Property Portfolio Management, Property Role in Multi Asset Portfolio – Part III

Canada’s public pension funds (CPP Inv. Board, PSP Inv. and Ontario Teachers’ Pension Plan for instance) own assets all over the world, including property in Manhattan, utilities in Chile, international airports and railway connecting London to the Channel with returns well above 10%. They brought most of their investments in-house, reducing costs to a tenth [ECO3].

Property Role in Multi Asset Portfolio

Property exhibits return-risk characteristics that can be, at some times, defined attractive but these features are strongly correlated with, among others, the country and the economy where the property is, the interest rates curve and the currency exposure. Depending on the emphasis put on return or risk, each of the above factors can improve or deteriorate a position in property.

Direct property investment by financial institutions, insurance companies and pension funds differs in each country: in the UK the residential sector is scarcely considered while in France and Switzerland is quite common; therefore social, political and historical reasons are still dominating property investment. Computing average returns and standard deviations in different markets and times, with and without valuation smoothing and taking in account the illiquidity premium, points to figures that suggest yields and risks well below the ones of shares and bond. This result is coherent with the fact that usually property investment is leveraged. In fact, when geared, property in mean-variance context positions itself between bonds and shares. Other studies have explored the characteristics of property as a diversification asset, reporting correlation coefficients moderately positive or near zero but not stable over time. These results have been justified with theoretical considerations in three main areas: property market efficiency, index construction technique and adjustments in supply. The same results apply for commercial and residential sector, whilst the estimated weights in mixed asset portfolio are slightly different: in the UK, 20-25% for commercial and 20-30% for residential (because of higher yields). The indirect property investment, using REITS or property derivatives, usually is less correlated with direct markets and more influenced by stock market factors but, curiously, the correlation with shares lowers when REITS are degeared. One important clue of REITS is their level of floating-rate debt: a sudden rise in interest rates could reduce cash flows significantly, thus, most funds hold some interest rate caps on longer term floating rate debt. Another issue could be the sensitivity to interest rates: while theoretically REITS should be a hedge against inflation and rising interest rates, usually, when the slope increase, in the short term the shares of REITS drop. Conversely, when economy stagnates, secondary property is divested by small firms and traded at bargain prices, thus large funds can profit in the long term. We remember here that international real estate investment will not provide effective diversification for pension plans but could enhance returns when properly used and it is naturally currency edged when leveraged. It could be easier to diversify risk with a careful allocation of funds to sector and regions.

For a small property fund we can suggest to use direct property investment to build wealth in the long term and to lower the risk profile of the portfolio whilst the indirect investment should be used to reduce the risk of the held assets when the volatility of the overall property market increase and could be part of a short term multi asset tactical strategy aimed at increasing performances and ranks. For instance swapping all property returns for other asset classes: equities, using the stock index, or cash, using a borrowing rate; conversely increasing exposure to real estate swapping a long position on a property index. For larger funds, indirect investment is more used with the aim of reducing running costs and specific risk [GPRO],[UBSI],[EFF],[PROP].

References.

The Economist, www.economist.com,

03/06/13, Buttonwood, [ECO1]

20/04/12, Buttonwood, [ECO2]

03/03/12, The Economist, [ECO3]

Ubs Asset Management, www.ubs.com, Pension Fund Indicators 2013, [UBSI]

Global Property Investment: Strategies, Structures, Decisions, Baum and Hartzell, [GPRO]

Efficiency in the UK commercial property market: A long-run perspective, Devaney, Holtemoller, Schulz, [EFF]

The Role of Property in Mixed assets Portfolio, Hoesli, MacGregor, Adair, Mac Greal, [PROP]