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Take Care with Property Funds
Gordon Rose, CIIA 2014-02-17

Investing in property through REITs, real estate mutual funds, ETFs, and private offerings has become significantly easier in recent times. This is particularly so since ETFs came more popular. Consequently, investors can now choose between active or passive funds and direct or indirect property fund investments. While indirect passive property funds are nothing more than listed equities; a sector fund so to speak, active and direct investments are a little trickier.

Firstly, there is the liquidity mismatch: mutual funds typically offer daily redemption, while the underlying real estate assets are highly illiquid. Valuations are another problem. Real estate valuations are based on estimating the market value of a property and should reflect the price at which an informed investor is willing to buy or sell it.

However, properties are usually not traded for years and hence they are either typically valued using the income approach - discounted cash flow approach, or comparable sale prices. Meanwhile, properties where the value is driven by the actual business use of the real estate are valued using the profit approach. However, it must be noted that the correlation between an appraisal-based index and a market-based index shows no consistently positive or negative correlation, ranging in some regions between -0.30 and 0.30 over the last 20 years.

These liquidity and valuations issues can lead to stale pricing, meaning the fund’s NAV has yet to catch up with the most recent market trends. This creates an arbitrage opportunity that incentivises some shareholders to sell in bear markets and new investors to buy in bull markets. Ultimately, exploiting this arbitrage could be viewed as a transfer of wealth away from existing fund shareholders. In bull markets, new shareholders will automatically profit when the fund price catches up with real market trends. By contrast, in bear markets, those redeeming before fund prices catch up with reality would also pocket the difference.  

Returns Analysis is Not Easy

Given the illiquidity of direct property investments, a returns analysis relative to a benchmark is rather difficult. One way to go about it is to use indices based on appraisals where property values are estimated professionally using the income approach. Alternatively, a valuation can be based on comparable sale prices. By comparison, REITS are much easier to value, as their prices are based on real market values.

Selecting an active fund manager is no easy task either. From a purely mathematical point of view, only 50 per cent of fund managers can be better than the average manager. However, countless studies have shown that only about one third of managers successfully outperform their benchmark over the long-term. In addition, a study by Jeroen Derwall of Tilburg University (2009) showed that the REIT momentum explains a great deal of the abnormal returns that actively-managed REIT mutual funds earn in aggregate.

The authors found that residual returns of actively-managed REIT portfolios might reflect exposure to an omitted REIT momentum factor rather than managerial skill. Hence, REIT managers seem to offer less alpha than they have been given credit for. The study therefore suggests that relatively unsophisticated or inexperienced investors might be better off with indexation.

Outlook for the Real Estate Market

Overall, global realestate services firm Jones Lang LaSalle is optimistic about the market in 2014 as the global economy continues to improve and strong corporate balance sheetsencourage capital expenditure. All major markets are posting volume growth as liquidity improves across the board. Jones LaSalle expects 2014 global volumeto be only 20-25% below the highs of 2006/2007. Meanwhile, for full-year 2013, it raised its global transaction volume forecast to $525-575 billion, implying 10% growth.

Despite being traditionally a slower quarter, transaction volume in Q3 2013 grew by 16% on the previous quarter, and by 21% on the previous year. After months of uncertainty, markets now expect the US Fed to continue its QE programme for some time, thereby providing further liquidity for transaction volumes.

Going forward, it will be difficult for REITs to mirror their pre-crisis performance. During the last decade, REITs mainly benefited from increasing leverage, lower borrowing rates, rising property values, and strong growth in demand for properties. For now, interest rate developments remain supportive of real estate markets, as many central banks around the globe continue to keep rates at historical lows. However, rates will eventually rise again, which will increase REITs' cost of capital, pressure asset values, and reduce cash flow.


Gordon Rose, CIIA is an ETF analyst with Morningstar Europe.