For real estate, think global

Everyone knows the old adage about the three most important things in real estate, but when it comes to real estate securities, “location, location, location” is not so much repetition but a call to diversification.

“A global approach, in my opinion, is recommended as it provides the widest range of return opportunities, and it also provides some important diversification benefits versus the single country approach to listed real estate investing,” said T. Ritson Ferguson, a chief investment officer at ING Clarion Real Estate Securities, speaking at IMCA’s New York Consultants Conference.

He pointed out that returns on real estate securities—in North America, typically real estate investment trusts (REITs)—are not perfectly correlated with equities, and therefore offer portfolio diversification benefits. That makes them an important element for both institutional portfolios and individual investor portfolios.

As publicly traded securities, they offer benefits over private real estate investments, including regulator-mandated disclosure and oversight by independent boards, auditors, and analysts.

“Global real estate stocks are still a proxy for real estate as an asset class. They still offer substantial—maybe enhanced—liquidity, and they still have high income relative to other equities.”

Massive market Globally, the listed real estate universe is massive, with more than 800 listings, over US$1.5 trillion in market capitalization and daily trading worth up to $9 billion dollars.

Roughly 30% of that market is in the Americas, with Europe and the Middle East making up 20% of the universe. The remaining half of the market is based in the fast-growing Asia-Pacific region.

“By approaching listed real estate with a global strategy you increase the opportunity set…by maybe threefold,” he said. “An allocation to global real estate stocks offers the potential to increase investor’s portfolio returns while reducing risk.”

His firm estimates there is over $18 trillion of high grade commercial real estate assets in the world. Listed real estate companies control just over $2 trillion of real estate, with debt issuance reducing the equity market capitalization to $1.5 trillion.

“That $2 trillion certainly represents a large pool of commercial real estate accessible to investors [but] it’s only 11% of the global asset class. There’s clearly room to grow.”

A big driver of that growth may be the aging boomer population, who are scrambling to add income yield to their collective retirement portfolio.

There is huge variation in the average yield from country to country. At the end of 2010, the indicated yield on the Australian REIT universe was 5.9%, while Japan’s real estate operating companies (REOCs) were yielding just 1.1%, and the global average yield was 3.7%. In Canada, REIT yields vary widely, but average between 5% and 6%.

“They have historically seen dividend growth at a rate equal to or greater than inflation, an issue that seemingly has been dormant for many years but is increasingly on many investors radar screens,” Ferguson said.

In the U.S., REITs have delivered an average annual total return of 10.4% over the past 25 years, edging out the S&P 500 (9.9%) and handily beating the NASDAQ (8.9%) and what is now the Barclay’s bond index (7.6%), according to data from the National Association of REITs (NAREIT).

“A key component of that total return is the high dividend component of REITs and by extension globally, listed real estate companies,” he pointed out. “The dividend has averaged between 5 and 10% of the return contribution in any given year.”

DiversificationOver the past 10 years, correlations between regions have ranged from 0.4 to 0.6, suggesting a relatively weak link.

“The inherent nature of real estate as a local business bleeds through to the returns of real estate stocks across regions,” said Ferguson. “This makes a global REIT allocation attractive for the additional diversification benefit it offers.”

Returns also vary wildly on a global basis, making a global approach all the more important. As an illustration, Hong Kong real estate returned 73.1% in 2009, while nearby Japan returned just 2.9%. In 2010, the tables were turned, with Japanese real estate returning 32.5%, easily outpacing Hong Kong’s 17.9%. The global average returns for those two years, however, were 37.7% and 21.5%, respectively.

Most importantly, a global approach is likely to smooth returns over the long term. Not surprisingly, Ferguson advocates an active management style.

“Over the last 20 years there’s been no single market that has consistently produced the best return,” he said. “The opportunity for a meaningful value-add exists through an active management approach that can identify regions that are likely to outperform. Easier said than done, but at least the opportunity exists.”