Risk and return in real estate: Lessons from the listed market

Listed real estate data are a rich source of information.  But how can it be use to analyse risk and return in the broader real estate market?  

14th December 2015

Listed real estate data are a rich source of information for direct real estate markets.  This article examines how listed real estate data can be used in an analysis of risk and return in the broader real estate market.

Continue to the other two articles in this edition of Global Outlook.

Positive economic outlook but divergence continues.

The global economy has continued to grow at a steady but underwhelming pace through 2015. What are the expectations for 2016? Graham Parry, Group Research Director, Grosvenor Group, shares his views. Click here to read more. 

European urban retail investment has been increasing, what is driving investors' interest? 

Urban retail is a sector that is expected to fare well in Europe over the long term. In this month's 'Questions & Answers', Simon Chinn, Research Analyst, Grosvenor Group, explains why. Click here to read more. 

Risk and return in property

Several key real estate markets have witnessed a strong recovery over the past five years.  In many markets, property yields are now close to or even below their all-time lows.  With the US widely expected to raise interest rates in December, investors are questioning whether current pricing still represents fair value or whether there has been an increase in property sector risk.

Given the uncertainty over the current stage of the cycle, timely measures of market conditions are more important than ever for property investors. Unfortunately, property is an illiquid and data-poor asset class, making real-time risk measurement difficult.  Appraisal-based valuations are a smoothed, lagging reflection of market conditions and individual property assets are much more idiosyncratic than traditional equity and fixed income investments.  The time lag between measurement, compilation, and delivery of real estate data can reduce the value of even the most current data when the market is moving fast.

One potential answer is to use listed property stocks to gain insights into emerging real estate sector risks. Listed real estate equity data are free from many of the shortcomings of those in the direct market. Listed real estate trades in real time, is actively priced, and is less idiosyncratic as an investment compared with direct property. While listed real estate is subject to greater short-term volatility than direct property, over the longer-run listed real estate returns are closely related to direct real estate returns*.

In addition, there is some empirical evidence that the listed sector data leads direct real estate, by between six and 24 months. Thus, listed real estate offers a potential way to measure real-time risk and required returns in direct property.

Listed real estate betas as a risk-return measure

One tool for measuring sector risk is to look at the equity beta of companies in that sector.  The equity beta is a measure of how volatile the returns on a specific company or sector are relative to the equity market as a whole. A beta of 1 indicates that the asset’s returns are identical to the market’s returns, while a beta greater than 1 means that the asset’s returns are more volatile than returns on the market as a whole.  Because it is a measure of sector specific risk, beta is also a key component of an investor’s required returns.  One of the fundamental assumptions of the capital asset pricing model (CAPM) is that the required return on any asset depends on that asset’s beta.  Thus, an asset with a higher beta (i.e. higher risk) warrants a higher required return by investors.

What drives property betas?

Betas tend to move through time and are ultimately a reflection of the underlying uncertainty in the cash flows of individual property companies in the sector. There are several broad factors that determine riskiness in the real estate sector:

  • One of the primary drivers of risk of cash flow to equity is the loan-to-value (LTV) ratio.  This is due to the amplifying effect of leverage on returns, both gains and losses. Another feature of debt financing that accentuates risk is debt covenants.  If underlying cash flows fall significantly, investors could be required to sell asset and monetise the equity value of property early to avoid violating their covenants.
  • Development exposure is another driver of beta.  Property development requires large up-front expenditure without immediate returns, sometimes for several years.  Market conditions can change dramatically over the development cycle.  Together these features of development increase the range of uncertainty over future cash flows and elevate beta.
  • Finally, the transparency and accessibility of a real estate market partly determines beta.  The more opaque and closed the market, the more uncertainty over future cash flows and the higher the risk, required returns, and beta.  Prevailing legal, regulatory, and data conditions in local real estate markets are important here.

What have property betas done historically?

To understand what betas are now telling us about the current real estate market, it is worth reviewing the recent performance of global property stocks.  Following their debt-fuelled bull run through the mid-2000s, many real estate equity indices have still not recovered from the correction that accompanied the financial crisis (Chart 1).  Indeed, the only countries where listed property returns have surpassed their previous peak are in Canada, France, and the US.

The scars from the property market crash are still reflected in today’s betas.  Chart 2 shows the average betas across a sample of regions broken down by time period.  As can be seen, prior to the 2003-7 global debt binge, listed property had been a relatively low-beta asset class.  On average betas were significantly lower than 1, indicating that listed real estate returns were less volatile than returns on the broader equity market.  Over this period, leverage was relatively conservative and listed real estate were essentially cash flow pass-through vehicles, focussed on collecting and distributing rents.

Betas started to trend upwards in the mid-2000s as listed real estate vehicles took on increasing leverage to enhance returns, with betas peaking at between 1.4 to 1.9 — indicating the listed real estate returns were between 40% to 90% more volatile than global equity returns — during the crisis and remained there for the next several years.

 

Betas started to come down materially first in the US.  This reflects that US companies as a whole deleveraged quickly and the US economy began its recovery ahead of other developed markets.  Betas in the UK and the Eurozone remained high throughout the sovereign debt crisis period of 2010-2012.  In the UK, the beta began to trend downward in late 2013 as the broader economy began to turn the corner.  More recently, betas in the Eurozone have been falling in light of the recovery of embattled peripheral Eurozone countries and the ECB’s QE programme.  Across the regions, listed real estate betas are below 1 again.  Still, none have returned to their pre-crisis levels yet, with the US being the closest.

Implications

On the surface, the message from the listed sector is that property has de-risked.  Much of this has been driven by de-levering since the financial crisis.  Although it is too early to say so definitively, property could be returning to being a relatively low risk, low beta asset class.

As risk and beta have fallen, so have required returns to equity in real estate, all else equal.  At current levels of government bond yields and assuming a risk premium of 5%, today’s betas imply required returns on real estate investment varying between 5% and 7% in major developed markets.  In this return environment, investors should not expect to enjoy high returns simply by following the market.  Going forward, higher returns will depend on investment-specific outperformance (or “alpha”).  This means more emphasis on asset and sub-sector selection going forward.

One potential shortcoming of beta analysis stems from the fact that LTVs are pro-cyclical and mask a build-up in risk if asset values are in a bubble, artificially reducing LTVs**.   This problem is even more acute in a QE world; one of the ways QE works is to stimulate the economy by increasing asset prices.  So while beta is a more timely measure of risk in real estate markets, it can be biased if assets are overpriced.  But with existing data, it is difficult to identify the impact of debt versus asset values in LTV movements.  This reinforces the need for better aggregate data on commercial real estate debt, something the Bank of England has acknowledged and started developing for the UK.  Once available,
this information will improve the use of beta as a real-time risk indicator.

*See the April 2015 Global Outlook article “Investing in real estate equities – can the market volatility be mitigated?”.

**Investment Property Forum (2014) “A Vision for Real Estate Finance in the UK”.  Debt coverage ratios, such as net debt to EBITDA, can be used instead but also suffer from pro-cyclicality, albeit to a lesser degree than LTV.

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