ABN AMRO Property Securities Funds

ABN AMRO Property Securities Investments

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ABN AMRO Property Securities Investments

Investing in local property worldwide

Introduction: Investing in property

The attitude towards real estate gradually changed in the late 1960s and early 1970s as inflation and interest rates suddenly started to increase, which had a negative impact on the investments in stocks and bonds. The gains of the previous periods were eroding quickly (in only two years over half of the value of the stocks was wiped out). Real estate on the other hand seemed to perform quite well under these conditions. Investors, looking at opportunities to hedge their inflation risk, got more and more attracted by real estate. In order to protect the portfolios from inflation, a lot of pensionfunds started to add real estate to their investment portfolio’s in the early and mid 1970s, even without having all the necessary information to base such an important decision upon.

With its specific characteristics, property has developed into a separate strategic asset category. Property investments have acquired a place within many investment portfolios, partly thanks to the relatively stable flow of income resulting from the generally long-term, index-linked nature of the underlying rental contracts. The assumed inflation-proof quality of property is only one of the other arguments for including this asset category in the investment mix. The fact that property market cycles often do not run parallel to the economic cycles is just as important for spreading the risk. The correlation with the general equity markets is relatively low. All this makes it is an asset category which attracts a good deal of interest from a/o institutional investors.

Besides the decision to allocate to real estate, also the within-decision is important. Research shows that geographic diversification is as important, if not even more important, than for any other investment. Diversification over different economic areas will have a big impact on the risk profile of the real estate portfolio.

Choosing the right strategy: a condition for success

Several investors have had somewhat disappointing experiences with property investment in recent years. A number of reasons can be put forward for this, such as a poor understanding of local market conditions, investing in speculative project developments, high leverage, exposure to only one sector or one country with a specific property cycle, and so on. These risk factors could undoubtedly have been avoided by following the right strategy.

Because of the increased levels of attention on the fundamentals of real estate investing, the knowledge about investing in real estate improves all the time. Investors are learning more and more about the return/risk profile of these kind of investments. This learning curve investors are going through leads to drastic and structural changes in investor behaviour.

Up until the early 1990s, real estate portfolios consisted almost exclusively of a collection of individual buildings, which were owned and managed by the investor. Their was hardly any synergy between those buildings, if at all. Nowadays, an increasing number of investors is putting a question-mark behind the effectiveness of such a strategy.…The alternatives are generally based on the concept of indirect investing.

Indirect international investment

Indirect property as a substitute for direct property

Obviously, shares in public real estate companies look a lot like other stocks, since, like stocks and unlike bonds, those shares are a perpetual-lived equity without fixed periodical cash flows or par values. On the other hand, the performance of those shares must be closely linked to the performance of the real estate, “just as auto makers’ stock prices are tied to vehicle sales and profitability” (Giliberto [1996] ). Research on the behaviour of publicly traded real estate companies can be divided in three categories:

• research focusing on the similarity between securitized real estate and common stocks
• research focusing on the differences between securitized real estate and common stocks
• research focusing on the similarity between securitized and unsecuritized real estate

Several studies have shown that property shares are sensitive to fluctuations in the general equity markets in the short term, but that in the somewhat longer term (6-18 months, depending on the country) there is a strong correlation with the direct property markets. Indirect property can therefore be regarded as a good substitute for direct property. The Property Securities Group, by keeping close tabs on the property investment profile, ensures that the typical property characteristics are in fact reflected in the portfolio.

Over the past two decades public real estate in the US outperformed privately held real estate significantly (and exhibiting low correlations with stocks and bonds), caused by the fact that publicly traded real estate companies are operating businesses in stead of standing investments and due to a higher leverage. The higher performance on itself would be a sufficient reason for investors to use listed companies as a proxy for direct holdings.

Securitized real estate might be less volatility than common stocks but on the other hand it is more volatility than unsecuritized real estate. However, if direct real estate is adjusted for the appraisal-effect, the volatility of that market increases substantially and appears to be almost comparable to the volatility of securitized real estate.

The advantages of an indirect investment in property

With a direct investment in property, the investor acquires part ownership of the property itself. In general the investor will also manage the property, alone or with others. An indirect property investment offers the investor an opportunity to take a stake in one or more listed or unlisted property companies. He then becomes part-owner of an organisation that manages property commercially. Although in-depth knowledge of the local markets is essential here too, this investment opportunity nevertheless offers a number of important advantages over direct property investments.

