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Its stable rental income makes real estate a popular choice in periods when interest rates are low. According to Folmer Pietersma, fund manager of Robeco Property Equities, real estate prices will not automatically come under pressure if interest rates start to rise again.
Next year the discussion on whether listed real estate counts as an alternative investment or forms part of the broader equity category will come to an end. Nowadays real estate stocks in the major indices still form part of the financials sector, but from August 2016 index compilers such as MSCI and S&P Dow Jones will create a separate subsector for the real estate industry.
On the basis of market size, this promotion of real estate to a separate subsector is more than deserved. The total value of listed real estate companies amounted to USD 3,200 billion at the end of 2014, according to real estate service provider LaSalle. According to LaSalle USD 6,000 billion is invested in unlisted institutional funds. Both these categories are classed as indirect real estate. The largest part of the real estate market – around USD 40,000 billion – comprises direct investment in real estate properties.
As a result of the lack of daily liquidity, direct real estate prices seem to move less than those of the listed variety. The volatility of the MSCI World Real Estate Index was 19.9% in the period from the end of 1994 up to the end of June 2015. This is slightly higher than the average of 19.0 percent of the sectors that make up the MSCI AC World Index. The average annual return was 6.8% (index: 7.5%) and the dividend return was 3.4% (index: 2.5%).
Investors in listed real estate are generally able to buy and sell constantly. They see the value of their investment change on a daily basis. For non-listed real estate, the benchmarks are the periodical valuations by surveyors or the sales of comparable properties. This creates much smoother price movements that lag the stock price movements of listed real estate.
In a recent study of 884 pension funds between 1990 and 2009, researchers Aleksandar Andonov, Piet Eichholtz and Nils Kok show that high management costs offer an important explanation for why returns on direct real estate are lower than those on listed real estate stocks. This is particularly true in the case of smaller pension funds that focus on both listed and non-listed indirect real estate to achieve sufficient diversity; for them the costs can be extremely high.
The long term correlation of listed real estate with equities is higher than with fixed income securities. However, its correlation with price movements in other asset classes changes constantly.
“In the period after the credit crisis the prices of real estate stocks moved more in line with the market average initially,” says Pietersma. “Since the end of 2012, as a result of low interest rate levels, the emphasis has come more to rest on the income component of real estate investments, One result is that the correlation with the bond market has increased significantly. That explains why recent price movements are more similar to those in the bond markets and less similar to equities.
One characteristic of real estate investments is that rental prices have a tendency to rise with inflation. However, in Pietersma's view, it is far too simplistic to see this investment class merely as potential protection against rising inflation. “Price movements are affected too much by other factors such as market sentiment for this to work. And it is also evident that in the case of indirect real estate, investors price in expected changes in rental growth for the next one to two years."
The real estate market usually follows a clear cycle. A strengthening economy translates into increased demand and higher prices, which often tempt people into investing in new projects. Investors should also be aware that there are frequent bubbles in local markets. “However, every region has its own cycle too, so good regional diversification can help moderate the effects of local price swings,” explains Pietersma.
‘Major brands have a strong preference for top locations’
In addition to the cyclical movements, a number of structural changes are also taking place in the real estate market. The most important trend is the growing difference between top locations and the rest of the market. “Big brands attach great importance to having a prominent presence in the most well-visited locations to showcase their products,” says Pietersma. "Shops in less popular areas are finding it increasingly difficult because consumers are buying more and more products online instead of at the local shop."
In the office property market, the gap between top locations in city centers and offices in less popular areas is also widening. "In certain sectors such as technology and pharmaceuticals the larger companies tend to look for locations close to each other," says Pietersma. "This makes it easier to attract talent and share knowledge."
A low interest rate that makes it difficult to generate income with investments makes real estate stocks a popular choice on account of their high dividend return. According to fund researcher Morningstar, inflows into the real estate asset class in 2014 amounted to 9.1%, versus 3.6% for equities and 6.4% for bonds. However, Pietersma is not worried that potential rate hikes will put prices under pressure. To support this statement, he adds that since 1992 there have been eight periods during which the yield on 10-year government bonds rose.
Prices of real estate stocks fell on only two occasions and the average return in these periods was 14.8%. "If interest rates rise in response to a strengthening economy, it is not necessarily negative for the real estate sector", Pietersma goes on to explain. "Of course, if there is another reason for rising interest rates, that's another story. In constructing the Robeco Property Equities Fund we also take into account a rising rate scenario."
The portfolio consists of 50 to 70 stocks that are selected via a bottom-up approach using quantitative, fundamental and ESG research. It is also positioned to take advantage of major trends, such as the increasing popularity of prime locations. The managers also have a preference for companies with a solid balance sheet and a solid record in terms of ESG.