Property: riding the rebound

Stephen Ryan: Since 2007 we have witnessed a severe correction in the UK property market followed by an unexpectedly quick recovery. Do you believe that this recovery is sustainable? Is it possible that the major property markets, particularly in prime investment destinations like London, will experience shorter and steeper market cycles in the future?

Jenny Buck: Given the current pipeline of capital that we can see for the UK property market, we do believe values will continue to rise. This is despite the fact that rents are falling and we expect them to continue to fall into 2010. So why is this happening? To explain this, property yields should be seen in the context of yields on other assets. At present, the gap between the IPD all property initial yield (7.7% end September 2009) and 10-year gilts yield (3.8% end October 2009) is virtually unprecedented and suggests that a lot of the bad news on the occupier market is already in the price. Even if the all property initial yield were to fall to around 6.25% to 6.5% next year and long gilts yields were to rise to 4.5% as quantitative easing comes to an end, the gap would still be well above its long-term average of 1.25%.

What happens after mid-2010 is less certain. One scenario is that property yields will settle at a new equilibrium in the second half of 2010 and that capital values then tread water, until rental values recover in 2010 or 2011. However, we cannot rule out a repeat of 1993/1994 when property yields first fell by 2.25% on relief that the recession was over, but then rose by 0.25%, as the recovery in rental values fell short of investors’ expectations. Clearly, the UK economy is still in unchartered waters and the speed of the recovery cannot be taken for granted. In addition, there remains a risk that the banks will trigger a wave of forced sales and disrupt the property investment market.

Over the last few years, it is clear that UK property returns have become more volatile. In part this is because the market has become more transparent. While valuations may still not be perfect, the degree to which valuers smooth out the peaks and troughs in the cycle has reduced considerably. The volatility over the last few years, may also be reflected of the fact that the overall level of gearing has risen and property capital values became more sensitive to movements in short term interest rates. Whether this gearing impact persists will be dependent on how the real estate finance markets eventually unwind themselves and stabilise. Looking forward, another factor which might add to volatility is the lack of new development as when the economy does finally recover, the fall in vacant space and rise in rental values could be relatively sharp. 

Peter Mackaness: Whilst the 2007 downturn in the market was expected by many, the strength and speed of the rebound has surprised almost everyone. It is worth noting that the recovery to date has been driven by a re-pricing of very cheap assets in selected areas – namely, good quality properties that had been the victim of forced selling in the downturn, resulting in unsustainably high yields. It has also been focused on central London, where mainly overseas buyers have capitalised on historically cheap pricing, encouraged further by the weakness of sterling. A capital-driven recovery at the current rate may prove unsustainable. Several factors continue to overhang the market, including continued falling rental values, ongoing economic uncertainty and the estimated outstanding £300bn (US$497.1bn) of commercial property debt.

This market cycle does appear steeper than those of the past, but this should be considered in the context of a market that last saw a severe downturn in the early 1990s. The central London office market (particularly the City) has always been more volatile than other markets, with its heavy reliance on financial occupiers. Rents have tended to fluctuate wildly, peaking at over £70 per sq ft in the late 1980s before slumping in the early 1990s. They peaked again about two years ago at around £65 per sq ft but are now probably less than half this level. 

Stephen Ryan: For many clients and property managers, the last two years have been an unpleasant experience. How have the fund managers maintained client relationships in the market? Is there a better way of structuring UK property funds so that cash inflows in the good times and redemptions in the bad times do not undermine performance? In the area of staff remuneration and alignment of interest, are there lessons to be learnt? 

Peter Mackaness: The severe redemptions in open ended funds over the last two years have exposed the illiquidity of property and the inability of some managers to handle redemptions in a satisfactory manner. Many managers did not anticipate the downturn and were caught with low cash weightings at a time of increasing redemptions. In many cases they also had illiquid assets in their portfolios. Moreover, some managers were reluctant to sell in the early stages of the downturn, adopting a “head in the sand” attitude and refusing to sell below valuations that reflected historic highs. Many client relationships have been damaged by the failure of managers to handle redemptions adequately.

For an open ended property fund, managing cash inflows and redemptions is always a challenge, because of the time delay in executing property transactions. To limit cash inflows, staggering or waiting lists can be used and to manage redemptions some deferral is usually accepted. Large penalties or long periods of funds being “locked up” are, however, generally not acceptable to investors.