• no involvement in the management: the management of the properties, including aspects such as liability, acquiring tenants, etc., is contracted out;
• local expertise and management: indirect investments allow the investor to benefit from local expertise in the local property markets. The investor can invest in local organisations with an established track record and proven performance;
• risk spread: in view of the lower unit prices of shares, it is easier to diversify the investments among different countries, sectors and companies, thus leading to better risk/return profiles;
• transparency: the (continuous) price formation which takes place on the securities markets is directly related to the objective value of the underlying investments, their management and the future expectations (in direct contrast to the non-transparent nature of the valuation of direct property). Investors have continual access to an objective performance measurement;
• flexibility/liquidity: its greater liquidity means an investment in listed property companies enables a faster response to be made to changing market conditions;
• cost benefits: the transaction costs are generally considerably lower than in the case of direct property investments.

Reducing risk by including indirect property in an investment portfolio

1. Real estate combines some of the investment characteristics of stocks and bonds, which are considered to be the two pillars in a well diversified investment portfolio. When an investor invests in stocks, his return will almost entirely consist of a change of the price of the stock. Dividend-returns are in most cases very low and are not the main reason why investors invest in stocks. Bonds, on the other hand, have the opposite features of stocks: investors invest in bonds because op the interest (the coupon) and generally not because of an expected increase of the principal. Real estate combines the characteristics of stocks and bonds: the income stream is relatively high and generally with relatively low risk, while at the same time the value of the original investment (the principal) will change over time. These characteristics make real estate in essence quite interesting within the context of the Modern Portfolio Theory (MPT), assuming correlations did not match perfectly.
2. The real estate cycle and the stock market cycle differ. Downs [1994] describes the relation between both cycles. Stock prices typically hit their high points in the middle of a general economic expansion and begin to move downward somewhat in advance of the following general recession. Stock prices are for that matter considered to be a leading economic indicator in relation to the general business cycle. In contrast real estate property prices typically hit their high points right at the peak of a general economic expansion. Then they fall in the following recession, but begin raising again as the general economy expands out of that recession or even when the recovery is already well underway.

The graph below shows the correlation of various indices with the MSCI World index. The indices used include a range of MSCI sector indices, the Global Properties Securities Index (GPSI) and the Salomon Brothers World Bond index (unhedged and with a term of at least one year). The graph shows that the correlation between the GPSI index and the MSCI World index is the lowest of all the (equity) indices.

The extent to which the GPSI approaches the correlation of the Salomon Brothers World Bond index is an illustration of the position that (indirect) property holds as a separate asset class.

The table below shows that property has the lowest correlation with any other asset class as well. Given the negative correlation with cash and bonds, property adds an extra diversifying element to a balanced portfolio.

Correlation between different asset classes (Jan. 1989 - Dec. 1998)

Asset classes (used indices) /

Cash

/

Bonds

/ Property / Equity

Cash (Sal. Bro. World Money Markets U$)

/ 1.00
Bonds (Sal. Bro. World Bond U$) / 0.82 / 1.00
Property (GPSI U$) / (0.52) / (0.24) / 1.00
Equity (MSCI World U$) / 0.19 / 0.37 / 0.56 / 1.00

The correlation between the general equity markets and property shares is declining further. Including property shares in the portfolio consequently leads to an increasing risk reduction. As the following graph shows, this applies particularly for the regions Europe and America.

The advantage of diversification offered by indirect property is greater in the Far East than is apparent from the graph below. This is because the general share indices in a number of countries in the Far East consist largely of property shares; this produces a distortion in the correlation calculations.

other considerations

Besides due to typical investment reasons previously mentioned, there are also several other reasons for institutional investors why they decided to build up an exposure to real estate:

real estate part of total wealth

Real estate is an important part of the available total wealth of any economy. In the United States, the value of the total real estate market is estimated between $10 and $15 trillion (according to the Quantum Company). According to ERE Yarmouth, about one-third of the total market is considered to be of institutional quality and is therefor suitable for investment purposes. Just the size of this investment potential makes it worthwhile for investors to seriously consider investing in this market.

legal reasons

In the United States, an important reason why investors invest in real estate was the congressional passage of the Employee Retirement Income Security Act (ERISA) in 1974. The purpose of this act was to impose fiduciary guidelines to legally insure that the private pension system was responsibly managed by plan sponsors. All ERISA fiduciaries must invest according to the “prudent man” rule, diversifying into other assets besides stocks and bonds. As a result of this act, non-traditional assets such as real estate and international equities, were added to portfolios. Although the US was clear example of how legislation had an impact on how investment portfolios were constructed, also in a lot of other countries legislation had a direct or indirect impact on constructing portfolios and the role of real estate.

