Valuation and yield gap between property securities and bricks and mortar is throwing up key opportunities in the former, with market beating equities seven years in a row
The property securities market outperformed equities for the seventh year in a row in 2006, leading some to argue that the asset class is overvalued. Indeed, on various valuation metrics it looks as though listed property is fully valued, or even overvalued.
But yields in listed property markets are higher than those in direct markets, indicating there is still a valuation gap between bricks and mortar and securities. There is a perception that property is overvalued, but this reflects what is happening in direct property markets, not what is happening in listed property securities.
Substantial liquidity - due to low interest rates and ample oil linked revenues - is fuelling the robust demand for direct property, feeding some headline-making transaction prices. Yet the rise in security prices has yet to match that of direct property.
There are a few possible reasons for this. The first may be that the market just does not believe that this growth in property markets is sustainable. Another is that it is taking a while for property securities markets to reflect the yields at the direct level in their pricing.
But the fundamentals for direct property are actually improving, suggesting that the surge in markets is only going to continue. Strong economic growth in recent years has driven demand in property, raising pricing and occupancy rates. Yet in most major markets around the world, construction of commercial real estate is struggling to keep up with strong demand. As a result, existing vacancies are quickly filled, causing occupancy rates to rise and putting upward pressure on market rents.
This is happening more or less across the board globally. Fundamentals are improving in many countries at the same time. The US market was the first to move into a positive cyclical phase, and now Europe has started to strengthen, while Asia is just emerging from the bottom of the property market cycle.
The yield differential between direct and listed property markets is becoming increasingly apparent to a number of market players and this is reflected in a number of market developments.
The first is a surge in the adoption of real estate investment trust (Reit) legislation. The concept has spread like wildfire in Asia. Japan, South Korea, Singapore, Taiwan, Hong Kong and Thailand have all established regulatory framewaorks for Reits in the last five years, and now Reit legislation is regaining momentum in several European markets. France introduced a Reit-like structure in 2003, while the UK adopted Reit legislation on 1 January 2007. Germany and Italy are expected to follow sometime this year.
The proliferation of Reits in the global property market is unlocking a significant amount of value. The shift from investing in bricks and mortar real estate to liquid, tradable, tax friendly property securities has led to a sharp rise in the global market capitalisation of property companies.
As many large-cap property companies converting to Reit structures are trading at a discount to net asset value, it is perhaps not surprising that shareholders are the most vigorous proponents of Reit adoption.
The valuation gap is also evident to private equity companies. Blackstone's recent purchase of Equity Office Property at a 25% premium to the pre-bid price sent shockwaves through the property investment community as the largest ever leveraged buyout. Only months later, Blackstone had reportedly sold off more than half of the portfolio, in some cases setting record breaking capitalisation rates.
Nor are property companies - listed or unlisted - unaware of the differential. Mergers and acquisitions (M&A) activity throughout Europe has occurred at a furious pace.
Indeed, while property security markets seem to be slow to reflect the yields in the direct markets, if M&A activity continues at this pace we can expect this catch-up to accelerate.
The yield gap differs between markets as well. This is why there have been a significant number of cross border deals recently, such as Australian shopping centre owner Centro's purchase of US shopping centre company New Plan Excel Realty Trust at a 13% premium to the share price.
Though the yield differential varies by country and property segment, the average is between 50 basis points (bp) and 100bp. The catch-up by listed property markets to direct markets has been happening for a while. But as long as the current climate of strong demand for direct property remains, securities are likely to remain undervalued.
As a result, for investors concerned that the property market is overheated, listed securities offer an attractive alternative, as they are not actually overpriced.
This may start to change as demand from institutional investors boosts listed property prices. This demand reflects the need for institutional investors to rebalance their portfolios to correct their underweight position in property. European institutional investors have a structural underweight exposure to the asset class dating back to the 1990s when riskier assets were favoured over property. According to the European Pension Real Estate Association's 2006 survey of pension funds, 76.8% of the survey's participants were below their target property allocation. The mean target allocation was 8%.
The move by institutional investors to incorporate property into their portfolios also reflects a growing understanding of the asset class's diversification benefits. Correlations between the returns of global real estate and global bonds/equities tend to be very low. This is because real estate as an asset class has different growth drivers to equities and bonds.
The addition of property to a portfolio thus enhances the portfolio's risk return profile. Moreover, the low correlations of property returns between regions or countries make global property an ideal diversifying element in a portfolio.
Demand for listed property may rise further if volatility such as in the Q1 of 2007 continues. Due to their defensive nature, property stocks are likely to be resilient in a more risk-averse climate. If investors become concerned about stock markets, or if interest rates begin to decline, they may very well switch to property, and especially Reit shares, in order to benefit from the dividends they offer.
Higher interest rates could be a trigger for a pull back in direct property markets. At some point, rates will rise such that the current level of growth in direct market pricing is no longer possible. And yet, interest rate hikes reflect a strong economy, suggesting an improvement in real estate fundamentals. As a result, any decline in property equities due to higher interest rates should be short-lived.
Because listed property is underpriced it is a much more defensive investment. If there is a pull back in direct property markets, I do not expect it to be as strong as in property securities.