Executive Money
Published January 24, 2007

Optimal property investment

Investors should consider an exposure to global property stocks that focus on the ownership model, says TODD CANTER

ASIA'S burgeoning real estate investment trust (Reit) markets are predicted to double their market capitalisation to over $100 billion by 2010 from $55 billion now, according to figures recently released. Singapore is anticipated to be a major beneficiary of this with 14 Reits listed and several more due to join the market.

Reits offer access to stable secure income streams from a variety of real estate asset classes and increasing liquidity as the size of the investable universe expands. Singaporean investors are becoming increasingly comfortable with an allocation to Reits in their portfolios, just as they previously embraced investment in residential units, due to the diversification benefits gained from Reit investing.

With strong sector fundamentals worldwide, Reits have generated a total return of 37 per cent for the year to last November, according to UBS Global Investors Index. Investors in mature markets, such as those in the US and Australia, have turned their attention to the global Reit market, encouraged by these returns and the desire to further mitigate risk by achieving greater diversification in their portfolios. Correlations between the regional real estate markets of the US, Europe, and Asia are low, providing an opportunity to enhance long term returns through diversifying across regions.

Singapore will inevitably follow this trend as domestic offerings lessen and their return profiles become less attractive. Given the funds under management in Singapore and the desire for products that exhibit the characteristics of a global Reit portfolio, once this offshore move gains momentum, Singapore will become an increasingly influential investor in the global Reit sector.

Around the globe, investors have many choices when it comes to putting capital into real estate. In fact, the choices seem endless, including securities versus directly held real estate, development companies versus ownership companies, and domestic versus global. Investors should take heed before making their choice as the risk-and-return trade-offs vary dramatically.


The first question to ask is whether an allocation to real estate should be in the form of direct real estate, indirect property securities or both. Allocation models, looking at ex-post data, suggest that a mixed-asset portfolio should hold between 10 per cent and 15 per cent real estate. Within that real estate allocation, the optimal mix between direct and indirect varies based on risk and return tolerance levels. At the midpoint of risk and return the optimal mix is 60 per cent direct and 40 per cent indirect.

With securitisation trends continuing to spread around the globe, more and more investors are looking to this investment vehicle not only because of strong risk-adjusted returns but also because of added liquidity these stocks offer. Investors should be cautious, however, as not all property companies are the same. There are three basic forms of listed property company in the marketplace today: ownership companies, service providers, and pure-play development companies. The investment characteristics of these companies vary dramatically.

Ownership companies focus on owning and operating commercial real estate. The business model is quite simple, in that most of their revenue is derived from collecting rents and growing occupancy. The risk is moderate, averaging 12 per cent to 14 per cent, as measured by standard deviation. With risk falling in this range, this places commercial property stocks focusing on the ownership model in between traditional equity and bonds.

Pure-play development companies, mostly found in Asia, have business models that are dramatically riskier. In particular, development companies that act as merchant builders are at the mercy of the boom and bust cycles within the overall real estate cycle. Timing is very important to this volatile business model, resulting in significant swings in shareholder returns. Despite the added volatility, returns over the long term are actually quite low.

When comparing the risk and returns characteristics of ownership and development companies, the differences are remarkable. The average annual return for ownership companies over the time period 1990 to 2006, as proxied by the UBS Global Investors Index, was 11.6 per cent versus 4.1 per cent for the UBS Global Developers Index. As for risk, the standard deviation of the ownership companies over the same time period is 11.5 per cent versus 23.9 per cent for the development index.

Looking more closely at where this added risk is coming from within the development index, we find that Asia has very high risk, with standard deviations over 26 per cent per year over the time horizon noted. This is not surprising in that Asian property companies tend to be dominated by riskier development business models. Although this is changing due to Reit legislation being adopted by major real estate markets in the region, it will take a few more years before the balance shifts away from risky development companies to more stable ownership companies.

The next question to confront is where to invest. Most investors begin by investing domestically. With domestic commercial real estate exposure in many investors portfolios, is there a need to look abroad? Studies conducted over recent years have demonstrated that real estate markets around the globe behave quite distinctly from each other.

In fact, the relationship between the commercial real estate markets in Asia and Continental Europe is moderate at 0.42, and the relationship between Asia and the US property markets is even lower at 0.30. These low correlation numbers suggest that for an Asian investor, for example, there is considerable diversification benefits to be gained from adding international property securities to a mixed asset portfolio already consisting of Asian property.

In conclusion, not all real estate is the same. Pure-play development companies are significantly riskier relative to ownership companies. Commercial real estate markets around the globe also behave quite differently from one another so investors who add international real estate to a domestic portfolio can gain significant diversification benefits.

Despite these differences, commercial real estate fundamentals are, for the most part, strong around the globe, with the sector in the early stages of recovery. With strong fundamentals and the ability to gain significant diversification benefits, investors should consider an exposure to global property stocks that focus on the ownership model.

The writer is global strategist, LaSalle Investment Management (Securities)