Steel-nerved investors who held firm through last year's 11%-plus fall in European listed property values could be in for another uncomfortable ride, according to a Morgan Stanley forecast predicting a further market correction.

Research published by the investment bank's real estate team suggests that a fall in average property values, including prime, is more likely as more banks suspend new lending. The forecast is based on a historical correlation between performance and restricted loan availability, and probably also reflects a narrowing of what constitutes ‘prime' real estate. When investors feel optimistic, the number of assets they perceive as prime expands; when they feel pessimistic, the number contracts.

After the 2008 crisis there was a significant contraction in the number of prime assets. The nascent recovery stimulated some optimism, but that was reversed with the recent downturn.

None of the factors Morgan Stanley analyst Bart Gysens said could change the forecast - a silver-bullet solution to the euro-zone sovereign debt crisis, banks lending more freely or GDP growth improving - is especially likely.

But Gysens is not downbeat. Despite the market consensus that prime will be resilient with broadly flat values for European portfolios, Gysens sees more weakness with a doubling of yield expansion in the UK and an increase of as much as 90% elsewhere in Europe. But he argued there would not be a significant correction because most companies have refinancing under control. In any case, he said, "not only is a meaningful double-dip in property values unprecedented, [but] property yields are relatively robust at around halfway between peak and trough levels."

Whether the underperformance of listed real estate will have a significant impact on where investors put their capital is moot. Even when returns are disappointing, real estate equities have one major advantage - liquidity. Disillusionment with the performance of real estate equities is unlikely to drive pension funds to switch into, for example, non-listed funds - simply because the latter will not do the same job.

Where there is no need for daily pricing - in defined benefit schemes, for example - pension funds are unlikely to favour listed for its own sake. One analyst said: "If you're making a choice between investing in listed real estate and direct investment, you're looking at a discount to NAV."

Listed has its advocates: APG and PGGM include listed sub-portfolios within their non-listed property allocations, arguing that listed provides liquidity and exposure to a broader range of assets than by direct investing.

Moreover, there is some evidence that REITs, specifically, perform somewhat differently from other property equities. REITs fell harder after 2008, but Deloitte reckoned that a pension fund investing in a UK REIT could expect a tax-related 35.1% higher return than one investing in non-REIT equities.

S&P's Alka Banerjee has argued that REITs occupy a niche sub-category within equities because they are subject to more influences, including higher-than-average leverage and a preferential tax position. In fact, Russell Investments locates REITs firmly within the alternatives portfolio, rather than as an equities sub-category. But even if you accept distinctions between REITs and other property equities, investors in both are primarily concerned with liquidity and diversification, as well as returns.

But there are some alternatives to underperforming equities. Invesco Real Estate portfolio manager James Cowen has called on investors to consider adding REIT debt to their property portfolios to enhance income returns and manage portfolio volatility. "If you're talking about investors who want to maintain liquidity, most will just opt for listed," Cowen said. "In reality, they can invest in fixed income listed and get a different risk and return profile."

He pointed out that while both volatility and correlation have increased in real estate equity markets over the past 12 months, fixed income instruments have shown a low correlation.

If there is a shift in allocations, Cowen argued, it will be from listed to debt - not to direct. "All investors are different, but most will have a preference for one or the other. If your primary concern is volatility, you don't get that in direct," he said, "so some investors will be willing to lock up all their capital in directly held assets."