During a sustained period of strong performance for real estate assets, an investment strategy based on mimicking the benchmark paid off handsomely. But as we move into an altogether more challenging period, this approach will no longer reap the same rewards, argues Chris Urwin.
5 minute read
The UK has some of the best-developed commercial real estate (CRE) indices in the world in terms of history, market coverage and detail. The most prominent are compiled by the Investment Property Databank (IPD)1 which compiles monthly, quarterly and annual indices – the latter having a history back to 1980. As at the end of 2015, the IPD Annual Index contained performance details for almost 24,000 properties, with a total capital value of over £200 billion2.
Their availability gives institutional investors the opportunity to manage CRE portfolios with a significant awareness to these indices as benchmarks. And, according to the Investment Property Forum (IPF)3, the vast majority do just that. It estimates that about 85 per cent of institutional investors by value deploy investment strategies that explicitly reference a CRE index as a benchmark.
There are, however, a number of difficulties with the development and application of CRE benchmarks. These reflect the characteristics of commercial real estate as an asset class and its less-efficient nature relative to stocks and bonds.
Not the whole picture
While the numbers captured by the IPD Annual Index are impressive, they reflect just a fraction of the total market in the UK. The IPF estimates the total value of the CRE market at the end of 2015 was £871bn4, with £483bn held as investments and the remainder in owner-occupation. IPD’s coverage of c£200bn equates to a little over 40 per cent of investment stock.
Incomplete coverage means the breakdown of the index in terms of sector and geography will not mirror the breakdown of the overall market. Likewise, the index is unlikely to be representative of other factors such as property quality. IPD is heavily biased towards institutional portfolios and is likely to over-represent higher-quality assets.
Structural flaws
CRE indices are typically structured on a sector and geographical basis. This is one of the easier ways to aggregate the diverse individual properties that comprise an index.
However, these are not the only characteristics that matter when it comes to explaining investment performance. In fact, there are likely to be many other significant characteristics not captured by the sector or regional breakdown. Examples include property-specific factors such as age, quality and size of the property. Simply looking at portfolios in terms of sector and geography does not reflect the breadth of factors that can be used to inform an investment strategy or the range of investment styles available.
Benchmark bias
In contrast to equity and bond indices, where performance can be measured from actual transaction prices, most CRE indices are derived from property valuations. This can introduce error and bias into their construction.
Valuations involve a degree of subjectivity, with valuers relying on their judgment of evidence from recent sales of comparable properties. This element has the potential to introduce error and means a property’s value may not accurately reflect the price it would achieve if sold. Valuation inaccuracy may mean a valuation-based index is not a precise estimate of the underlying market-clearing price.
The most prominent bias is valuation smoothing. Valuations are performed infrequently and rely on historic comparables for information. Indices based on these valuations will exhibit serial correlation as the values used in composing a previous value of the index will also be used in determining the current value. This smoothing is particularly an issue when markets move quickly.
While these issues may appear to be of academic interest only, they have practical implications for investment strategies and portfolio construction. Specifically, they suggest an investor who pays too much heed to a CRE benchmark in an effort to track or not deviate too far from “the market” runs three key risks: buying randomly, buying high and lagging behind the market.
Instead of slavishly following a lagging benchmark index, concentrated portfolios of well-understood assets have the potential to add value. Having a forward-looking view of how the demand for retail, office and industrial space is changing is key and the evidence suggests real estate fund managers whose portfolios look least like the benchmark index create most value5.
In addition, private and institutional investors are increasingly unwilling to pay large management fees to earn market-type returns. In other asset classes they don’t; investing instead in low-cost passive funds. Such solutions are at a nascent stage in real estate but the notion managers should deploy genuinely active management to justify their fees is taking hold.
As a corollary of this, a portfolio’s deviation from its benchmark can be seen as an opportunity for out-performance rather than just a risk. For these reasons, the importance of benchmark indices to portfolio construction is likely to diminish over time.
Important information
Past performance is not a guide to future performance. The value of an investment and any income from it may go down as well as up. You may not get back the original amount invested.
Except where stated otherwise, the source of all information is Aviva Investors as at 21st March 2019. Any opinions expressed are those of Aviva Investors and they should not be relied upon as indicating any guarantee of return from an investment in our funds.
Nothing in this article is personalised advice or a recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice.
11506 03/2019
References
- IPD was acquired by MSCI in 2012.
- IPD UK Annual Property Index 2015.
- UK Institutional Investors: Property Allocations, Influences and Strategies, July 2010.
- The Size and Structure of the UK Property Market – End 2015 Update, July 2016.
- How Active is Your Real Estate Fund Manager? – Cremers & Lizieri, December 2013.