Proposal for european real estate

Task - A

INTRODUCTION

Asset Allocation Committee - Proposal for European Real Estate

Executive Summary

Characteristics and Advantages- Overview

• Property is a real asset and it wears out over time suffering from obsolescence creating depreciation.
• The cash flow delivered by a property asset is controlled or distorted by the lease contract agreed between the owner and occupier. For example rents in Europe are commonly fixed for five-year periods[1], after which they can only be revised upwards.
• The supply side is controlled by planning regulations and is highly price inelastic. This means that a boom in the demand for space may be followed by a supply response but only if permission to build can be obtained.
• The supple side is regulated by local and central government which complicate the way in which economic event such as positive or negative demand shocks translated into return.
• The returns delivered by property are likely to be heavily influenced by appraisals rather than the marginal trading prices.
• Property is also highly illiquid which means it is expensive to trade property, there is a large risk of abortive expenditure and result can be a wide bid-offer spread between what buyers will offer and sellers will accept.
• Property assets are large and lumpy in terms of capital price which means that property portfolios cannot be diversified and suffer hugely from specific risk[2].
• Property rents seem to be closely correlated with inflation in the long run, producing an income stream which is similar to an indexed bond over a long term[3]
• High transaction costs leads to longer holding periods than would be the norm in financial asset markets which means real estate markets to be thinly-traded.
• Heterogeneity creates low correlation and high specific risk in the return performance of individual properties which contributes towards tracking error while the large lot size makes it difficult to diversity away the risk.
• No benchmarking was available before but now since 1990s - IPD - major provider of commercial real estate benchmark now reports 14 European countries.
• Specific risk in property whether measured as a standard deviation or as a tracking error against a benchmark, is a key problem especially for international investors[4].
• Leverage[5] is used in the vast majority of property transactions which distorts the return and risk of a property investment[6].

Disadvantages:-

• High information and monitoring costs associated with international real estate investment and risk of information asymmetry and lack of awareness of local market practise and circumstances.
• Sector diversification is more effective than geographical diversification although care should be taken to distinguish between administrative regions and economical functioning regions.
• Most available time series data are short and relatively short frequency.
• Benchmarking and performance measurement is problematic in commercial real estate where there is relative benchmarking used rather absolute one. For private real estate there are data issues relating to valuation based company indices and valuation based fund performance measures.
• Market timing being an issue - excess supply and demand which has driven the prices up and capitalisation rates down where sustainability of value is open to question.
• There is high management burden issue which can be in directly owned where the asset must be managed by employed personnel or indirectly owned in which case it will be managed by manager for an additional fee. This fee is not included in return figures but is usually higher and therefore, particular adjustments should be made to account for it.
• Real estate is non-homogeneous asset therefore investor can not usually buy the market. Therefore an investor has a component of specific risk except of property index certificates.
• If the benchmark used only includes a small weight of real estate or no real estate at all then allocating a big proportion of portfolio increases the overall tracking error of the portfolio.
• There are few issues in international portfolio as investor might bear risks of being less informed about the market changes and the lease terms, tax implications and regulations understanding is also time consuming and foremost important.

Illiquidity is much of a disadvantage - much of the concern for investors is to ask for higher compensation returns[7]. This shows much of the justification for Real Estate investment vehicle REIT used to enhance the liquidity. Liquidity is a complex multi-dimensional concept which takes a lot of attention rather than the time taken to execute a trade. It includes

• Direct and indirect costs of trading.
• Risk and uncertainty concerning sales price achieved.
• Risk and uncertainty concerning the time scale.
• Trading volume and frequency and price impacts of the act of sale and purchase.[8]
• Investors will vary about liquidity because of both additional ex ante uncertainty and potential differences in realising values to meet the unexpected liabilities quickly.
• There are other liquidity related risks such as difficulties faced in realising the asset values to meet liabilities and danger of asset sales causing price effects in thinly-traded markets.[9]
• Investors mostly expect a premium for facing this risks and investors with long term horizon and low liability risk usually benefit from this premium[10]

(A) Real Estate - Introduction

The total returns delivered by UK property over the period 1971-2008 have been less volatile even than the returns from gilts[11].

