By Stefan Wundrak, Director of Research, Property at Henderson Global Investors
Are property investments like businesses?
When thinking about commercial property strategy, you might take the view that direct investment has more in common with running an independent business than is firstly obvious. Is this the case? And most importantly, what implications does that hold for investors?
It is certainly not the case with investments in equities or bonds. So how comparable is direct property investment?
By way of rental contracts, property shares the fixed income quality with bonds but with the key difference being that properties have no maturity values. The exit value of a property has to be realised by a successful sale and is not only unpredictable but can also, to a large extent, be influenced by the owner. The management capabilities of the landlord during the holding period are crucial in order to secure continuous income and capital values. To fulfil this role in all unexpected and adverse circumstances, the owner also needs a strong capital base to ensure the property may not be deprived of the necessary capital expenditure in order to protect and create value. Additionally, a “default”, which in property can arise from a tenant becoming either insolvent or deciding to not renew the lease, may result in a massive loss. However, if a new tenant were to be found quickly and the market rent was above the passing rent on the previous contract, a substantial gain may be realised. The absence of a (fixed) maturity value and the required active, even capital intensive management, makes the comparisons between bond and property assets quite misleading.
Equities trade on efficient, transparent stock markets and their funds often have dispersed ownership structures, which curtails investor influence and can again seem far removed from property. The distinctive feature of stock markets, the ability to deliver a total loss as well as multiplying values in a short time, is not normally replicable with real assets, except those with particularly volatile cycles. Essentially, properties are more like simple, capital intensive businesses that are very much defined by their constraining bricks and mortar and run in the highly standardised structure of leases. In other words, property investors are more like small scale entrepreneurs than financial investors. Applying popular financial market investment strategies to property and ignoring their critical real estate idiosyncrasies can therefore easily lead one astray.
Seeing properties as small businesses has implications for both building and running property portfolios.
Sophisticated stock market strategies such as short selling are obviously not applicable to physical property markets. However, even the most obvious fund management strategy to buy when prices are low and sell when prices are high is not straightforward in property. In the current cycle, with perfect foresight, you would have invested as much as possible at the bottom of the market in Q2 2009. However, property markets become illiquid in times of stress and only €12.9bn of commercial property in all of Europe was traded in that quarter, compared to €72.1bn at the pricing peak in Q2 2007. Even the most ambitious investment programme would have yielded rather modest results in terms of volumes. Additionally, trading commercial property is a complicated and lengthy process taking at least a couple of months, and can stretch to over half a year. The process requires significant resources to analyse potential investments and even more to actually complete an acquisition. No compromise can be made with investment analysis and due diligence, so the number of deals an investor can execute in any given time is limited by the number of people available, which also can not be changed materially in a matter of months. This is very different to stock and bond markets, where large amounts of capital can be invested and divested within minutes. (see chart 1)
While overall investment volumes of €12.9bn in one quarter might sound like quite a lot of product being available, it is important to consider that property markets are far from transparent. The owner will know more about his possession than any prospective buyer, which means poorly-performing assets are more likely to be offered than better-performing ones, although clearly there are other reasons for selling. This adverse selection phenomenon excludes a large part of the market for performance-driven investors, but they may still have to assess many opportunities in order to identify fairly or under priced investments. Essentially, favourable transactions boil down to the few cases where the buyer believes to have better information than the seller, or more importantly, as we will argue below, superior asset management capabilities to identify and extract value.
This analysis could leave the impression that direct property as an asset class is impeded by a number of intrinsic disadvantages compared to other financial assets. It should, however, also be acknowledged that by treating property investments as businesses, investors are not left to the mercy of markets as is the case with liquid “paper” investments. Property owners have the necessary direct control to actively turn things around, even in most adverse market conditions. Landlords, for example, can seek innovative ways to retain and find tenants in economic downturns or perhaps time refurbishments to take advantage of periods when good quality property is in short supply. In retail in particular, owners of shopping centres have endless possibilities to re-gear the mix of retailers in line with the economic climate, popular fashion trends or changes in the local demographics. In the business space arena, modest architectural changes can turn a bland office building into a sought after address and obsolete office blocks can rise like a phoenix with residential use. A lot of these undertakings are particularly effective when used in a countercyclical way. Past cycles show that the best timing to start developments is around the bottom of the market. This adds to the natural countercyclical characteristics of property, such as the CPI indexation of leases and the flight to safety which the values in core locations often benefit from in times of financial market turmoil.
Landlords have a variety of powerful tools at their disposal in order to protect their capital and ultimately add value. In order to leverage these key advantages of direct property holdings, investors should seek exposures which allow utmost control, coupled with maximum flexibility and a variety of angles on which to work on assets.
From this business point of view, acquiring prime properties in the sense of new long let assets (the choice of many risk averse investors), actually combines the worst of both worlds. A long lease most closely mimics a bond like investment. However, investors can not hold to maturity in the same way they might hold a bond because the value falls in line with the approaching lease expiry. At the same time, physical depreciation can erode the value. Only cyclical market rental growth may counteract the downward trend. In the worst case, the landlord could be confined to sit and watch the value eroding as this type of investment minimises the scope for entrepreneurial active management. By applying a financial asset inspired strategy on property, investors are most likely to inadvertently add risk, and most importantly, miss out on the most powerful feature of physical real estate investments.
To answer the question ‘Are property investments like businesses?’ the analysis seems to suggest that in order to maximise their potential, they certainly should be treated in such a way.
For more information, please visit: http://www.henderson.com/property