With the real estate market booming across the country, it may be hard to ignore the capital appreciation aspect of real estate investments. But for many institutional portfolio managers, real estate is a core holding rooted firmly in the fixed income side of the asset mix.
Sure, housing prices seem sky high, but residential property makes up only a small piece of most institutional real estate portfolios. Besides, have you looked at equity valuations lately? How about commodities — are you comfortable upping your client’s allocation at these levels?
Institutional managers are still in love with real estate, as long term holdings offer a steady stream of income. The relative lack of liquidity does little to deter the managers of massive pension portfolios, since longer-term leases on industrial and commercial properties make it easier to match assets to future liabilities.
As with all asset classes, shortsightedness and the traumatic impact of periodic downturns tend to distort perceptions of real estate. For some investors, the bloodbath of the early 1990s left the impression that real estate is volatile.
“The stability of real estate is something that really surprises a lot of people when they see it for the first time,” says Catherine Marshall, CFA, senior vice president, research and strategy, LaSalle Investment Management, a global real estate portfolio advisor with offices in Toronto and Vancouver. “It’s as though people only remember real estate recessions and think that real estate is very unstable, when in fact real estate recessions have very minor impacts on long term performance.”
The scope of private real estate portfolios can be mind-boggling. According to Michael Catford, vice president, Hospitals of Ontario Pension Plan, institutional portfolios currently control 53% of all Class ‘A’ office space across Canada and 71% of regional shopping centres. Among the 100 largest defined benefit plans, the average real estate allocation is 5.7%.
He says the combined market value of publicly listed REITs and real estate operating companies is about $46 billion, while the value of institutionally held real estate is closer to $58 billion.
“The real estate industry, by and large, has had a terrific run these past few years,” he says “We’re no longer a social pariah; we’re a legitimate asset class.”
He says the globalization of the legal infrastructure in real estate is in turn creating a global market for investment. Not only are foreign investors becoming more active in Canada, but Canadian institutional investors are looking to Europe and Asia to diversify their holdings.
The surging real estate market has attracted a great deal of capital to the sector at a time when supply is dwindling, he says. As a result, the acquisition market is far more competitive.
“Sometimes in order to get deals done, people are pushing their own standards and looking through rose-coloured glasses,” Catford says. “There can be the view that they have lost the last ten deals, so they want to close the next one at any price.
“If there is a downturn, some of those folks who over-reached for B and C assets may end up regretting the day. That being said, there’s nothing on the horizon for the next 12 to 18 months that says that’s going to happen.”
He says the good news is that lenders have not forgotten the lessons they learned from the real estate recessions of the late 80s and 90s, and they are playing a greater role in risk management this time.
“While I am always reluctant to say ‘it is different this time,’ it actually is,” he says.
Like stocks and bonds, private real estate portfolios have their own benchmark, the Investment Property Databank (Canada), which consists of 30 years of data. The IPD Canada index represents $45 billion in privately-held real estate assets and has a strong orientation toward income, rather than capital appreciation.
Large institutional portfolio managers like real estate because it has a very low negative correlation to stocks (-0.05%) and bonds (-0.04%). Despite its reputation for volatility, it is actually a more stable asset class over the long term than both the Scotia Bond index and the S&P/TSX Composite.
“Real estate not only provides diversification, it provides downside protection,” Marshall says. “In 2001, one of our clients, the California Public Employees Retirement System, had positive returns, when most other investment managers were experiencing negative returns due to their stock portfolios. Real estate was strongly positive and boosted the overall performance of the portfolio into positive territory.”
Such performance in a notoriously rough year did not go unnoticed by other institutional investors, she says, and in the ensuing five years there has been a trend toward bulking up on real estate.
Looking at real estate as an equity investment, the IPD has consistently been priced over the long term to yield 12.5%, Marshall says, pointing out that the TSX has been “all over the map.” The income return alone on the IPD has averaged 8.2% since inception, and co-incidentally, has had the same rate of return over the past 5 years.
Since the IPD index is calculated quarterly, the daily liquidity of REITs virtually guarantees tracking error. With Canadian REITs primarily used by retail investors — as opposed to the much less hurried institutional market — they tend to trade off bond yields, instead of being treated as long term income instruments.
“Unfortunately right now in Canada there aren’t any exchange traded funds or derivatives that you to allow invest in the index,” says Marshall. “It’s probably a matter of time — in Britain and the U.S. options are developing and derivatives appear to be the way to get exposure to the IPD.
“If any investment bankers want to create derivatives (based on the IPD) I definitely know there are institutional investors who would love to be able to buy the index in order to get up to their allocation.”
Marshall characterizes real estate portfolios as hybrid investments, describing holdings as a “bond-like instrument with an equity kicker.” Therein may lie the difference between the mindset of the institutional manager and the retail investor.
To the average investor, real estate is a capital appreciation game, because their primary exposure to the market is through the ups and downs in the value of their own home. Apart from investing in exchange traded REITs, income-oriented real estate investing is out of reach for all but the wealthy.
REITs are actually not a good proxy for privately-held real estate, such as that held in institutional portfolios. They do offer superior liquidity, being traded on their exchanges, but behave far more like equities than the income generating assets held in private portfolios.
“Here in Canada, REITs are largely a retail instrument. They are priced off of the bond market and so pricing of that instrument moves around quite a bit,” says Marshall. “They are not a bad investment and certainly the income does derive from real estate, but at this point in time they really are not giving you a real estate return. Hopefully that will change in the future.
“In the United States, REITs are a very good proxy over long periods of time for the private real estate market and are a really good alternative. It would be great to have that happen in Canada as well, giving investors more choice in terms of investing in real estate.”
Next week: Legal structure vital in real estate investing.