Stuart Beevor is managing director of Grosvenor Fund Management.
The real estate sector has experienced bull market conditions in the first half of 2007. Stuart Beevor examines how the savvy investor can profit from the sector's strong diversification characteristics and reap the returns
Investor interest in real estate has risen dramatically in recent years, reflecting its attractive risk return profile relative to other asset types. Bull market conditions in the sector have seen investors hungry for acquisitions causing prices to go up, yields to come down and investors to benefit from excellent returns.
The advantages of real estate as an asset class are increasingly obvious: it offers strong diversification benefits; it is a tangible asset with low volatility; and it generates an attractive income stream and long-term capital appreciation.
And although real estate has drawbacks too – it can be illiquid, needs expert management and is "lumpy", requiring significant capital to build a diversified portfolio – innovations in real estate investment vehicles over the past decade have successfully begun to address these objections.
The global investible universe of real estate is now estimated at over €11 trillion ($15 trillion). Europe and North America account for 37% and 36% respectively whereas Asia (which includes China) and other emerging markets account for 21% and 6%. While directly-held real estate still accounts for 70% of the total, the listed sector share has risen to 19% and unlisted funds now account for 11%. As the Asian and central and eastern European economies continue to grow, the development of new real estate and the transfer from owner occupation to investment stock looks set to grow.
Investor appetite has led to a structural market shift. Cross-border investment has grown six times more quickly than domestic investment in the past five years and there has been a boom in cross-border funds. European managers and investors are primarily focused on pan-European real estate, with a current focus on the Nordic countries, Germany, and the developing markets of southern Europe and central and eastern Europe. There is huge interest in China, with a more general interest in the Asian markets.
The world's top investors are going global and, as a consequence, there has been a boom in unlisted funds supporting the huge increase in cross-border investing. At the same time, the listed market has grown as Real Estate Investment Trusts (REITs) have been introduced in new countries.
There are multiple routes that investors can use to find their way into real estate. Each has merits and drawbacks but the trick is selecting the right one for the particular level and type of investment required.
Direct and indirect investment
Historically, investment in real estate was through the direct acquisition of individual investment properties. This provides direct control over assets with the ability to add value through management expertise, although significant capital is needed. Research suggests that a minimum of 20–30 properties is required to manage stock-specific risk through diversification. Bearing in mind the large lot sizes, this route is only realistic for investors with hundreds of millions to invest. Furthermore, investing directly becomes more challenging in foreign markets where there are different market practices, laws and cultures.
Direct investment in individual properties is often viewed as "lumpy". Investors have consequently sought alternatives such as joint ventures, syndicates and funds. Each of these adopts a different investment strategy in terms of numbers of properties, use, location, legal structures and risk profiles. The quantity and size of indirect funds has grown dramatically over the past 10 years. There are now over 800 funds with an aggregate value of almost €300 billion in Europe.
In response to growing investor demand there is a myriad of fund vehicles offering exposure to varying countries (and regions), sectors and risk profiles. The most popular vehicles are private real estate funds which typically bring together a relatively small number (between five and 20) of like-minded investors. These normally have a fixed life (up to 10 years), offering investors a share in a portfolio of assets.
The growth in popularity of private real estate funds has prompted the formation of the European Association for Investors in non-listed Real Estate Vehicles (INREV), which earlier this year published its Investor Intentions survey. This identified four major reasons for investing in non-listed real estate vehicles:
- Access to expert management.
- International diversification for an existing domestic portfolio.
- Diversification benefits for existing multi-asset portfolio.
- Access to new markets.
The survey also identified the major reasons for not
investing as being:
- Lack of transparency and market information on non-listed vehicles.
- Lack of suitable products.
- High costs associated with investing in non-listed vehicles.
- Limited liquidity.
Potential investors in these funds should consider the funds' tax and fee structures, as well as their management controls and liquidity. Typically, they are structured as special purpose vehicles (SPV) domiciled in Luxembourg or the Channel Islands. They tend to charge a composite fee covering a number of activities. This is normally charged at a rate of somewhere between 0.5% and 2.5% per annum depending on the profile of the fund. Strategic decisions are made by shareholders with day-to-day decisions delegated to managers. And the private, unlisted nature of these funds means they are relatively illiquid. These vehicles can be attractive to high net worth investors, but have been particularly attractive to pension fund investors. Investment commitments tend to be €10 million upwards so perhaps they are most appropriate to the ultra high net worth investor market.
Other forms of indirect investment have also grown in popularity; for example, syndications allow investors to share in a single property and have a more manageable minimum investment size of tens of thousands up to several millions.
In addition, other unit trusts and mutual funds of varying profiles exist in various markets around the world. The UK has a plethora of these products, the US has mutual funds, Australia has unit trusts and Germany has open-ended funds. They all allow investors to gain exposure to portfolios of assets within a defined strategy, with expert management. And, in keeping with industry trends, property fund-of-funds and hedge funds are now being offered providing a wide range of approaches and a one-stop-shop option if required.
Listed real estate
The past five years have seen a substantial rise in market capitalisation of publicly-traded real estate and a corresponding growth of REIT-like structures around the world.
Although specific legislation in each country results in some differences, the common features of REITs are that they own and manage income producing property, distributing most of this income to shareholders through dividends in a largely tax exempt way. They offer liquidity, low transaction costs and immediate exposure to portfolios. However, they are heavily influenced by broader equity market conditions and offer little influence on management. In 2005 alone, the total free-float market capitalisation of the FTSE EPRA/NAREIT Global Listed Real Estate Index rose 27.5% from $505 billion to $644 billion. Currently, the index represents over $700 billion in market capitalisation with 328 publicly-traded companies.
REITs were first established in the US and Australia offering private investors access to real estate they would otherwise be unable to acquire. Other countries including France, Japan, Singapore and the UK have recently followed and 19 countries now have REIT-type structures. Many other countries are planning to launch similar legislation.
As property performance indices have developed, the potential for financial instruments, such as derivatives, has emerged. Barclays were the first to offer Property Income Certificates in the UK that pay a quarterly return based on Investment Property Databank's (IPD) all property total return.Over the two years to December 2006, there were a total of 333 trades with a notional value of £4.65 billion. This exciting new market looks set to deliver a record year in 2007.
Real estate has enjoyed impressive returns over the past decade reflecting strong economic conditions, low interest rates and high levels of investor interest – which has been boosted by investors appetite to diversify away from equities.
This fertile environment has led directly to the creation of innovative new products such as REITs and unlisted funds, putting real estate on a par with other major asset classes. For a growing number of investors, these innovations have helped them access a diversified portfolio of real estate investment.
For newer entrants, there is now a well-established and ever-increasing range of investment opportunities to meet the most discerning investors' real estate requirements.