Investment Week - Benefits of Global Property investing
19 April 2010
The performance of commercial property is critically linked to growth in the underlying economy. After all, decisions by businesses to expand, invest in, or reduce their operations drive both GDP growth and floor-space demand. It is perhaps not surprising therefore that global property has had a torrid few years, with global GDP in 2009 contracting for the first year since 1945 and large developed economies losing between 6% and 8% of output. Fortunately, the global economy has already embarked on a recovery. It is likely however that the path will be slow, with the consensus of economists expecting just 3% in totality this year. Much of this is supported by stronger growth in Asia where more than 5% is forecast, compared to just over 1% in Europe. This sluggish recovery - lower than in previous post-crisis episodes - hinges on the depth of the damage caused by the financial crisis.
A much heard quote 'the only thing to go up in a global recession is correlation', highlights why the case for global property diversification has been tested in the recent cycle. There are a number of key reasons for this: the globally synchronised nature of the downturn; the property sector's heavy dependence on debt; and recent higher correlations between listed property stocks and global equity markets. The speed of the economic downturn (see chart A) was unprecedented in modern economic history, hence the world saw its first year of global contraction in more than 60 years. Against this backdrop global listed property markets recorded three year rolling correlations of more than 85% in 2009, for the first time since the early 1990s. In tandem with the lack of geographic diversification, i.e. between countries, real estate securities were subject to the same 'flight to safety' investor sentiment as broader equity markets and hence 3 year correlations with equities were above 80% for the first time since the mid-1990s.
Chart A: Global GDP (%p.a.)
Property is a large lumpy asset which, combined with its high and relatively secure running yield, has in the past fuelled its addiction for debt. Various estimates suggest global commercial property debt accounted for about 60% of the $12 trillion (tn) or so real estate investable universe at the end of 2008. The western world has been the most prolific debt abuser through the last cycle, with US REITs (real estate investment trusts) recording a mighty 162% average debt to equity at points during the downturn in underlying asset values. The property sector's exposure to debt, and the global nature of the financial crisis, meant that the asset class underwent a wholesale re-pricing in 2008 and into early 2009 under pressures of constrained credit, risk aversion and consequent higher margin costs. Peak to trough global listed property markets fell 70% through the downturn, with the less indebted Asian markets falling as hard as the problematic indebted Western markets (see chart B).
Chart B: Listed Sector Index Returns (31/3/2010)
2009 was the year that the majority of listed global real estate companies tackled their debt and refinancing issues. In general management teams have successfully raised equity through the capital markets and now most are through the worst in terms of re-financing. Therefore as the major repair of balance sheets is behind us, we see 2010 as a return to the fundamentals driving performance rather than debt concerns and investor risk aversion. So why does the case for global diversification still stand? In the first instance, we have to acknowledge that the recent global slowdown and financial crisis are extreme in the context of economic history. The long term benefits of diversification and low global correlation between property markets bares this out (see table 1). In terms of diversification between different asset types, rolling 3 year listed property correlations with global bonds remain low, at between 20% and -20% since the mid 1990s.
Table 1: Correlations (Monthly 1990 - 2009)
Much of the data above relates to the listed property universe because unlisted property markets do not offer the same level of transparency and valuation data. Furthermore, accessing some global property markets on a direct basis is difficult due to the underlying ownership within the markets. In some countries, particularly in Asian and emerging markets, property remains very much a local business. Therefore investors may only be able to enjoy the growth in that section of the universe through investing in local management teams in private vehicles or in listed companies. Clearly in the short term, i.e. less than three years, listed investments provide liquidity but demonstrate significantly higher volatility than direct ownership.
The construction of a globally diversified property portfolio should hinge on an investors requirement for liquidity. This liquidity requirement then drives a 'core and satellite' approach to building exposures which would include a mix of directly held assets, investment in private property vehicles and holdings in listed companies. Each of these investment mediums has positive and negative attributes relating to control, fees, local expertise, access to market and volatility. Short-term investors are likely to employ a more tactical approach to their property portfolio with liquidity and transparency key and using listed real estate securities. Medium-term investors may use both a strategic and tactical approach in allocating between listed, private indirect and direct holdings depending on diversification requirements. The optimum long term view would favour a more strategic approach with a higher 'core' holding in direct assets while maintaining flexibility and ability to adjust weightings over the medium term, either through listed exposure or private vehicles. Optimum weightings under the above investor types could vary between: direct ownership making up 60-70% of portfolio, private vehicles between 10-20%, and listed securities 10-20%.
The mantra of the investment world remains that past performance is not a guide to the future, and in this context recent levels of volatility and pricing movements are unlikely to be a repeated feature of the market in the medium term. More probable is that performance will be driven by underlying fundamentals: regional economic policies, tenant demand, supply of space and the skill of management teams. Given the range of forecasts for the global economy, the case for global diversification is valid with our forecast returns for property markets ranging from more than 15% in London, New York, Sydney and Paris offices over the next few years compared to less than 5% in Dublin, Madrid and Tokyo.
Anne Breen, Head of Property Research - Property, Standard Life Investments
This article was first published in Investment Week on Monday 19th April 2010.
