Asset management: Investors stick with real estate through the bad times

The story of how real estate has emerged from being a so-called alternative investment to become a staple of many investors’ asset allocations, along with fixed income and equities, is one that has been told many times to clients over the past decade. With the asset class promoted as a diversification play as well as a way of generating inflation-linked income over the long term, in the past 10 years investors have increased their allocation to real estate from nothing to 5% and in some cases up to 10%.

Most asset managers now have sizeable real estate units, demonstrating the asset class’s importance as part of their overall businesses. The top 20 respondents to Liquid Real Estate’s survey of the largest asset managers have a total of $366 billion invested in the asset class. Respondents were ranked by real estate assets under management. Real estate investing constitutes 7.8% of these managers’ total AUM and most of them are planning to keep their allocations as they are or increase them over the next year. Only 8% of managers responding to Liquid’s survey plan to reduce their real estate exposure in 2009. Even though 2008 has not been one to shout about from a returns perspective, managers are confident that real estate is here to stay as a mainstream asset class. Compared with equities, real estate looks relatively strong, but apart from that relative outperformance to recommend it, the asset class simply has become entrenched in asset allocations, especially as more ways of measuring its performance have become available.

"We’re not getting the sense that institutional investors are pulling back from property," says Andrew Smith, chief investment officer at Aberdeen Property Investors, part of Aberdeen Asset Management, which manages $49 billion in real estate. "They intend to maintain property exposure, but they’re not looking to invest more money in the short term."

The investment thesis for property remains intact, argues Anne Breen, head of property research at Standard Life Investments in Edinburgh, which manages $24.9 billion in real estate assets. Investors like property because it is a stable, long-term income generator.

"There may be some changes in attitude, not on real estate allocations but about the method of investing in the underlying market," says Breen. "An example could be open-ended real estate funds. There may be a change in attitude on these funds and their ability to provide liquidity in what is a relatively illiquid asset class."

Investors will likely demand a higher premium for less liquid and opaque investment opportunities as they move into the next investment cycle. They will seek to spread their investments in different types of vehicles.

"It will be important not to have all your allocation in an open-ended vehicle or listed stocks, for example. A mix of investments could be more appropriate to diversify market risk and vehicle risk," says Breen.

Real estate investors, such as pension funds and insurance companies, are not running for the exits; nor though are they moving to boost allocations. A wait-and-see approach is the order of the day. Investors are keeping cash positions at the ready to deploy when the markets show signs of recovery.

"Allocations to real estate of up to 10% are here for the long run because investors have realized that diversification is important," says George Ochs, managing director in real assets at JPMorgan Asset Management, which manages $58.4 billion-worth of real estate. "Real estate has performed on a risk/return basis and is not correlated to stocks and bonds. There may be a pause in terms of allocations changing for the next few years, because all bets are off. If we get back to more normal times, you will see allocation to real estate rise again and to other real assets."

The explosion of measurement tools such as indices has contributed to real estate’s coming of age. It used to be difficult to measure performance outside such markets as the US, the UK and the Netherlands where there is a history of performance benchmarking and indices.

"There’s a change now in that there are enough indices available with sufficient histories, which can give investors some comfort through one or two cycles of real estate performance," says Russell Chaplin, global real estate strategist at UBS Asset Management, which manages $50.7 billion in property. "Investors are able to make some assumptions when they include real estate in their asset allocation models."

Today, there are more analysts dedicated to real estate than 15 years ago when research on the asset class was a backroom discipline, which typically didn’t have much influence on what people did, according to Chaplin. More research has brought transparency to real estate, which in turn has bolstered interest in it and cemented its place in the investment orthodoxy. "I don’t see any reason real estate would go back to the status it had 10 or 15 years ago, when it was considered more of an alternative investment," says Chaplin. "Real estate is an asset class that is firmly established and it’s an asset class that’s come of age over the last five years with more Reit structures, which allows greater transparency and public pricing on a daily basis."

Real estate could indeed be benefiting from the current turmoil in the capital markets and global economic downturn. Investors are beating a retreat from esoteric alternative investments and hedge funds, in particular, have been hit with requests for redemptions as they post quarter after quarter of eye-wateringly bad returns. Investors are abandoning the high-fee world of hedge funds and retrenching into traditional fixed income, equity and property.

"You can argue property is almost a beneficiary of wider forces at work and risk aversion," says Aberdeen’s Smith. "Investors don’t have to go into highly leveraged vehicles and opportunity funds. The majority of our investors are in core and value-added funds that are income-generating rather than relying on development to generate their returns."

Unlisted funds

Real estate’s illiquid nature has been highlighted in the past year to 18 months. Commercial property sales have slowed and investment vehicles, especially unlisted funds, have been hard hit. Unlisted funds have been popular with investors seeking to deploy cash beyond their home markets. These vehicles permitted investors to access a diverse pool of assets with a limited amount of capital. Unfortunately, over the past 12 months while returns in many of these funds plummeted so did investors’ ability to cash out. Many of these funds are highly leveraged and that served to magnify their poor performance.

"Investors have discovered under these conditions unlisted funds, even though they are open-ended and in theory tradable, have become less liquid than the underlying assets," says Smith. Investors, perhaps mistakenly, assumed these funds were going to be more liquid than direct property investments, because they trade in units.

"Real estate should be a long-term investment and to try and use unlisted real estate funds to time the market as if they had the liquidity of equities is not really sensible," says UBS’s Chaplin. "If you want liquidity in real estate, the only place you will find that is in Reits. The cost of liquidity is volatility."

These funds are unlikely to recover in the near term because many will face refinancing issues as debt markets continue to be closed to most. This situation could force these funds to sell properties they hold at deep discounts. Smith says in future these kinds of vehicles will be structured much more carefully with more of a focus on redemption provisions. He reckons there will be some consolidation among players in this sector and says Aberdeen is seeing more interest in direct property from investors who previously invested indirectly. As for 2009, it looks as if it will be a mixed bag of opportunity and yet more difficulty. There won’t be any quick return to the good old days of 2004–07 when in the UK, for example, investors saw total returns of 18% to 20%.

"The good old days never really worked because risk was masked by clever packaging," says JPMorgan’s Ochs.

In the long term, real estate should give 6% to 7% unlevered return. The high returns experienced prior to the onset of the credit crunch came from a conjunction of circumstances – the income return on real estate was very good, there was strong GDP growth feeding into the occupier market and debt was widely available as well as cheap.

"Those three things need to line up for that situation to happen again and that won’t come around again for some time," says Chaplin. "We’re looking at a period where managers are going to have to be focused on the income portion of total return, which typically means strong asset management, low levels of vacancy and a real time to work closely with the occupiers of your properties."

Chaplin believes that while 2009 will remain tough going there will be plenty of opportunities for those in a position to take advantage. He sees a range of investment options at the country and sector level and says that at the individual asset level, there will be some openings in the market in 2009. He says that in 2007, which was a good year for most markets, the IPD indices and the Nacreif index for the US show a lot of value in country and sector combinations for example French/retail, German/offices or US/industrial. Many such combinations are still good bets today.

"The range of the returns across the globe was around 40%, representing a huge range of opportunities," says Chaplin. "Taking those indexes back as far as they would go the range of returns was 25% between the best and worst performers in a weak or strong markets."

Globally, the property market is still far away from showing signs of a recovery. Most don’t expect that to happen until 2010 at the earliest. Values still have quite a way to come down in most regions and until that happens investors are going to be choosy about where they put their money.