Who said location was the be-all and end-all of property investment? As the range of returns across countries narrows, risk has become the new point of focus, as Alice Breheny reports
As capital becomes more global, barriers to international investment are lifted and capital markets become better connected. The investment world is becoming flatter.
Rapid cross-border investment activity has led to convergence of economies and, increasingly, property markets. As markets converge, the greater the need for diversification. The further we diversify the more convergence we see as a result.
Rapid harmonisation of property markets across Europe means the traditional sector and geographical calls are less beneficial in reducing volatility and gaining outperformance. Within Europe, investors now need to be more imaginative than just picking countries and sectors to maximise performance and minimise volatility.
Until the last decade, property investment was overwhelmingly domestic, lagging other industries and asset classes. Diversification for most domestic investors was typically limited to sector allocation or local geographies. While sectors and local markets can offer differing performance characteristics, they are ultimately tied to the same economic drivers and, quite simply, market size curtails the scope for diversification and finding outperformance.
During the past decade, though, cross-border investment activity within Europe has grown rapidly as investors have looked to enhance returns and diversify outside their domestic market. This has been particularly beneficial to investors based in those markets with limited property investment stock.
This ever-increasing scale of cross-border investment has produced excellent performance in recent years and has resulted in rapid maturation of many markets. Liquidity and transparency have improved for many of the less established countries - notably southern Europe - and yields have been driven down to record lows in most markets. Prior to the credit crunch, yields in most markets were at or below their equilibrium level in most countries.
Less mature markets and sectors, and secondary property in general, have witnessed the most marked yield compression. As such, pricing differentials across countries, sectors and asset types is as narrow as it has ever been. And, crudely speaking, with pricing being more uniform than ever before, future performance prospects vary less widely.
Harmonisation of economies and property markets across Europe has meant that finding outperformance at the national level is increasingly challenging. Broadly speaking, the range of expected returns across countries and sectors in Europe is now much narrower than just five years ago. In 2003, Henderson research forecast returns across Europe to vary from just 4% per annum over five years for Germany to 14% per annum for Greece. Most markets were forecast to deliver double-digit returns, though we expected retail to outperform offices significantly.
Looking back, we underestimated performance at the upper end of the scale, which has been driven by an unprecedented weight of money. Our most recent forecasts look somewhat different. We now expect much less differential between the main sectors and core countries. The outlook is now considerably weaker, with double-digit returns being few and far between. Country and sector recommendations alone will not drive significant outperformance at present.
The rate of cross-border activity, and indeed any activity, has slowed significantly since the credit crunch. Some yields have moved out too, as a result, but tough lending and investment conditions mean that short-term performance for most European markets is likely to be modest at best. But irrespective of the credit crisis, we were already entering a lower-return environment purely based on pricing across the market.
Pre-June 2007, investors were already looking further afield to enhance returns. For most this will have meant looking further up the risk curve but, if anything, the credit crunch will have made investors more risk averse. Outperforming while managing risk will be trickier than ever. Is global geographical diversification the answer?
In expanding outside their domestic market, most European investors have historically targeted first countries then sectors. Most will have sought to construct a portfolio that reflects market size, so targeting the largest countries (UK and Germany) and sectors (offices) first. Most investors, when looking outside their own market, will have first targeted those markets most akin to their own or, even less rationally, their physical neighbour. This approach means that the geographical diversification benefits have been modest.
The largest markets are the most mature and display similar performance characteristics. Investing across a number of major European office markets (a popular strategy) does little to reduce volatility - even if they do span several countries - as they are, in the first instance, highly cyclical and, in the second instance, highly correlated. Investing in markets that are at differing stages of maturity, with different economic conditions, will have the greatest impact on reducing volatility.
New property markets continue to emerge and investors are now starting to construct global portfolios to enhance returns and obtain geographical diversification. But, given lessons learnt in Europe, they should not assume that a broad geographical spread alone would boost returns or dampen volatility. Constructing a global portfolio according to geographies alone is unlikely to deliver outperformance. And if geographies are chosen based on market size, then the diversification benefits will be inhibited too.
As within Europe, the largest property markets globally are the most mature, and also offer broadly similar performance characteristics. Indeed, at present, the world's largest invested property markets are likely to deliver, at best, uninspiring performance over the next couple of years. On the global scale, a combination of developed and developing property markets will deliver outperformance and offer diversification as they occupy different positions on the maturity curve. So what is the best approach to constructing a global portfolio if the traditional country/sector method is outmoded?
