liquidity.
Diversification: The variety of funds available and the wide ranging investment criteria between funds offer investors considerable choice when building an internationally diversified real estate portfolio. Similarly, a derivatives trade gives exposure to an index which is in itself already made up of the returns from thousands of different properties.
Access to gearing: Almost all funds will have the benefit of gearing, which will typically range from 30% up to 70% at a portfolio level, although there is a huge variety depending on the strategy of the fund, be it core, value add or opportunistic. Investing into such vehicles thereby allows an investor to gain access to a level of gearing they might not otherwise have been able to enjoy through direct ownership, and with it the potential for enhanced returns on equity this gearing provides. Additionally, access to this gearing is provided without the associated debt liability, and is usually offered to the fund manager at preferred rates. Funds with considerable critical mass are sometimes able to securitise their assets to reduce their debt costs further.Derivatives can also be bought with high levels of ‘synthetic gearing'. This means that a bank is prepared to offer an investor large amounts of exposure to the returns of a given index while little actual capital changes hands. This depends on the credit rating of a trading entity and some collateral may be required. No amount is actually borrowed, but the returns - both positive and negative - are amplified in the same manner as if leverage was in place.
Ability to hedge and short: Derivatives offer the unique opportunity to profit from a property downturn by shorting the market. For funds, however, it is impossible to reduce exposure to a given market without being forced to sell assets. This offers the opportunity to outperform funds that do not use hedging to lower their risk curve. Fund managers are also able to avoid the ‘round costs' of exiting and re-entering property in a short period of time.
While the advantages of unlisted fund ownership and derivatives trading are evident, as with all investment products, this type of investment is not without its drawbacks for some investors, and these should be taken into consideration when taking a balanced view in apportioning a portfolio to the product.
While investing in a fund removes the asset management intensity of direct ownership, there is an argument to suggest that there is in part a loss of control and that performance is largely dependent on the skill of the management team.
The costs and management fees associated with unlisted vehicles should also be factored into real returns. Most fund managers will expect at least an annual management fee and share of the out-performance above an agreed hurdle rate (required rate of return). Additionally, if investing into an un-seeded fund, an investor must accept the risk associated with a ‘blind pool', ie that the construction of a portfolio, while within the defined investment criteria, will be dependent upon the ability of the management team.
Finally, the timing of fund terminations should be considered. Closed-ended funds will have a defined term of typically five to seven years -although extensions are often possible for one or two years - therefore analysis is essential to form an opinion on the position of the market at this point in time and whether modelled exit values are achievable. Timing is also a potential issue for derivatives, as trades take place for a fixed period and are therefore subject to a specified time frame.
Another issue with the use of derivatives arises from basis risk - the fact that it is impossible for a product to provide a perfect proxy or a perfect hedge for a given property or portfolio of properties. This is because the performance of a given property will never identically match the index which is used in the portfolio transaction.
While it is possible to find a good correlation for most types of property - often over 85% - some larger portfolios and more idiosyncratic property types may be difficult to efficiently match.
To conclude, the advantageous characteristics of unlisted and derivative real estate investment demand that such products should form an important part of any pension fund's allocation to the sector.
Clearly, it is important to strike the correct balance between direct ownership and indirect investment, and exposure must be tailored to each investor's individual requirements, portfolio size, current and desired weightings (geographic and sector) and level of sophistication, in order to achieve a balanced, mixed direct and indirect portfolio.
At a time where there is increasing pressure on fund managers to achieve consistent, strong performance safely, indirect real estate products are able to offer all of the above, while continuing to aid portfolio diversification. Going forward, there is little doubt that these products will grow to be greatly important in the armoury of real estate fund managers.
Jamie Goss is director, derivatives, at Jones Lang LaSalle Corporate Finance
Julian Schiller is head of indirect investment at Jones Lang LaSalle Corporate Finance
