Non-core properties offer best opportunities

A two-speed real estate market has emerged from the financial crisis. While prices in core, good quality properties across most markets globally have increased substantially, secondary market real estate, which represents the large majority of the total property universe, is still struggling.

“We have this bifurcation in the market between, on one side, the core, safe properties, which are very expensive, and on the other side opportunistic properties, which are very hard to find,” explains Stephen Blank, senior fellow, finance at Urban Land Institute in the US.

A significant number of secondary properties have a very high level of leverage and banks still have a large amount of non-performing loans on their books, which indicate distressed situations in real estate.

Governments in the UK, Europe and the US have not forced lenders to clean up their balance sheets. Financial institutions, for their part, are not taking active action on troubled borrowers, preferring to restructure loans, while being able to borrow from the government at very low rates and build up strength in their balance sheets.

Employment growth will drive prices up for secondary properties but there has to be more capital seeking real estate exposure before secondary properties see a recovery in capital values. This is complicated by the fact that investors are no longer able to finance them with the levels of debt seen in the past. This is the reason non-core properties represent such a good buying opportunity, says Alessandro Bronda, head of Global Property Investor Solutions at Aberdeen Asset Management.

“Most investors are really just focused on low-risk investments, but if they move a little bit more up the risk spectrum, they can pick up good assets at good prices – which still have a good cash flow and long lease terms,” he explains.

In the UK, in particular, the gap between secondary yields over prime assets is larger than other markets. Prime property has repriced more quickly and to a stronger degree, by about 25 per cent over the past 18 months. “One has to be very selective when buying secondary properties, but we see a lot of opportunities in the UK, because the price is very appealing,” says Mr Bronda.

The Barbell approach

When investing in real estate, it makes sense to adopt a “barbell approach,” says Alan Supple, portfolio manager at Urdang, BNY Mellon’s global real estate investment specialist. On one hand, individuals can invest in Reits (real estate investment trusts). These are highly liquid instruments and correlated to the equity market only in the short-term and their bias is generally towards higher quality property. At the other end, higher up the risk spectrum, closed-end, private equity style structures are the most appropriate vehicles to gain exposure to opportunities in the distressed space.

“If you are willing to do without the liquidity, there are going to be great opportunities for people at this stage in the market to make money from these closed-end fund structures, with experts creating value from troubled assets.” In this low interest rate environment, the spread between cash rates and yields on real estate is close to historical highs. That kind of scenario will continue to make real estate attractive from a yield stand point, says Mr Supple.

In core markets, such as the US and Europe, there is already some evidence of better quality income and good yield streams from real estate. The focus must be more on cash flow growth and on taking advantage of rental growth, driven by the relative pickup in economic activity.

“Until we can see a sustained expansion of the economy, it is hard to see a sustained recovery in rents, so that tends to make us gravitate towards the markets which show the most resilience, ie the core markets, which may be more expensive but they are going to offer a level of certainty,” says Mr Supple.

“Today is a good time to invest in real estate, both directly and by way of property stock investing,” states Christian Lange, president and founder of European Investors.

The primary risk for commercial real estate is oversupply and not lack of demand, except for during the recent recession prompted by the financial crisis. Oversupply is not on the horizon because development activity is in a nascent stage, debt financing is scarce and construction costs are higher due to rising commodity prices.

“Commercial real estate should have clear sailing for the next two to three years. We think we will be able to generate returns of 10 to 12 per cent per year in our real estate stocks over the next four years,” says Mr Lange.

If investors are looking for high current income, they should gravitate towards direct investments or mutual funds. If the focus is on yield, Asian real estate stocks will generate the highest returns. “In Asia it is difficult to acquire well-leased assets due to family ownership; families, who don’t sell, usually own most of the large, and not so large, properties. Development projects generate more money, but risks are higher,” he says.

The best way to play Asia is through the security route, with a portfolio of listed securities or a fund which invests in Asian real estate companies whose shares are publicly listed, according to Mr Lange. From a real estate securities perspective, Asia is the cheapest region, with discounts to Navs (to the value of the underlying real estate) in the order of 20 to 50 per cent. European real estate stocks are selling at average discounts of 10 to 20 per cent while US Reits have a premium of approximately 15 per cent, but the estimated Navs may be too low, he says.

East to West

In the last few months, the biggest money flows have been towards real estate in London, says Kwang-Meng Quek, co-head of the Global Real Estate Group at Citi Private Bank. Wealthy Asian investors have looked at London properties for improved yields, although prices have now gone up and yields have starting coming down, he says.

