A central benefit of the real estate asset class is the potential to generate alpha from effective portfolio and asset management. But navigating through the current environment poses investment challenges. Strong recent performance has contributed to a surge of capital toward the asset class. The growing scale and importance of real estate as an asset class has been accompanied by a desire for greater scrutiny of the actual exposure, from investors, regulators and managers.
This scrutiny is part of broader moves for greater transparency, as well as increasing concerns over the pricing of real estate across most markets. It is in this context that “benchmarking” is coming to represent a powerful tool in helping provide this scrutiny and, as such, a central activity to help manage risk and return within the investment process. Moreover, real estate benchmarking can function as a crucial nexus between the shifting winds of a global marketplace and the on-the-ground local decisions that drive performance. It is a simple, but powerful framework for strengthening decision-making through the investment process.
#1 Think globally. Understand the broad context of your investments
The strong recent performance of real estate is well demonstrated for the funds and assets contained within the IPD Global Property Fund Index. This index, covering more than $300 billion (€276 billion) in 90 funds globally, delivered a global performance of 13.4 percent in the year to Q3 2015, well ahead of other asset classes, including public real estate. This strong performance has persisted since the financial crisis, with an average annual return of 11.4 percent over the past five years, stronger than equities, bonds and real estate securities.
Real estate has been performing strongly across most markets, with, most recently, the European markets experiencing a surge of performance. The United Kingdom generated asset level returns of 14.8 percent to Q3 2015 and continental Europe 13.7 percent. Within Europe, there has been a dramatic turnaround in some of the formerly weak markets. After lagging much of the rest of Europe for most quarters since the financial crisis, southern Europe posted another quarter of strong performance, of close to 20 percent in the year to September 2015. Although the sample size is relatively small in this part of Europe, it reflects the turnaround in Spain and Italy, and runs in parallel with improved performance in Benelux, France and eastern Europe.
#2 Never forget that transactions remain local. Allocate capital and select assets carefully
Although performance has been strong, one of the enduring characteristics of real estate is the portfolio and property-specific variations associated with direct exposure. These variations can be understood on a number of dimensions, with one of the most useful being the difference between “structural” and “property-specific” factors. Structural factors relate to allocation decisions covering property types and locations, while property-specific factors relate to specific characteristics of individual buildings such as their vacancy rates, costs and income security (including lease length and tenant quality). The relative importance of these structural and property-specific factors is shown for the United Kingdom over the past 40 years, demonstrating that “property-specific” factors are the most significant, accounting for more than 60 percent of the deviations from benchmark return for the UK market.
It is the significance of property-specific factors that demonstrate the risks and challenges associated with investing in direct real estate. Real estate, by its nature, involves the management of unique assets, each of which can vary significantly in terms of their characteristics (age, size, location, quality, tenants, etc), the relationship with the local and broader market, and their investment performance (income, costs, appreciation, etc). The effective management of these idiosyncratic assets can only be carried out with good understanding of their characteristics and their role within a broader portfolio.
Although these asset-specific characteristics have been recognised as critical drivers of performance and risk, it is only more recently that the availability of good data and technology has enabled managers to understand their significance when investing across global markets. Over recent years, there have been huge advances in the ability to understand and attribute the reasons for over- and underperformance. The ability to conduct such analysis enables assessments to be made of fund-specific variations on a range of dimensions, such as vacancy and development exposure.
At a regional level, vacancy rates are broadly comparable, with all regions being close to the global average. There are, however, significant fund-specific differences in vacancy rates, particularly in the United Kingdom and continental Europe, but also in the United States and Asia Pacific. These variations also exist for development exposure, although there are also more significant regional variations, with the highest levels being in the Asian market, which has experienced strong fundamentals over recent years. This contrasts with the continental European market, where development levels are particularly low, perhaps reflecting the depressed nature of that region over recent years.
These averages provide important insights into the strategic choices that different funds take as they position themselves for the next stage of the real estate cycle. But performance is ultimately delivered through individual assets and, as can be seen in the “Distribution of asset- level returns” chart on page 32, there are even more significant variations by individual assets, property type and region. The shape of the lines demonstrates the significant number of assets that perform far better or far worse than the regional or property type averages. In the best-performing UK market, for instance, which generated a return of 15.8 percent for the year to June 2015, 20 percent of the assets generated a return in excess of 25 percent, and 20 percent generated a return of less than 8 percent. Although the US and Asian markets underperformed the United Kingdom by some margin, more than 30 percent of US assets and 17 percent of Asian assets exceeded the UK average.
#3 Yes, benchmark. It is the next logical step to improve decision-making
These examples of the wide variations in asset characteristics and performance illustrate the significance of understanding the drivers of performance. It is in this context that real estate benchmarking is increasingly being seen as a tool for providing the transparency and discipline that investors, managers and regulators seek. Such analysis takes the scrutiny of an investment portfolio from a simple statement of the return to a fuller understanding of how that return was actually achieved. This kind of understanding is particularly important for real estate investments, given the complexity and secrecy of information on individual buildings, and also the subjective element contained within appraised values.
The fundamental reason for benchmarking is to provide strategic insights to improve decision-making through the investment process. Managers and investors can dig down from the headline statement of overall relative return to gain a comprehensive understanding of that result through attribution analysis and other analytical tools. This can provide insights that can help managers improve performance. Attribution analysis, as also applied widely across other asset classes, allows all those involved to assess the effectiveness of portfolio strategy and stockpicking. It also provides pointers to areas of strength and weakness within the portfolio, which can then be scrutinised further.
These insights are increasingly being used as a central dimension of risk management, at the level of individual assets, portfolios and markets. Many companies use attribution analysis to help identify high- and low-risk assets within the portfolio. This profile may not necessarily conform to the original expectations for the assets, but it will enable the causes of volatility within the portfolio to be identified, in particular whether they stem from the behaviour of the market segments in which they sit, or rather from specific aspects of asset quality. As a result, a more rational view of expectations for future portfolio volatility should emerge, providing valuable input to investment decisions and the potential benefits that active asset management could bring.
#4Remember that real estate is cyclical. It requires effective management and communication
Although real estate continues to post strong performance across many markets, there are growing concerns over its pricing and the way that it will perform when interest rates start to rise. These concerns are increasing at a time when portfolio managers have a greater range of tools at their disposal for measuring and managing the drivers of asset and portfolio performance. These tools provide important insights to help position assets and portfolios for the next stage of the real estate cycle. Beyond these insights, these tools also represent powerful ways of communicating with investors and regulators, with “transparency” increasingly being seen as a critical element of good governance for portfolio management.
Source: IREI