Investing in real estate equities – can the market volatility be mitigated?

Listed real estate equities provide an attractive alternative to directly accessing the global real estate markets but how can investors manage the short-term equity market volatility that comes with it? 

28th April 2015

Real estate has a role to play in any diversified portfolio.  Direct global real estate has performed well historically, returning 7.2% p.a. in the 15 years to the end of 20141

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It has typically provided a 7 to 8% p.a. return on average over the very long-term, has a high income return component (around 60% of total return comes from income)  and can provide inflation protection, making it a desirable asset class for investors.  It also compares favourably with other asset classes, outperforming both global equities and bonds over the same period, which returned 3.2% p.a. and 5.0% p.a. respectively2.

Accessing real estate efficiently can prove difficult for many investors, as building a diversified real estate portfolio through direct ownership can be challenging.  Real estate assets are large and require specialised management and local expertise, making it difficult for investors without large pools of capital to invest at the required scale for both diversification and cost efficiency.

Investors that cannot access the direct market efficiently can gain access indirectly through, for example, unlisted funds or partnerships with property specialists.  Another way of gaining exposure is through the listed market.  Listed real estate equities, like listed Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs), can provide easy and efficient access to the global real estate markets.

The listed real estate universe is geographically well diversified, providing access to the underlying real estate markets in all continents through more than 500 liquid and tradable companies with a combined market capitalisation of over US$2.4 trillion.  Sector diversification is also possible in most markets, especially in the US (the largest listed real estate market), where sector specialist REITs represent the traditional sectors like office, retail, residential and industrial but also alternative niche sectors like healthcare, student housing and self-storage.  Listed players hold a significant proportion of prime real estate assets and manage them professionally.

But are real estate equities real estate?  This is a common question asked by investors.

The aggregate property portfolio of the listed real estate sector represents around 17% of the high grade global investment property universe, and unsurprisingly its value moves in line with the wider real estate market.  It can be argued that investing in a portfolio of REITs, for example, is similar to investing in a diversified portfolio of prime assets, except with liquidity.  REITs are tax transparent vehicles that pay out around 90% of their earnings, so cash flows that investors receive from REIT shares (and those that ultimately determine investment value) are basically the same as those receivable from the underlying real estate portfolio.

What can mislead investors is the short term volatility usually observable in the price of real estate equities. This difference in volatility between the return of the underlying property market and returns on real estate equities causes most investors to think that real estate equities are related to but not the same as real estate.

Comparing the performance of the listed real estate market (EPRA/NAREIT US Total Return Index) and the direct real estate market (US NCREIF Total Return Transaction Based Index (TBI)) we can see that the two series are related (Chart 1), having the same basic time series profile, but with real estate shares being more volatile.  The main factor that makes this basic comparison slightly misleading is gearing.

The US NCREIF Total Return TBI index is a property return index that measures returns from US commercial real estate as indicated by transactions (as opposed to valuations or appraisals) and it does not suffer from valuation smoothing3 .  The index assumes an all-equity financed investment position.  Investors financed by both debt and equity would see more volatility in the Net Asset Value (NAV) of their portfolio due to the impact of gearing on underlying property price movements.  By de-gearing this index (i.e. reverting it back to an all equity position) we can take out the volatility (although not completely) and make a more sensible like for like comparison between the listed and direct markets.  The results, again in Chart 1, show strong similarities between the two indices.  The performance statistics are also supportive. Returns for the direct and de-geared listed indices are around 10.9% p.a. over the long-term (since 1993) and on a risk-adjusted basis both series show an information ratio of around 1 (vs 0.6 for the listed real estate market).

In addition to gearing the listed real estate market is also influenced by broader equity market volatility.  Over the medium term, listed real estate prices follow a stable relationship with the NAV of the underlying, but due to stock market fluctuations unconnected to real estate, can deviate from it in the short term. This deviation causes shares to trade at a discount or premium to NAV, but the process is mean-reverting i.e. prices revert back to the anchor of NAV over time (Chart 2). 

The price to NAV ratio has a stable mean, albeit different for each market.  In more efficient markets like the US, where discount gaps can close quickly through M&A activity, the mean is near zero.  While in markets where inefficiencies exist the mean is below zero i.e. the shares trade at a discount to NAV on average. The Hong Kong market is one such example where significant family holdings in many listed real estate companies do not allow for efficient market activity, driving the sector to trade at a historic discount averaging 26%. This short-term mis-pricing can provide opportunities for savvy investors that have an understanding of what fair value should be.

Gaining real estate exposure through listed real estate equities has many positives but in order to access the underlying property performance investors need to manage the short-term market volatility from which the sector suffers.  One way of achieving this is through a long/short investment strategy.  Such a strategy allows investors to manage their exposure to the sector through the cycle (both at the portfolio and country level), increasing net exposure when the market provides value and reducing it when the markets appear overpriced.  Investors with a good understanding of the underlying real estate markets can identify value in the listed markets and trade their views profitably through the cycle.


 

Chart 3 shows the results of a simulated portfolio applying such a strategy for the US with encouraging results. We use the US since it is the largest listed real estate market (representing around 50% of the global universe by market capitalisation) but the strategy is applicable at a global level.  A long/short strategy is also applicable at the company level by taking long positions in listed companies with desirable characteristics; such as those with good quality assets, growing dividends, low gearing, strong balance sheets and strong management teams.  Whilst short positions can be taken in weak companies that do not display such characteristics.

A combination of the above could provide an effective strategy in accessing real estate returns with increased liquidity and reduced volatility.  Our outlook for 2015 is positive with expected returns around 10% but as we head towards more uncertain times with increased market volatility, a long/short strategy could provide positive returns no matter what the direction of the market.

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[1] IPD Global All Property Index (local currency), Grosvenor Research
[2] MSCI World Equities Index, Barclays Global Government Bond Index, Grosvenor Research
[3] Valuation smoothing affects real estate performance indices that are valuation based and it occurs due to the use of a weighted average of transactions evidence and the past valuation to estimate the current valuation.

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