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With the financial markets volatile, Stuart Webster makes the case for direct commercial property as the third asset class.
Negative comments about investing in 'bricks and mortar' have made headlines in the broadcast and print media in recent months. Rhetoric about the potential for a property market crash naturally attracts attention. The result has been that arcane financial markets jargon such as Libor and collateralised debt obligations has been introduced to a wide audience. Concerns about residential property prices and falling commercial property values in the US and some Western European markets are valid. In many instances, however, the commentary has been shallow and on occasions flawed.
Misinformation creates the danger that investors will make ill-informed asset allocation decisions and in considering property as an asset class they should avoid throwing the baby out with the bathwater.
Property is anything but a homogenous entity and should not be assessed as such. There is the obvious divide between residential and commercial property; there are also differences between commercial property sub-sectors and between countries and regions. The offices, retail and logistics sub-sectors perform differently in response to changing economic conditions and market cycles.
International property markets, therefore, present numerous and varied opportunities. In addition, investors can also obtain different returns from investing directly in bricks and mortar or indirectly through real estate investment trusts and other property shares. There is, however, a risk that the negative sentiment of recent months tars the entire asset class with the same brush.
Over the past five years, commercial property has emerged as a genuine third asset class, used by investors to complement equities and bonds within a balanced portfolio. During periods of volatility in the equity and bond markets, it has been viewed as attractive for the income and capital gains it can provide. In the past year, however, commercial property has lost some of its safer haven status. Instead, money market funds have attracted strong inflows and commodity funds have gained in popularity. A key question now is whether this shift is justified or whether the sentiment change actually provides longer-term profitable opportunities for bricks and mortar property investors.
While past performance is not necessarily a guide to future performance, it can provide an insight into long-term trends. When looking at the performance of direct commercial property there are limitations. There is no global index and data for individual countries are sporadic. The most comprehensive single country measure is the Investment Property Databank (IPD) UK Index. This shows returns from UK commercial property and covers more than two decades. As a proxy for property funds, however, it does have drawbacks. The index is not marked to market on a daily basis, it can lag the market and it is geographically specific. If these limitations are borne in mind, however, the IPD UK Index can provide a useful indication of the risk versus return potential of the asset class, as shown in chart 1.
Chart 1*
Source: Datastream, Lipper, sterling, at 30/04/2008
Measured against other assets including commodities and cash, UK direct property has compared favourably over the long term despite the recent falls in the IPD UK Index. It has offered one of the highest annualised returns and, with the exception of cash, has had the lowest volatility as measured by standard deviation. It has also compared favourably to indirect property investment through shares.
On a Pan-European basis, the industry is in the early stages of data collection. Over the period for which data is available, however, direct property, as represented by the IPD Pan European Index, has produced consistently positive annual returns as shown in chart 2.
Chart 2**
Source: Bloomberg, IPD, total return, sterling
While Pan-European property shares, as represented by the MSCI Europe Real Estate Total Return Index, posted superior gains in certain years, they have also been more volatile and fell significantly in 2007. The indirect route, which involves investing in a sector of the equities market, exhibits different characteristics to direct property investment. Rather than providing a tangible asset on which to base valuations, the performance of property shares depends on stockmarket sentiment. While property shares can be useful for liquidity purposes, their similarity with equities weakens the diversification argument. Consequently, property shares should be kept separate from bricks and mortar in the minds of investors.
Exposure to a broad spread of markets in any asset class provides diversity that can deliver stable gains with lower risk. While direct commercial property returns in some single countries fell in 2007, including in the UK, annual percentage returns from many international markets were well into double digits, as shown in chart 3.
Chart 3
Source: Bloomberg, IPD All Property, total return, sterling
If economic growth in Europe is slowing, as the data suggest, then an ability to invest in certain sectors and higher-quality properties and markets will be important for any international property fund. France, Germany and Italy stand out while secondary markets in Central Europe are likely to feel the credit drought more acutely. Parisian office space provides an attractive balance of supply and demand while in Germany, where in April the economy expanded at its fastest rate for seven months, the office sector is buoyant and high street retail space is experiencing steady rental increases.
While overall European growth may be slowing, Asia should benefit from being lower down in the economic cycle and from lower levels of debt on company balance sheets. The risks are higher than in Europe but the rewards are commensurate. In Japan, the labour market remains healthy; unemployment was at a 10-year low during the year to 31 March 2008. Land prices have risen in Tokyo and Osaka and vacancy rates have been falling. In Hong Kong, confidence is high in response to robust economic growth and thriving financial markets. Singapore is also being spurred on by positive sentiment.
By viewing direct international property markets and their sub-sectors as a diverse range of investment destinations, investors can see that the long-term case for property as an asset class remains firmly intact. Negative sentiment in individual countries should not detract from the wider picture.
In the current conditions it is important that investors analyse the potential risk/return balance of the asset class correctly and recognise the broad scope of direct international property funds. The broader the range of countries and sectors available to a fund, the lower is the potential risk. The funds that can shift their exposure to suit prevailing conditions will help put right the asset class’s image problem; namely by delivering the stable income and gradual capital gains with which direct property has rightly come to be associated.
*Chart 1
| Direct property | UK IPD: Total Return Index |
| Equities | FTSE All-Share - Total Return Index |
| Property shares | FTSE All-Share Real Estate £ - Total Return Index |
| UK gilts | FTA Brit. Govt. Fixed 5-15 Years - DS Total Return Index |
| Cash | UK Interbank 6 Month - Offered Rate |
| Commodity index | S&P GSCI Commodity Total Return Index (OFCL) |
**Chart 2
| Direct property | IPD Pan European Property: Total Return Index |
| Equities | MSCI Pan-Euro US$ - Total Return Index |
| Property shares | MSCI Europe Real Estate US$ - Total Return Index |
| Eurozone govt bonds | FTSE Global Govt. E-Zone All (E) - Total Return Index |
The opinions expressed here represent the views of the fund manager at the time of preparation and should not be interpreted as investment advice.
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