What makes property different?
As with all equity-type assets, the performance of property is ultimately linked to some extent to the performance of the economy, and like all assets its performance is linked to the capital markets. The economy is the basic driver of occupier demand, and, in the long term, investment returns are produced by occupiers who pay rent. However, in the shorter term – say up to ten years – returns are much more likely to be explained by reference to changes in pricing, or capitalization rates, which are in turn driven by required returns. Required returns do not exist in a property vacuum but are instead driven by available or expected returns in other asset classes. As required returns on bonds and stocks move, so will required returns for property, followed by property capitalization rates and prices.
Nonetheless, history shows that property is a true third asset, distinctly different from equities and bonds. The direct implication of property being different is its diversification potential within a multi-asset portfolio, and hence the justification for holding it. Generally, the impact of the real economy and the capital markets on the cash flow and value of real estate is different from the impact on stocks and bonds, and is distorted by several factors. These are as follows:
Property is a real asset, and it wears out over time, suffering from physical deterioration and obsolescence, together creating depreciation.
The cash flow delivered by a property asset is controlled or distorted by the lease contract agreed between owner and occupier. US leases can be for three or five years, fixed or with pre-agreed annual uplifts. Leases in continental Europe may be ten years long, with the rent indexed to an inflation measure. Leases in the UK for high quality offices are commonly for ten years, with rents fixed for five-year periods after which they can only be revised upwards.
The supply side is controlled by planning or zoning regulations, and is highly price inelastic. This means that a boom in the demand for space may be followed by a supply response, but only if permission to build can be obtained and only after a significant lag, which will be governed by the time taken to obtain a permit, prepare a site and construct or refit a property.
The short-term returns delivered by property are likely to be heavily influenced by appraisals rather than by marginal trading prices. This leads to the concept of smoothing.
Property is highly illiquid. It is expensive to trade, there is a large risk of abortive expenditure and the result can be a very wide bid–offer spread (a gap between what buyers will offer and sellers will accept).
Property assets are generally large in terms of capital price. This means that property portfolios cannot easily be diversified, and suffer hugely from specific risk.
Leverage is used in the vast majority of property transactions. This distorts the return and risk of a property investment.
Property is a hybrid asset, with similarities to stock and bonds, but different. While real estate is not technically a good inflation hedge, property rents appear to be closely correlated with inflation in the long run, producing an income stream that looks like an indexed bond. But rents can be fixed in the short term, producing cash flows that look like those delivered by a conventional bond, and the residual value of a property investment after the lease has ended exposes the owner fully to the equity-type risk of the real economy.
The risk of property appears low. Rent is paid before dividends, and as a real asset property will be a store of value even when it is vacant and produces no income. Its volatility of annual return also appears to be lower than that of bonds. This is distorted somewhat by appraisals, but the reported performance history of real estate suggests a medium return for a low risk, and this can appear to be a mispriced asset class.
Unlike stocks and bonds, real estate returns appear to be controlled by cycles of eight to nine years.
Real Estate Investment,A Strategic Approach
Andrew Baum
