Hugo Machin
Senior Portfolio Manager

In this Insights article the myth is dispelled that listed real estate assets are more volatile than unlisted assets. The importance of understanding the inherent characteristics of real estate and how these can benefit investor portfolios is also explored.

Real estate assets – which type?

The real asset of real estate can be held in either listed or unlisted formats. Currently, there is a belief that listed real estate is more volatile than unlisted real estate. However, this is a myth.

The fundamental asset is the same whether in a listed or unlisted format. The reason that unlisted real estate appears less volatile is a time lag between valuations in unlisted portfolios, whereas shares are marked to market every day (and the share market is, by nature, forward looking).

This means listed real estate investment trusts (REITs) have to show, to an even greater degree, that they provide property-like returns rather than equity-like returns.

It is worth repeating that a REIT in its purest form – high payout ratios and low financial engineering – provides investors with a low cost way of owning institutional grade real estate with the benefit of liquidity.

Importantly, it is a good diversifier of an investment portfolio. Whilst there will be points in the investment cycle where low growth stocks with high dividends appear unattractive, it is vital for the sector that this point of difference is maintained.

Listed real estate markets have come unstuck when the business models have changed. Property-like returns managed by experts in a conservative capital structure is a through-cycle truism. A conservative capital structure dovetails well for a further reason why capital would be attracted to listed real estate.

Look at gearing

High gearing can lead to higher share price volatility. This is the single biggest reason why investors view listed real estate to be unsuitable as a means of diversifying their portfolios.

Lower gearing means that the shareholder will receive returns that are a closer proxy for direct assets (due to low financial engineering).

It is the age old adage – risk adjusted returns.

Investors in the sector want to receive high and predictable income streams backed by real assets. Thus, a reduction in volatility greatly aids the argument of listed real estate being a diversifier in a balanced portfolio.

The point of being true to label is hugely important.

Returns on capital in excess of a companies’ cost of capital will result in share prices being ‘bid up’. Better returns to shareholders will result in the availability of more equity capital, as investors are drawn to the sector. This alternate source of funding is a key benefit of a market listing. Thus, growth driven by better returns will, in turn, lead to a more highly securitised and sophisticated market – the virtuous circle.

A second building block towards a strong share price is that of a suitable capital structure. The question of what is the optimum gearing level is difficult to answer. Generally speaking, investors invest for operational not financial returns. Investors are not, according to Green Street Advisors, universally compensated by better returns from higher gearing, even in a rising market.

The issue is that the higher the levels of financial engineering the less ‘true’ the real estate returns are when owning the shares. It is this point of operational over financial returns that are critical for the property companies to understand. Importantly, high gearing in companies compounds volatility at times of market dislocation and lower gearing levels would alleviate some of this pressure.

For the sake of argument, if we assume that specialist real estate companies are expert at buying, developing and leasing real estate, then it is the capital structure that can often be the critical factor that causes a company to underperform, especially in a down cycle.

A sound capital structure is of equal importance to management being financially aligned with shareholders. Arguably, if management are aligned, then they would not allow the capital structure to jeopardise the share price. Nonetheless, it is vital that the sector should provide operational returns to its owners.

Asset allocators do not always see listed real estate as a ‘separate’ asset class to be included in their portfolio. Accordingly, the sector needs to become as true to label as possible. Lower gearing will help in this process, by reducing volatility in share prices. This will further provide investors with the cheapest and most efficient way of owning the asset class.

 

^ Top





Important notice to all investors: This article has been prepared by AMP Capital Investors Limited (ABN 59 001 777 591,AFSL 232497) (“AMP Capital”) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (“AMPCFM”) for providing general information about the product referred to in this document (“Fund”) and is qualified in its entirety by any product disclosure statement, information memorandum, private placement memorandum or other disclosure or offer document and legal documentation that may be subsequently available. This document is not intended to be and does not constitute a recommendation, offer, solicitation or invitation to subscribe regarding the Fund, and is not intended for distribution or use, in any jurisdiction where it would be contrary to applicable laws, regulations or directives. Prospective investors should make their own inquiries and consult their own professional advisers as to the applicable laws, regulations and directives (including any requisite governmental or other consents and any other prescribed formalities) in any particular jurisdiction (including, in which the person comes into possession of this document) and the consequences arising from a contravention of them at any relevant time. Any failure to comply with such restrictions may constitute a violation of applicable securities law. While every care has been taken in preparing this document, except as required by law, none of AMP Capital or AMPCFM or their associates makes any representation or warranty as to the accuracy or completeness of any statement, including, without limitation, any forecasts, or takes any responsibility for any loss or damage suffered as a result of any omission, inadequacy or inaccuracy.

This document does not purport to be complete, does not necessarily contain all information which a prospective investor would consider material, and has been prepared without taking account of any particular person’s objectives, financial situation or needs. Accordingly, the information in this document should not form the basis of any investment decision. A person should, before making any investment decision, consider the appropriateness of the information, and seek professional advice, having regard to the person’s objectives, financial situation and needs. Past performance is not a reliable indicator of future performance and there can be no assurance that the Fund will achieve its objective or its target returns or that investors will receive a return from their capital. This document is provided to you strictly on a confidential basis and the information contained in it must be kept strictly confidential (with the exception of providing it to your professional advisors who are also contractually and/or professionally bound to keep it confidential) and may not be reproduced or redistributed (in whole or in part) or otherwise made available to any other person in any format without the express written consent of AMP Capital or AMPCFM. All information contained in this document, unless otherwise specified, is current at the date of publication and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after that date. By accepting a copy of this document, you agree to be bound by the limitations, terms and conditions set out in this notice.