Real estate is an increasingly important investment. Securitizations, more pro-active management and an abundance of investment vehicles with global scope have helped the profile of this asset class. Besides offering investors with competitive, high yields, and prospects of capital appreciation, real estate provides diversification benefits in a multi-asset portfolio due to its low correlation to other asset classes. Improved transparency and liquidity provide investors with an additional reason to increase exposure to real estate as an alternative to investment grade bonds and equities.
In the past, direct purchase of property was sometimes the only way for investors to invest in real estate. However, constructing a well-diversified portfolio — in terms of property type and location — is generally capital and labor intensive. Additionally, high transaction costs and limited liquidity are other obstacles confronting investors. The introduction of the REIT (Real Estate Investment Trust) in 1960 in the United States, the LPT (Limited Property Trust) in 1971 in Australia and the fiscal investment institutions (Dutch Bls) in 1969 enabled investors to participate in the property market with a minimal nominal investment, superior liquidity and in a cost-efficient way compared to the direct property investment alternative.
Recent years have seen the adoption of REIT-type structures in Europe (France, Belgium) and in Asia (Japan, Singapore, Malaysia, Thailand). Other countries that are also considering the introduction of similar structures are Germany and the United Kingdom. But what are REITs and why have they boosted investments in property assets? Essentially, REITs are tax-transparent structures whereby no tax at the corporate level is levied so long as most of the income is paid to shareholders in the form of dividends. Because of the tax-treatment benefit, they have attracted the attention of yield-orientated investors as these vehicles offer high yields together with the potential for price appreciation.
Real estate is becoming mainstream with more pension funds initiating or raising their allocations into real estate assets. However, REITs are not the only way to invest in property and may not be appropriate for all investors. In general, they are listed property companies and therefore may trade at a premium or discount to the NAV (Net Asset Value). Consequently, they may exhibit higher price volatility than the underlying property assets.
Besides REITs, numerous non-listed real estate funds now target diverse real estate assets not only in traditional markets but also in less developed countries, exploring opportunities in less mature and efficient markets.
According to INREV (European Association for Investors in Non-Listed Real Estate Vehicles), the number of non-listed European real estate funds (excluding German open-ended funds) has grown from around 50 in 1995 to over 300 in 2004. During the same time, the gross asset value (GAV) of funds has expanded from less than EUR 30bln to nearly 150 billion euros. This speaks favorably for further strong capital flows into real estate, as the options for investors with a global perspective have never been more diverse.
A recent global survey shows that 90 percent of respondents agreed with the statement that global real estate investment funds will experience a significant increase in their allocations over the next three to five years. Transparency and liquidity are among the reasons cited to support this growth outlook. Another important aspect that has given an impulse to real estate investment is the fact that the number of countries that have adopted appraisal-based return indices has grown substantially. Return benchmarks play an important role by providing transparency and credibility to the market, as benchmark data provides valuable information on risk and returns.
Real estate investments have different types of liquidity. Open-ended funds are highly liquid providing investors with daily or monthly liquidity data. German open-ended funds and UK property unit trust are some examples. On the other hand, private equity real estate vehicles are less liquid as many of these funds have terms of 6-8 years on average and are therefore not suitable for those who trade investments frequently. Needless to say, the higher the liquidity the lower the probable investment return, as part of the funds must be invested in lower yielding securities (money market instruments, etc) in order to meet liquidity requirements.
Diversification benefits are obtained when adding real estate to a portfolio of mixed assets i.e. including stocks, bonds and cash. Furthermore, global real estate can even add greater benefits to purely domestic investments. A recently published professional study concluded that the inclusion of real estate assets leads to a 5-10 percent reduction in the portfolio’s risk level. When international real estate assets were also considered, the risk reduction was increased to 10-20 percent. The study concluded that an optimal allocation to real estate in a multi-asset portfolio is in the 15-25 percent range. Another more intuitive approach to understand the effects of global real estate in a multi-asset portfolio would be to identify how country and regional economic cycles relate to each other. Over much of the past 25 years, economic cycles in North America, Europe and Asia have been largely unsynchronized.
Given that economic activity is the fundamental driver of real estate demand, the fact that economies operate in different cycles has positive implications for the benefits of diversification of real estate investments across regions. To conclude, real estate investments have benefited from increased investor demand in recent years. However, property market fundamentals have not been particularly positive — with weak rental markets and high vacancy rates. Strong capital inflows have been the main driver of yield compression, resulting in capital gains for investors. Nonetheless, 2005/06 forecasts have recently shown that property markets are reaching bottom in several regions, with leases moving upward or with a reduction of tenant benefits. Vacancy rates, although high, have stabilized, and with limited supply reaching the market, are expected to improve soon.
Real estate remains an interesting alternative to investment grade bonds and equities since its characteristics offer investors unique features. A growing number of investment vehicles will help investors to identify the most appropriate allocation to real estate.
(Habib F. Faris is vice president at Clariden Bank, London)
(The information contained is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information.)