Real estate: the long view
The returns of both listed and unlisted real estate are driven by variables such as rent, capitalisation rates, capital expenditure schedules and tenant covenants.
There is a view that the returns and diversification benefits listed real estate delivers are the same as physically owning the asset. Here, we explore this view and review the role of real estate in a portfolio at this point in the market cycle, looking at US assets in particular given this is the world’s deepest market.
The correlation of returns between listed and direct real estate increases as the investment horizon lengthens. As a result, listed real estate is likely to bring similar long-term diversification benefits as direct real estate to a diversified portfolio.
Short term versus long term
Given listed real estate has daily liquidity it behaves more like equities than direct real estate in the short term. But investors should choose to invest in this asset class for the long term.
Real estate is a long-term investment by the nature of the leases that are tied to these assets, as well as the longevity of the physical asset and the freehold ownership in most developed markets.
Over the longer term direct real estate and listed real estate prices are highly correlated to each other, but lowly correlated to equities
What about returns?
Returns on US listed real estate have been substantially higher over the 1978 to 2015 period that in the past. Research1 shows US$1 invested in 1978 would have grown to US$27.03 by 2015 if invested in direct US property. The same amount invested in listed real estate would have returned US$95.76 over the period. This data captures numerous real estate cycles, economic recessions and equity cycles, including the global financial crisis.
After accounting for the costs of investing, US listed real estate recorded an average annual net return of 11.31 per cent between 1998 and 2011, the highest average annual net return of any asset class over the period. Over the same time frame, the performance of private (direct) real estate investments trailed listed equity real estate investment trusts (REITs) by 3.7 pert cent a year due to their significantly lower gross returns as well as their relatively high investment costs. Direct real estate still outperformed US large cap equities by 1.55 per cent a year after fees2.
Accounting for risk
On the surface listed real estate appears substantially more volatile than unlisted real estate; the annualised volatility of quarterly REIT returns is 17.7 per cent, compared to only 4.3 per cent for direct real estate returns3. But that’s intuitive because you have minute by minute liquidity.
When investing for the long term, the volatility of the two asset classes begins to converge. Over 40 quarters, returns for direct US real estate are 19.2 per cent versus 25.1 per cent for REITs4.
In fact one myth that’s important to debunk is that direct real estate is not volatile. During the financial crisis, direct real estate looked like a low-risk safe haven. However, real estate returns are actually closely linked to other risky assets in the market, but with a lag.
What listed real estate says about direct property
In markets where listed real estate trades at a discount to net asset values (NAV), the best fund managers are taking advantage of strong pricing in direct real estate markets, selling non-core assets and using the proceeds to either de-leverage balance sheets or shrink the equity base by returning capital to investors. This is driven in part by the fact listed real estate managers see less value in certain direct markets given the underwriting of their deals is done on an unleveraged basis compared to other levered buyers such as private equity.
Listed real estate is trading at a discount to NAV in a number of markets, implying the market believes the direct market has become overheated for the time being. Our analysis suggests global listed real estate should deliver superior out performance in the next five years over global direct real estate.
Direct real estate assets have several disadvantages such as relatively low liquidity, high transaction costs and lumpiness. The listed real estate market was developed to circumvent these complications back in the 1960s, so that all investors, big or small, could reap the benefits of a well-diversified real estate allocation.
Listed real estate suffered during the financial crisis of 2007/2008, but many lessons have been learnt subsequently. Now, listed real estate is back to where it should have always been, a proxy for direct real estate.
This puts listed real estate in a favourable position relative to direct real estate in the next leg of this market cycle. The two asset classes are essentially the same over the longer term as returns are driven by the underlying real estate cash flows they have in common. For investors wanting to maximise risk-adjusted returns, an asset allocation between both listed and direct should be used at different points in the cycle.
About the author
James Maydew is AMP Capital’s Co-Head of Global Listed Real Estate, based in Sydney. Mr Maydew commenced in the real estate industry in 2002, starting his career as a chartered surveyor in London working within the capital transactions division of Cushman & Wakefield. Mr Maydew joined AMP Capital’s Shopping Centres division in 2006 before transferring to the firm’s global listed real estate team one year later. Mr Maydew holds a Bachelor of Science in Real Estate Investment and Finance from the University of Reading and is a fully accredited member of the Royal Institution of Chartered Surveyors.
1A review of real estate and infrastructure investments by the Norwegian Government Pension Fund Global, Nieuwerburgh, Stanton and Bever (2015)
2CEM Benchmarking, Asset Allocation and Fund Performance of DB pension funds in the US between 1998-2011 (2014)