Can listed investments be managed within institutional real estate portfolios alongside private holdings? Andrew Baum looks at the possible obstacles
Europe holds a smaller percentage of its investable real estate through listed companies than is the case in either North America or developed Asia (see table). At the same time, private real estate vehicles are relatively over-represented. Understanding why this is the case is important for the European Public Real Estate Association (EPRA) as it pursues its mission to promote, develop and represent the European listed sector.
An under-representation of listed real estate in Europe might be the result of performance (risk-and-return characteristics relative to equities, bonds and other assets). This has been the subject of considerable, often supportive, work: it might be to do with regulatory differences; or it may be because of historic organisational (or institutional) issues.
We know very little about the latter influence. To begin to redress this, EPRA has an ambition to undertake significant research designed to capture the organisational processes that determine whether European investors typically include listed real estate in their real estate portfolios. If not, we would like to know why not; if they do, we would like to know what (if anything) limits the weight they place on listed real estate.
As a precursor to any such significant study, the EPRA research committee designed a pilot survey to identify potential organisational issues limiting the exposure of European institutions to listed forms of real estate and to support the design of a comprehensive research study of this issue.
The case against
Views expressed by some of those investors that do not manage listed real estate as part of the real estate allocation were that property companies and real estate investment trusts (REITs) are securities. They do not come within the real estate team’s remit, and sit firmly within the equity team. Listed property analysts may be close to the direct real estate team, exchanging notes on markets, but the investments are fundamentally different. Real estate securities and private real estate should be separate, because (a) they are essentially different animals with different correlations and different volatilities, and (b) the skills for investing are different.
“[Listed] is currently not within the mandate or IMA [investment management agreement],” said one interviewee. “The client deals with real estate equities within the equity allocation. Real estate equities are not part of the real estate allocation. The client’s view is that they are more ‘equities’ than ‘real estate’.”
Others feel that they lack the required expertise: “We are a specialist real estate company investing in direct property, so [listed] would sit uneasily within the framework of our business. Our philosophy is to drive performance through superior asset selection and management... ceding control to another company would be inconsistent with this approach.”
At present there appears to be little or no perceived pressure from client investors for change, although new product development (for defined contribution pension schemes, for example) may lead to some demand to include listed real estate in the property portfolio.
But the case for predominates...
The majority of investors and managers interviewed said they managed both public and private real estate within the real estate allocation or mandate. Of these, most used a dedicated REIT team sitting outside the real estate group, sharing research only to a limited extent. One investor/manager suggested that as the allocation grows they may outsource to an external manager. One manager that uses listed securities believes that the listed sector should not form part of the real estate portfolio in future. All of the others believe that it should, one specified for liquidity purposes only. Several of the rest believe the allocation will probably stay stable in the future, while another significant group believes it will grow, with the growth of defined contribution pension schemes being seen as a driver. Importantly, only one suggested the allocation would fall. One investor/manager specifically stated that they would like to develop more integrated products using listed and private real estate together.
...despite execution difficulties
Several interviewees mentioned the volatility of the listed sector as causing them a significant problem. Another said this was more about perception than reality, and this issue required education for users and clients. High correlation with general equities was quoted as an issue for a few investors, expressed more fashionably by one as “the standard issue of real estate beta being different from equity market beta”. This could also be expressed as a focus on relative performance objectives and benchmarking by many European investors, especially in the UK and Netherlands, with special attention being paid to year-end valuations of private real estate and their consequent impact on returns, solvency and funding models. When NAV (net asset value) estimates are taken very seriously, REITs cause problems.
Several mentioned the operational difficulties involved in exploiting the arbitrage opportunities that should exist between public and private real estate. There is a failure to separate the active tactical decisions commonly used in managing REITs from the decision to use REITs as part of a strategic real estate allocation. Hence listed real estate is “seen by clients as equities rather than real estate, used as a cash pot, and holdings are tactical rather than strategic”.
Also: “The REIT allocation is actively managed against an EPRA benchmark, comprising 7.5% of the fund, but it is there to create a real estate linked liquidity buffer, so why trade it? This is a problem to do with the culture of equity managers. In addition, the fund is a UK product, but our REIT team uses European REITs because that gives them more tactical choice and liquidity.”
Another response was: “There is no way of reducing our unlisted allocation when listed is cheap, so the allocations remain separate; and short-term volatility has affected the returns badly. Our REIT manager aims to outperform his REIT benchmark on a six-12-month basis, but this has little to do with our overall objective.”
The next steps
We believe we may have uncovered some interesting issues for further examination. Within the sub-set of those for whom listed real estate forms part of the real estate allocation, some have an integrated approach to public and private real estate; but more do not, sub-contracting public real estate to a dedicated team, the equity desk, or even to an external manager. It appears that this goes some way to defeating the object of a combined mandate.
This pilot survey suggested that to some extent this results from a unique focus on (and faith in) net asset values, more predominant in Europe than elsewhere. But to what extent has the recent crisis eroded or cemented this faith and strengthened, or weakened, the case for listed real estate within the real estate allocation?
There is equal evidence in the survey to suggest that asset managers (with their greater experience of execution as well as a propensity for business unit separation) may not have developed a satisfactory integrated investment process.
As asset managers adjust and develop their product ranges to meet what might be a gently rising demand, they also need to solve the investment process problems of integrating listed and private real estate within one business and one portfolio, a facility which currently seems either elusive or absent. They also need to be able to show that the listed portfolio is being managed with an eye on the strategic objectives of the real estate allocation, and not on a standard solution that suits the objectives of the listed real estate team.
We need to know more about the relative weight and distribution of these positions among the pure investor community (pension funds) and the consultants, as managers are generally in business to respond to their needs. To what extent do investors want to use listed securities? Are they being disappointed by the industry response and, if so, what weight of capital is being frustrated? How much money would be allocated to the listed sector if managers had the appropriate investment solutions in place? Is there any difference in attitude between those managers with captive capital (where it would be expected that a rational solution could be developed and delivered in the client/owner’s interest) and the independent managers?
Andrew Baum is chairman of Property Funds Research