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:
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