The complexity premium in direct real estate
The complexity premium in direct real estate
Real estate is a unique asset class. It has long been used alongside the conventional portfolio building blocks of equities and bonds, because of characteristics that mean it offers genuine diversification in income and return.
It can provide sustainable income and is seen as a true inflation hedge. The physical backing also means that real estate can act as a store of value, insulating it from the same economic twists and turns other asset types may endure. But despite its familiarity to many investors, it is important to note it behaves differently for a reason.
Real estate transactions are not completed on electronic exchanges. Certainly, vehicles like real estate investment trusts (REITs) are tradeable, but the underlying assets remain bricks and mortar. This requires extensive due diligence before purchase and sale and intensive asset management to deliver sustainable income and value.
Individual assets are seldom sold into individual shares and are not offered on “minimum increments”, as with bonds.
Direct investment in real estate, our focus here, is probably the best reflection of the reality of real estate investment as what it ultimately is - a private asset. Its uniqueness means in addition to the qualities of diversification and stability, it has the underappreciated kicker of complexity premium.
In the latest of our series on the complexity premium in private assets, we explain how it works in real estate.
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The three main reasons investors hold real estate
- Store of value
- Complexity premium
The first of three key reasons investors hold real estate is for diversification against equity and bond movements. Including real estate can be shown to reduce volatility in a multi-asset portfolio. Historically, the correlation between European real estate and equities and European real estate and bonds were low or negative, at 0.3 and -0.2, respectively. This diversification has proven to be especially valuable over the last few years. Volatility has been high in equity markets and the world has dealt with major disruptions we hardly need to specify.
Source: FTSE, Schroders, May 2021
Of course, unless there is a systematic reason that the timing of real estate returns will continue to be different from that of equities and bonds, past correlations are not necessarily instructive. We think there are systematic reasons.
It is true that government bond yields provide an anchor for real estate yields in the medium term. However, the two do not move in parallel in the short term, because real estate yields are also heavily influenced by the outlook for the economy and for rental growth.
A lot depends on why bond yields are changing. For example, if bond yields are rising because the economy is growing strongly and there are concerns about inflation, then real estate yields could fall, as happened in the late 1990s and between 2005-07. Real estate could be a good hedge in this situation.
Moreover, the gap between real estate and government bond yields appears to change from one era to the next. Before the GFC, this “equilibrium gap” was around 2%. Since the GFC it has been closer to 3%. Part of the shift may be due to the impact of QE on bond yields. Partly this may be due to concerns about structural changes (e.g. online retail disruption) and greater caution about the long-term outlook for rental growth.
The main reason why real estate has been a good diversifier of equity risk is that, where equities are a leading indicator of the economic cycle, real estate is a coincidental, or even a lagging indicator.
There is a forward looking element to real estate yields, but rents are really driven by demand and supply of commercial space. In the early phases of an economic recovery after a recession, rents might initially be flat if there is a lot of vacant space which first needs to be absorbed.
The one period when real estate failed to provide much diversification against equities was between 2005-2010, when real estate returns were driven primarily by the availability of bank debt.
Through 2005-2007, the rapid growth in bank lending and development of the commercial mortgage-backed securities (CMBS) market drove real estate yields down and pushed up capital values and returns.
The opposite then happened through 2007-2010 when credit markets froze and there was a vicious cycle of distressed sales and falling real estate values. Since the GFC, banks have taken a more cautious approach to lending and real estate has once again followed a different path to equities, helping to smooth portfolio returns.
As a store of value
The second reason investors hold real estate is as a store of value. A good illustration of this attribute is the office at 25 Bank Street, in London’s Canary Wharf. 25 Bank Street was developed by Canary Wharf Group, originally for Enron, who became insolvent in 2001. It was completed in 2003 and let to Lehman Brothers, who collapsed in 2008. It was re-let in 2008 to several new tenants and sold to JP Morgan as their European HQ in December 2010. Quite the story.
However, while shareholders and bondholders in Enron and Lehman Brothers were wiped out in the respective bankruptcies, the owner of 25 Bank Street was able to re-let the building on both occasions and its value never fell even close to zero.
Although the value of a real estate asset is often expressed as a multiplier of the current income, ultimately its value derives from the ability of the owner to adjust it to the requirements of current and future occupiers and to generate a sustainable income over the years to come. That is why we believe that real estate returns should be less volatile than equity returns, even allowing for differences between valuations and prices and the underlying liquidity of the two asset classes.
The underappreciated complexity premium
The third reason for investing in real estate is that the potential for specialists to create outsized returns on top of a sustainable income creates a complexity premium in real estate. We believe this is often overlooked.
Although the core part of the real estate market has professionalised and become highly efficient and competitive, it is still possible in parts of the market to generate excess returns through specialist skills. As a result, the average ungeared total return on European real estate over the last 25 years at 7% per annum masks a huge range in the performance of individual buildings.
The key to generating excess returns varies depending on the type of opportunity and where the market is in the cycle. In opaque or emerging parts of the market a lot depends on personal relationships and expert knowledge to source deals which are off-market, or sit in the “too difficult” box for most investors.
One example is UK social supported housing. It offers strong financial and social returns, but access depends on good local relationships with housing associations and care commissioners, plus in-depth understanding of resident needs.
Off-market deals can also happen when markets are temporarily disrupted and investors who are facing a liquidity squeeze have to sell, but wish to avoid advertising their predicament. In this case the seller will look to deal with a party who they know well and can trust to execute quickly.
Recent examples were seen when liquidity squeezes arose in certain open-ended funds from larger redemption requests. We expect that the next two years will also see an increase in distressed sales of retail and other (temporarily) operationally challenged assets.
Another way to generate a complexity premium in real estate is through construction, or re-development.
This not only depends upon a thorough understanding of how businesses, or residents wish to use a space, but also requires skills in managing building projects and securing planning permissions. The logistics warehouse sector in Europe is a good example. Over the last five years many investors have entered into joint ventures with logistics specialists with the aim of capturing some of the profits on developments.
Paradoxically, the growth of online retail is also creating interesting opportunities in town and city centres to re-develop vacant shopping centres and department stores into mixed use schemes. These combine retail with offices, apartments, doctor’s surgeries and other amenities, including space that is free and open to everyone.
Ready for my close up - what redevelopment can do
Finally, we believe that to truly secure sustainable income and drive outsized returns - the complexity premium - the real estate specialist needs to maintain a “hospitality mind set” and superb operational skills at every level.
By this we mean an ability to deliver the services occupiers are after and that enhance the occupier’s business success. It means being able to efficiently manage the operations in the asset, limit CO2 emissions and waste, optimise the net operational income and navigate an every increasing complex regulatory (ESG) environment.
A good place to look for examples are hotels with management agreements, where the investor is exposed to the success of the operations of the hotel business itself. Managed hotels are priced on a multiple of profits, so an investor who really understands how to run a hotel and boost its profitability can add a lot of value.
Value drives the illiquidity, not the other way around
Many of real estate’s key attractions – its store of value and the complexity premium – derive from the fact that it is a physical asset and something which investors can control, unlike financial assets. These positive characteristics, together with real estate’s ability to diversify equity and bond risk, more than out-weigh the lower liquidity.