Investors should consider first their tactical risk bands and then seek geographies, sectors and themes that meet their requirements. Those who are too prescriptive regarding certain countries or sectors might struggle to satisfy their risk/return requirement, be it too safe or too risky. Indeed, North American and Australian investors - who don't have as many immediate neighbours to explore - often start with broad allocations to risk profiles - core, value add and opportunistic for example - and are less concerned with specific geographies.
International investors will increasingly look for funds or opportunities that offer a clearly defined risk profile. Core funds with a ‘value add upside', for example, seem to confuse some global investors. Such a fund might offer investors a 9% return, but perhaps 2-3% of that is reliant on asset management and rental growth, the latter of which cannot be taken for granted. Henderson research has significantly downgraded its outlook for short-term rental growth for many core European markets. And so the ‘value add' component of some core funds can be discredited for the short term at least.
An investor looking to achieve 9% per annum total return could invest 70% of funds in a core product that offers just 7% returns and then 30% in an opportunistic vehicle that could deliver 13%. The outturn in theory should be the same, but many investors believe that there is more certainty of the 9% being delivered through the latter route. The core fund is likely to be focused on a low-volatility market or sector where a large component of return is derived from income, and so any projected performance is likely to be realised. The opportunistic fund is likely to be focused on a maturing market where rental growth is driven by strong economic growth and so, again, is more likely to be delivered. To this end, investors could increasingly favour funds that are explicit about their risk profile, rather than their geography.
Geographical considerations shouldn't be written off, however. The main global regions broadly offer different performance characteristics. Commentators tend to talk about the Americas, Europe and Asia that do broadly offer different risk profiles. But clearly within these there are vast differences. Europe is the region that has seen the most marked convergence of markets, and so perhaps where geographical recommendations are least valid. Understanding differences within the regions is critical; all have core markets within and all contain emerging sectors and countries.
Investors should be wary of assuming that all products within global regions will offer a similar risk profile. Not everything in Europe is core, nor will everything in Asia be opportunistic. Emerging Asian markets are very different to the established financial capitals located in Japan or Singapore, where performance might be more aligned to that of London, for example. While Europe becomes increasingly core, economic recovery or development angles might present some interesting vehicles for the more opportunistic investors.
Investors throwing money indiscriminately across the globe could be unlucky and end up with a portfolio consisting of purely core or solely opportunistic assets, even if their money landed in each of the three regions. Broadly speaking, markets that are emerging or maturing can generally be classified as opportunistic. South America, Emerging Asia, Russia and Turkey might well fit this category. These are markets enjoying rapid economic growth that are also going through structural change.
Risk comes in the form of political and economic uncertainty. And, for the property investor, further risks include supply, planning and quality of income. Core markets are those that are much further up the maturity curve. Future change is likely to be cyclical rather than structural and outperformance will depend on timing of entry and exit into the market.
The cyclical nature of financial centres within core markets, such as old Europe and North America, means they will demonstrate as much volatility as some of the world's emerging property markets. Indeed, vehicles that take advantage of recovery in cyclical markets, such as vulture funds, could be deemed opportunistic in style.
Opportunistic markets will be considered increasingly core as they move up the maturity curve, and there is no guarantee that core markets will remain core. Perceived country level risk is a moving beast, unlike other factors that determine investment style such as the level of gearing or trading.
Diversification should be sought through product types rather than product location. Global investors looking for diversification should supplement defensive, low volatility markets, like core Europe, with investments in some of the world's emerging markets that, while they present a little more risk, should enhance returns as is the case with Latin America.
Cyclical markets, where timing of entry and exit is crucial, such as prime offices, should be balanced by defensive sectors such as retail and logistics. Dry, standing investments with long leases to good covenants should be boosted by more risky development or active asset management. None of these recommendations needs a country name attached to it.
As international boundaries are becoming less visible, geographical diversification becomes easier. The benefits of diversification cannot be overstated. Global diversification protects investors from over-exposure to economic or political risk and clearly offers exposure to a bigger pool of opportunities. But don't diversify for diversification's sake. Throwing money indiscriminately across the world's largest markets will do little to reduce volatility, and possibly even less to enhance returns.
Diversification by investment style and market cycle should be more beneficial than diversification by geography. Portfolios that target specific investment styles are more likely to deliver promised performance than those that try to span the core-opportunistic spectrum. International investors will increasingly construct portfolios according to risk group as geographical disparities lessen. And so funds should be explicit about their investment style. For truly international investors, funds that specialise in specific investment styles could prove more attractive than those that specialise in one market or sector.
Alice Breheny is head of property research, Europe, Henderson Global Investors