(B) Risk Return Characteristics

• Real estate returns have the ability to offer an inflation hedge which makes its primary inclusion in the portfolios especially for the pension funds.
• Real estate returns often have a low correlation with returns of financial assets, real estate investments are significant diversification alternative for wealth fund managers.
• It has the power to predict unsecuritised real estate returns as the asymmetric information nature of real estate markets makes the predictability of real estate returns more likely a sign of portfolio rebalancing than adverse selection. When analysing the inherent risk and level of variances associated with specific real estate investment valuation or performance, appraisal smoothing has been a significant factor. Usually the directly owned private real estate securities have high returns and low volatility and investors are generally happy with the returns.
• Mostly macroeconomic variables such as nominal interest rates explain about 60% of the variation in real estate prices and growth in employment reduce return betas and volatility in the long run but investment variables have no explanatory power. There is a noticeable relationship between the expected return, return and employment betas. Growth rate in real per capita consumption have a positive impact on commercial real estate returns.
• The risk return characteristics have the same similarities with bonds and equities but betas and risk premium vary with the home prices and have inconsistency with NCREIT[12] and NAREIT[13] indices.
• Appropriate theory or model and internal rate-of-return are as good supplementary method for measuring risk-adjusted performance for real estate funds. Office property returns in London are more volatile than those in European real estate markets which are caused by the fluctuations in capital flows[14]. Investors could achieve higher returns and lower risks from switching from bonds and other securities instead of holding only bonds and stocks in their portfolios.
• Monetary policy also influences returns on real estate assets volatility of real estate instrument such as REIT as a stable product in the financial markets shows that risk and returns of REITs can be improved by switching from real estate and small and large stocks using the P*strategy[15].
• Added Variable Regression Method shows residential real estate as a good inflation hedge but causality model finds it opposite. Real estate firms have unique characteristics such as management expertise and tax advantages that are reflected in returns.
• Real estate offers higher returns along with higher risk than stocks and other assets.
• It outperforms other investments on a risk-adjusted basis.
• They are ungeared asset returns where as returns for equities and listed properties are influenced by leverage.
• They only represent a sub-set of investment quality real estate
• Returns are based on appraisals (valuations) of the real estate in each database rather than on actual transaction prices.
• Appraisal based indices are believed to smoothed both due to temporal regression effects and appraiser behaviour in updating prior information[16]
• This creates a moving average process which reduces the reported risk measures creating lags in responsiveness to information shocks and may distort the correlation.
• Real estate prices are inclined by GDP growth rates where real estate factor is used to explain the variations.
• Securitised real estate returns are based on transactions and the delivered returns in accumulation to the performance of underlying property assets, on the leverage of firms and on management behaviour. The last effect will depend on the structure of the firm with the high distribution requirement of REIT like structure providing less flexibility for management influence than say UK property consumption structure.
• Risk return dimensions unlevered investment in real estate tends to fall between stocks and cash or short term bonds such as T-bills.

(C) Investment Qualities and Real Estate role in Mixed Asset Portfolio

As an advice it is important to see how different companies such as British Land, Land Property and Grosvenor have based on a portfolio in Europe in real estate and have done significantly good performance over the years - with British-Land being the highest of the major UK REITs[22]

Real Estate as a Portfolio Diversifier and Risk Reducer

The correlation between the real estate and stocks and bonds and cash suggests that real estate can play a significant role in mixed asset portfolio. Whenever the two imperfectly related assets[24]are placed together in a portfolio, there is an opportunity to earn a higher return at each level of risk[25]. When the return on an asset is high enough or the risk is lower enough the correlation reflects a sufficiently different pattern of returns, the asset class earns a place in the portfolio of the return-risk spectrum. Real estate meets these tests and is therefore a component of well-diversified mixed asset portfolio[26]

Real Estate as an absolute return enhancer

The second possible reason to include real estate in a portfolio is to bring high absolute or risk adjusted returns to the portfolio. In the previous figure, it shows that on average real estate did not outperform stocks and bonds in absolute terms over 14 years but in terms of total return per unit of risk, it does outperform both. It also outperforms both on risk adjusted basis in terms of the Sharpe ratio and assuming risk return of 5.4% (cash return for the period). The Sharpe ratio measure excess return (above risk-free rate) per unit of risk and thus constitutes a more relevant measure.

• Inflation is good for real estate and not for other assets which justifies that it can outperform both assets in future[27]
• Different quadrants periods show different performance of real estate assets. For example in the next figure, real estate outperforms the rest in total return per unit of risk

As real estate fell into disfavour through 1980s crash, this rationale for holding real estate assets was discredited but then it is important to understand the relationship between real estate and inflation levels. Inflation elicits different responses in the property types through divergent impacts on the income and value components of return and through variation in the effects of past and most recent inflation. Inflation impacts the capital value return in the way that it impacts net operating income (NOI) which feeds through to value via capitalisation rate and it impacts the cap rate directly by influencing NOI growth expectations and therefore investors demand for real estate investments.

• Real estate debt is not a good inflation hedge due to unexpected inflation and concomitant increases in nominal interest rates penalise outstanding securities (mortgage and CMBS). Therefore private equity is more successful transmitter of the value due to links to the stock market which is damaged by inflation.

