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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.
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 reference 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. The predominant strategy is what the IPF terms a “benchmark plus approach”, which seeks to provide a return marginally better than a specified index with a relatively small tracking error.
There are, however, a number of difficulties with the development and application of CRE benchmarks that investors need to keep in mind. 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.
While this is among the highest of IPD’s 25 country indices5, it nonetheless represents incomplete coverage and 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.
The coverage and sector/geographic weightings a CRE index provides is also likely to change over time as assets trade between investors who contribute to IPD and those who do not. A prominent example of this is the increased ownership of Central London offices by overseas investors who do not typically contribute to IPD. This has led to a big decline in the share of Central London offices in the index over time.
The charts below show some of the compositional changes of the IPD Annual index since its inception.
Source: IPD UK Annual Property Index 2015, MSCI (March 2016)
CRE indices are typically structured on a sector and geographical basis. This is one of the easier ways to aggregate the heterogeneous individual properties that comprise an index and also reflects the way most investors think about the practical considerations of managing assets.
It does not hold true, however, that these are 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; tenure-related factors such as covenant strength, unexpired term and whether it is single or multi-let; and geographical factors such as micro-location.
Academic evidence consistently finds that the sector or regional breakdown is of limited use in explaining relative performance. Devaney & Lizieri6, in surveying existing literature and in their own original research, found “sector-region groupings have some validity but do not characterize the variability of returns over time”.
These findings reflect the heterogeneous nature of commercial properties; the fact each property’s performance will be driven by a wide range of factors and the difficulty of aggregating such assets. 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.
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 the construction of CRE indices.
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.
A key difference between real estate and more liquid asset classes is frequency of trading; in part reflecting the higher transaction costs in the real estate sector.
Turnover ratios show the difference clearly. In equities, the turnover ratio measures the percentage of shares that change hands in a year. In the UK, turnover was estimated at 146 per cent in 2015; in other words, each share traded on average more than once7. By contrast, only a small minority of CRE assets change hands each year. According to the IPF8, approximately 10 per cent of London offices were traded annually in the period 2007 to 2015 for example.
As a result of infrequent trading, the make-up of a CRE index reflects the outcome of investment decisions made over a number of years. The index is slow to reflect how the underlying demand for different types of real estate is changing. Instead, it reflects what the market has invested in over, say, the last five to 10 years.
Implications for portfolio construction
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, outlined below.
As the market coverage of any CRE index is incomplete, the sector/geography breakdown of the index is to a degree random. And academic evidence suggests the typical index breakdown by sector and geography falls a long way short of explaining investment performance.
A desire to retain portfolio exposures in line with the benchmark can result in investors buying into markets as they get more expensive. For example, rising shopping centre values may result in the sector representing a bigger share of the benchmark. This may encourage investors to buy more shopping centres to prevent their relative exposure to the sector diminishing. Such an approach can result in investors buying high and selling low.
Lagging the market
Valuation smoothing and infrequent trading mean valuation-based CRE indices provide a lagging view of market participants’ preferences. Whereas in more liquid asset classes index allocations are the outcome of the market’s collective wisdom of which sectors are currently appropriate to invest in, this is much less true of real estate. Instead, the benchmark reflects investors’ decisions over a number of years and the index is slow to reflect how the underlying demand for different types of real estate is changing.
The courage of your convictions
Instead of slavishly following a lagging benchmark index, investors should aim to construct concentrated portfolios of well-understood assets that allow their expertise to add value. Investors must take a forward-looking view of how the demand for retail, office and industrial space is changing. The evidence suggests real estate fund managers whose portfolios look least like the benchmark index create most value for their investors9.
In addition, third-party 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, investors are increasingly willing to view a portfolio’s deviation from its benchmark 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.
1. IPD was acquired by MSCI in 2012.
2. IPD UK Annual Property Index 2015.
3. UK Institutional Investors: Property Allocations, Influences and Strategies, July 2010.
4. The Size and Structure of the UK Property Market – End 2015 Update, July 2016.
6. Individual Assets, Market Structure and the Drivers of Returns, Steven Devaney & Colin Lizieri, June 2005.
7. Source: World Bank.
8. Unravelling Liquidity in International Commercial Real Estate Markets, March 2016.
9. How Active is Your Real Estate Fund Manager? – Cremers & Lizieri, December 2013.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 17th March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.