London has offered good diversification benefits as capital values in Asia have shot up dramatically over the past 15 months, fuelled by government policies in Hong Kong and Singapore to cool down prices in the high inflation environment.

On the other hand, non Asian investors are increasingly looking to Far East real estate for the capital growth. The sustained process of urbanisation with continued strong migration from rural areas to cities, economic growth, strong currencies and low unemployment rates all combine to make real estate a good investment opportunity in Asia, he says.

“My recommendation is that European investors shouldn’t concentrate only on foreign managers but should consider looking at the merits of a local fund manager or developer,” warns Mr Quek. The market is getting more restrictive for foreign fund managers, making it more difficult for them to operate, while local fund managers should be able to form those strategic partnerships with providers of public infrastructure like schools, which are very much in demand.

There are a whole group of Shanghai-listed companies that foreign managers cannot have access to, acknowledges Mr Supple, but investing in mainland China through H shares in Hong Kong provides liquidity and transparency. “One of the concerns we have in many markets, including China, is transparency and we have a little bit more confidence in the financials and disclosure levels of Hong Kong listed companies. The liquidity that we get in the Hong Kong market, which is important for our clients, offsets any missed opportunity.”

Investors’ interest in real estate stocks is growing rapidly due to their attributes, notes Mr Lange at European Investors. They provide liquidity and they often sell at discounts to the underlying real estate value. Listed vehicles also have the advantage of being able to rebalance the real estate allocation, regionally or on a global basis, important due to the cyclical nature of commercial real estate. They are also tax efficient and cost effective, compared to funds.

The price to pay is some volatility. But it is a misconception to view real estate equities or listed real estate as just equity risk, he says. Historical analysis shows that the correlation between real estate stocks and general equities is high for the first year and reasonably low with real estate. After that, going into the second, third or fourth year, there is up to 70 per cent and, in some countries, 80 per cent correlation to real estate.

Moreover, the volatility of direct real estate, compared with listed real estate, is going to be understated, because the value of the property is appraised only on a periodic basis and does not capture price fluctuation.

Listed securities also make sense for small allocations to commercial real estate although institutional investors around the world are also showing increasing interest.

“Private banks and wealth managers are looking more intensely at this sector as an alternative to direct real estate investing,” says Mr Lange. “I think the Reit structure in Europe will take over the role of the open-ended fund eventually.”

Allocations

“In some ways real estate is still an emerging asset class and it is becoming more global. In my view, in the future it will sit much more comfortably with fixed income and equities,” says Aberdeen’s Mr Bronda.

Real estate provides with a monthly or annual dividend or monthly cash flow, basically the rental income, and has a low or even negative correlation with fixed income. In a multi-asset context, adding porperty to an equity and bond portfolio reduces the standard deviation, given the same returns.

Studies on commercial real estate, which is generally seen as part of an allocation within the alternative asset class, have shown that the income derived from real estate cushions against the illiquidity of private equity investments and hedge funds, says Mr Lange at European Investors. To optimise risk-adjusted returns from alternative investments, approximately 50 per cent of them can be allotted to real estate in direct or indirect form, he says, citing studies by Nareit and others, which have shown that 20 to 30 per cent of total real estate portfolio should be allocated to real estate equities publicly trading to optimise risk-adjusted returns from real estate investments.

“The main attraction of real estate, besides capital gain potential, is regular, generally sustainable income with a partial inflation hedge. Investments directly in property are usually income-focused with limited capital gain potential, whereas property stocks provide less income but have more capital gain potential,” says Mr Lange.

Real estate investors should have a longer-term view because real estate is a long-term asset and it is not liquid, says Mr Quek at Citi. In that sense, closed end funds are to be preferred. A longer-term investment gives the investor the opportunity to enjoy the value added derived from transforming a rural land into a completed property, for example.

A combination of direct investments and funds in a real estate portfolio is the ideal solution for a wealthy client, says Mr Quek. “One would buy direct property in locations where the regulatory environment is very transparent, for example in British-law cities like London, Singapore or Hong Kong, where there are no profit taxes and the buying and selling process is straightforward,” he says.

“But in places like China it is better to go through funds, because the environment is more complicated, is not entirely transparent, there are multiple regulations investors may not be familiar with. It is better to rely on professionals.”

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Kwang-Meng Quek, Citi Private Bank