Ascent autumn 2016 is now out! (by Degroof Petercam)
Listed real estate deserves a place in any portfolio
Nowadays, most investors acknowledge that listed real estate has deserved its status as a separate asset class or at least that it has a right of existence in a diversified portfolio. Index providers as well, recognize the specific nature of this asset class. Only recently, the Global Industry Classification Standard (GICS) introduced real estate as a separate sector based on its growing importance in the world’s equity market and its role as a foundational building block of a modern portfolio, rather than an alternative.
|
Listed Real Estate |
Small Cap Stocks |
Mid-Large Cap Stocks |
German 10Y bond |
|
|
Annualized Return |
10.9% |
7.5% |
1.8% |
6.5% |
|
Risk |
19.1% |
17.6% |
22.4% |
5.6% |
|
Efficiency (return/risk) |
57% |
42% |
8% |
117% |
|
Maximum Drawdown |
-70% |
-65% |
-60% |
-9% |
Period from 31-12-2000 until 25-7-2016. Calculated with FTSE EPRA/NAREIT EUROZONE Total Return , MSCI EMU Small Caps Total Return, MSCI EMU Total Return
The diversification potential is often claimed to come from the hybrid nature of listed real estate. The steady income through the underlying assets (often locked in by inflation-adjustable, multi-year contracts), combined with the high dividend pay-out ratios1, introduces a bond-like component. This is further strengthened by the hunt for yield witnessed over the past years. Lower yields (i.e. higher bond prices) pushed investors towards alternative income generating assets such as real estate, creating a feeling of strong correlation between both asset classes. Nonetheless investors shouldn’t jump to this conclusion too quickly. Although there was a clear increase in correlations over the past five years the overall picture remains that listed real estate is rather uncorrelated to bond prices.
Source: Degroof Petercam Asset Management
Where correlation is low/negative between bond prices and listed real estate, correlation with the equity market is considerably higher, with levels varying between 20% and 80% over the period studied. Whereas coupon payments are fixed over the lifetime of a bond, the dividend payments of listed real estate can grow (or decline) in line with the cash flows, creating a strong equity-like component in its behaviour. By definition, listed real estate is quoted on stock exchanges and consequently broader stock market movements will impact listed real estate prices.
Yet despite the similarities that listed real share with certain stock and bond investments, their risk/return profile is hard to replicate synthetically. In the simple style analysis below the performance of listed real estate is mimicked as closely as possible by optimizing the weights in a portfolio of equity (consisting of small caps and mid/large caps) and government bonds. This synthetic portfolio uses the stock-bond investment universe and minimizes the tracking error with a portfolio that has 100% EMU listed real estate.
The graph below shows the evolution in weights of this synthetic portfolio. In the period after the great financial crisis movements in the price of listed real estate were mainly determined by moves in the stock market. However, over the last 3 years the stable income stream provided by listed real estate became more important as bond yields dropped to record low levels and the search for yield increased the demand for listed real estate. Consequently the bond factor which was also present pre-crisis came back into the picture although to a lesser extent compared to the pre-crisis period. Central banks further stimulated this yield searching behaviour through the risk taking channel of monetary transmission.
Source: Degroof Petercam Asset Management
However, the synthetic portfolio certainly clearly doesn’t capture all variability observed in real estate prices as can be observed when comparing its historical return to that of listed real estate.
Source: Degroof Petercam Asset Management
Although there are periods where behaviour was quite similar, there are also clear periods where listed real estate dances to its own tune. One clear example is the period 2006-2007 where listed real estate posted an impressive return which cannot be explained by a pure bond or equity market component. Before the financial crisis of 2008, debt, not equity, served as the primary source of external capital. As a result, market participants grew accustomed to operating with far more leverage than is found in virtually any other industry based on the common belief that higher leverage boosts expected return on equity, not to mention earnings per share. This is what boosted the share price return of listed real estate in the pre-crisis period. However, leverage only adds value up to a certain point. Once leverage surpasses a level where a downturn in the firm’s fortunes might reasonably result in financial distress, it start to detract from shareholder wealth. This was demonstrated during the financial crisis especially in UK, where the direct property market fell 45% in a 2 years’ time. Before this collapse the “comfortable” Loan-to-Value (LTV)2 was considered to be 50%. However, due to the fall in the value of property this shot up from 50% to 90% (which makes a company basically insolvent). Balance sheet repairs were necessary and the entire community of pan European Real Estate Investment Trusts decided to lower the overall LTV (i.e. to deleverage) by at least 15%3. Today financial discipline of listed real estate companies is far better than it was in the past.
The graph below shows the beta of European listed real estate to European equities. The beta indicates how much the returns of European Real Estate fluctuate compared to the broader European equity market. The leveraging up of the sector pushed the beta above 1, meaning that its return were more volatile compared to the broader market. However, increasing financial discipline lowered this volatility considerably. The beta today is again well below one.
Source: Degroof Petercam Asset Management
This beta below 1 enforces the case of real estate as a diversifying asset, especially in a traditional equity/bond portfolio. This is further confirmed when calculating, through an optimization process, the most diversified portfolio over the sample period. A traditional euro investor should have invested around 4% in order to be optimally diversified. Not huge, but certainly not marginal neither.
Source: Degroof Petercam Asset Management
Moreover, listed real estate gives access to a more efficient asset class than pure equities. Efficiency is expressed as the ratio of the realized return over a certain period, divided by its volatility. The picture below shows the efficiency estimated over a moving window of three years for both traditional equities and listed real estate.
Source: Degroof Petercam Asset Management
All observations are above the 45 degrees line, indicating that for each 3-year stock market investment, there is a more efficient investment via listed real estate.
What about liquidity in the real estate market? Liquidity became again an important topic recently after the Brexit referendum result, when some shareholders of UK real estate open ended funds decided to sell their stake, forcing three UK real estate open funds to suspend redemptions. One should know that these type of open ended UK funds are typically invested for 80% in direct real estate (i.e. in bricks and mortar). So although the open ended UK funds are listed their underlying assets (which are of good quality) are illiquid. An investor should be very wary about this. Note that the 3 European listed real estate funds of Bank Degroof Petercam are solely invested in listed securities with daily liquidity (so no exposure to direct real estate, far less liquid by nature).
Conclusion
Listed real estate deserves a position in a well-diversified portfolio. A style analysis reveals that listed real estate has a clear small cap equity component and to a lesser extent a bond component. With an equity beta below one and a higher efficiency than pure equities, this asset class improves the return/risk profile of a portfolio. Moreover, the financial crisis forced real estate companies to demonstrate greater financial discipline in terms of leverage.
A style analysis reveals that listed real estate has a clear small cap equity component and to a lesser extent a bond component.
Authors
Damien Marichal, Frederiek Van Holle and Joeri Willems
Notes
1 Real Estate Investment Trusts (REITS) need to maintain these high dividend pay-out ratios in order to profit from a lighter tax treatment
2 in the real estate sector, the level of leverage is commonly measured by its LTV ratio, or loan-to-value. This ratio is far from being comprehensive but it gives a quick and easy gauge on the leverage
3 in the UK most REITS are now below 30% LTV, for continental Europe the average is at 40%.