Practical reason

Allocators can make use of the fact that real estate is some kind of hybrid. At some point in time they might want to allocate a large portion of the total portfolio to either fixed income and at another time to equity. However, a major shift in the total portfolio is practically impossible (and very expensive). By having a certain percentage of the portfolio “in the middle”, allocators get a certain flexibility. Also, by qualifying real estate as equity allocators might not be able to recognize or to use certain advantages of real estate over fixed income investments since these characteristics would get lost in the overall equity-environment. This would for instance be the case if the net return from real estate is higher than the long term bond-yields.

International spread of property shares

The indirect property markets form an exception to the growing globalisation within the investment world. Compared with the general equity markets, the indirect property market shows low interregional correlations. This is a reflection of the organic development of local property markets. Investing judiciously in the differing cycles of geographically diverse property markets thus creates a better risk/return profile (higher return for the same risk) than with a general equity portfolio.

Correlation per region between the MSCI share indices and the Property Securities Funds (Oct. 1995 - Dec. 1998)

MSCI / Global /

Europe

/ America / Far East

Global

/ 1.00
Europe / 0.92 / 1.00
America / 0.96 / 0.83 / 1.00
Far East / 0.83 / 0.68 / 0.69 / 1.00
PSF / Global / Europe / America / Far East

Global

/ 1.00
Europe / 0.83 / 1.00
America / 0.89 / 0.68 / 1.00
Far East / 0.63 / 0.30 / 0.37 / 1.00

Worldwide yet local

Investing internationally in property thus offers considerable added value. However, unfamiliarity with the local markets (understandably) prevents many investors from doing so themselves. The Property Securities Group invests mainly in local property companies. To demonstrate the importance of local expertise, a comparison has been made between the performance of shares in locally operating property companies and the shares of property companies which are active internationally in direct property investment. The difference in performance between the two types of company was calculated by GPR over the period 1984-1996, and averaged 2.8% per year in favour of locally operating property companies. One important reason for this difference is the edge these local companies have in terms of information.

Growing indirect market

There is a worldwide trend among institutional investors to sell off all or part of their direct property investments and replace them with indirect property holdings. Many property portfolios are securitised, i.e. brought to the market in the form of property companies, often with a stock exchange listing. In addition to a greater market value per company, the growing number of listed property companies has led to a rapid increase in the opportunities for investing in indirect property. The size of the world market in property company shares was around NLG 720 billion as at mid-1998. The growing interest being shown by financial analysts has in many cases led to a substantial increase in the efficiency of the market.

And yet only a relatively small part of the total property market is listed on the stock market. Estimates vary from 3-12 %, depending on the type of property that is deemed suitable for stock market flotation. The trend towards the securitising of property is expected to continue in the coming years, which means that the global property share market is set to become an increasingly important channel in the future for national and international property investments.

Investment process and benchmark

Investment universe

A large, wide investment universe has been established both for research on individual property companies and for acquiring an overall picture of the market through aggregation. More than 200 property companies from 24 countries have been selected for inclusion in the universe, which covers more than 50% of the total size of the indirect property markets. The composition of the universe evolves over time in response to market developments. One criterion for the preselection is whether the companies match the property investment profile, i.e. whether the lion’s share of their income comes from rental activities. This criterion means that companies such as hotels, companies focusing exclusively on project development, and estate agents fall outside the universe. The result is a universe with a property investment profile which enables the ABN AMRO Property Securities Funds to form a good substitute for direct property.

Investment process

The investment process has been precisely defined and structured. The process comprises a top-down approach for the allocation of the different markets, combined with a bottom-up approach to the selection of the best companies within those markets. The first aspect is related to the strongly local nature of property markets; the second is justified by the differences in quality between individual property companies.