Real estate as a reflection of the investment Universe

It makes it difficult to include the real estate in the portfolio due to its large size and the real measure of real estate tends to be inadequate due to problems like double counting, conflicting data and missing or not concrete figures.

Practical Issues:-

• Real estate prices are sticky and changes occur slowly.
• Liquidity problems
• Valuation problem - lagging effect, depreciation, large lot size, more capital investment, transaprarency and benchmark issues, performance-measure and leverage issue[30]
• Adjustments to changes in supply and demand occur as much as through transactions volume and time to trade as through shifts in values and prices.
• Ability to enter or exit the market depends on how long it takes to sell or buy.
• Uncertain time on the market in the assets markets (potentially lengthy) there is a significant ex ante risk facing a potential investor. In real estate assets, there is non-linearity and asymmetric in return distributions and for private real estate the return distribution must confront the appraisal smoothing issue[31]
• Leverage also influences return distribution adding capitalisation structure risk to underlying asset risk.
• The private nature of real estate their unregulated structure and absence of public information on transactions forces researchers to rely on survey-based research and simulations.
• Sheer diversity of equity allied to lack of standardisation makes perfect measurement difficult - major problems in quantifying the impact of fractional valuations realisation based performance fees and management costs, right to exit and impact of debt on structure of returns[32]

1. Which usually varies from country to country - here the focus is in general.
2. Specific property
3. But rents can be fixed in the short term producing cash flows similar to those delivered by conventional bond, and the residual value of a property investment after the lease has ended exposes the owner fully to the equity-type risk of the real economy. Hence, property is a hybrid asset with similarities to all the other assets, but different.
4. Decision to invest in property is often based on an analysis of historic risk and return characteristics produced from a market index or benchmark - the tracking error of a portfolio is seen as an additional and unrewarded risk and as a result, managers may be charged with minimising tracking error - See Appendix Table 6.
5. Gearing - describes the level of a company's debt compared with its equity capital and usually is expressed as a percentage.
6. Lenders are willing to lend more against the security of property than against other assets such as securities - See Appendix Table 7
7. Liquidity and market depth cannot handle the pressures from rapid changes to the allocation of real estate.
8. Importance of these dimensions mentioned will vary across asset classes and within property type of buildings, land, and sector and location and market conditions.
9. 5 aspects of liquidity are used to characterise markets such as cost of liquidity portfolio, ability to sell without affecting prices, ability of prices to recover from shocks, cost of selling now rather waiting and transaction costs which includes both direct and indirect costs of trading.
10. See Appendix Table 4.
11. See table below.
12. National Council of Real Estate Investment Fiduciaries Property Index of unlevered real estate owned by tax-exempt institutions.
13. Most commonly used index - National Association of Real Estate Investment Trusts index for all publicly traded REITs.
14. Lizieri, Baum and Scott (2000) conclusions
15. This includes an inflation-predictor variable help to reduce risk and improve returns when used with certain financial assets.
16. There may be computations changes in the indices over time - true for countries where indices have emerged recently.
17. The figure shows the ungeared total returns to directly held standing property investment from one open market valuation to the next in 2008 returns : -22.1%
18. The IPD UK Annual Property Index remains the IPD flagship service in terms of the number of properties and length of historic coverage (28 years). At the end of 2008, the 11,214 properties covered by the Index were valued at £130billion.
19. Stereotypical Characterization of Major Investment Asset Classes - Source Excel - Data from REIT- Europe View
20. The IPD UK Quarterly Index is based on a £78.0bn sample of 7,800 properties at the end of the quarter to 30thSeptember 2009.
21. The total performance achieved by large-scale investors in UK residential property. It shows the investment market performance of different assets in 2008.
22. This gives an indication that we as a team should make our focus on real estate to broaden our portfolio base and achieve higher returns in the future - See Appendix Analysis Part
23. Susan Hudson - Wilson, 2003
24. correlation coefficient of less than 1.0
25. or to reduce risk
26. See Appendix Table 4 and Table 5 justifying the tests.
27. Some real estate components provide absolute return benefits and real estate's lower volatility offers the investor protection from lower returns.
28. Hudson-Wilson, S., Fabozzi, F. & Gordon, J. (2003) Why Real Estate? Journal of Portfolio Management, vol 30 special issue, 12-25
29. Hudson-Wilson, S., Fabozzi, F. & Gordon, J. (2003) Why Real Estate? Journal of Portfolio Management, vol 30 special issue, 12-25
30. problems in comparions.
31. Desmoothing procedures helps to remove this effect by extracting the new information from valuation based returns.
32. Macroeconomic proxy such as GDP does not consider differing institutional structures of real estate markets and valuations in the amount of real estate available for investment.