Most open ended funds charge fees only on funds under management. There is an argument therefore that, by deferring redemptions, the manager is artificially holding onto clients’ money and charging fees for doing so. In our view, long-term fund performance and client relationships are more important.

Jenny Buck: Successful managers have typically maintained client relationships in two ways. They will have provided above benchmark performance through a combination of good stock selection, overweight allocations to cash, minimising exposure to gearing and where possible gaining exposure to non-correlating sectors and countries. The other main characteristic of the managers we rate is their communication. Those that have been transparent with their investors ensuring they understand the pressures caused by the exceptional market conditions and the strategies employed to minimise the negative impacts on performance have gained investor confidence and understanding.

In the future, funds could be structured to provide better liquidity in times of market stress, but this typically would involve holding higher than normal allocations to the listed sector and cash which has implications for volatility and potential dilution of performance respectively. The onus must be on the manager to employ strategies that sensibly regulate the inflows of cash and the use of debt to maximise performance and diversification rather than simply growing their own assets under management.

There has been much discussion about alignment of interest and long term performance with the implication that investors just sought to get money into the market regardless of the risks that were being taken. This may well have been true in a lot of cases, but investors must also take some responsibility; at the top of the market investors were encouraging managers to get the money into the market.  At Schroders, financial alignment is important, but its not the only matrix that we use to assess whether we think a manager will do the right thing to deliver the risk adjusted returns that we originally sought when investing in a fund. Here, strong corporate governance regimes and evidence that money has been returned rather than invested if the required returns could not be delivered are important.

Stephen Ryan: The proposed EU Directive on Alternative Investment Fund Managers, which covers real estate as well as private equity and hedge funds, has been criticised on many counts. What will the impact of this Directive be if implemented in its current form? Do you think investor choice will be enhanced or diminished? Will the Directive bring about any changes in how your firm does business in Europe? 

Jenny Buck: The proposal is just that -– a proposal. Once the Commission has proposed a Directive it usually comes into law. We do not think the final version will be as onerous as the much publicised proposal – indeed the Swedish have brokered a compromise in the Council, and the European Parliament will shortly give its view. Both must then come to an agreement and much due process and lobbying are anticipated before that finishes. So, it is difficult to accurately predict the effect of any final Directive on our business. From what we have seen of the negotiations and improvements to the text in the areas of depositary duties and liabilities, valuation, delegation and capital requirements, the Directive will not have such an impact as once feared. 

One area of concern remains the position of third country funds. Although we understand there is a majority in favour of allowing national private placement regimes to continue, that does not mean that national regimes will continue in their current form. This is particularly prevalent for our Channel Island business.

Peter Mackaness: Although the directive may not come into force until 2011, it is likely to have an earlier impact on investors and fund managers as the asset management industry is likely to comply as soon as is practical.

Established managers with robust risk management systems and due diligence processes will be at an advantage over less-established managers, as many of the former group already comply with some of the directive’s requirements. It is also proposed that “passports” will be required for the marketing of EU-domiciled funds to professional investors. This will allow managers authorised in one member state to market their funds in other member states, subject to providing specified information to the manager’s “home” regulator. There will be clear advantages for EU-domiciled managers that comply with the new passport regime, as they will be able to market their funds on a cross-border basis.

Investor choice will inevitably be diminished by the new regulations. However, whilst the number of opportunities may be reduced, the remaining players are likely to be the more robust managers, so the risk to the investor should be materially reduced.

For our business, we are confident of benefiting from the directive, being one of the early adopters of the proposals. We should also benefit from the new passport regime.

Stephen Ryan: The very largest investors such as sovereign wealth funds are already active investors in global property, whether through direct acquisition of asset or otherwise. Given that developments such as regional pooled funds, fund of funds, REITs and property derivatives make implementation of a global property portfolio a more realistic for medium size investors, do you expect to see more interest in global property going forward? 

Jenny Buck: We do think a global property portfolio is a realistic option for medium sized investors and we anticipate demand rising for global and regional products that allow this type of investor to target returns and improve diversification outside their home markets. 

The aftermath of the global financial crisis and the failure of several well known pan regional or pan global strategies reinforce our view that property is an inefficient asset class where local knowledge is an advantage. Investing through a fund of funds is one of the best opportunities for a medium sized investor to invest in a diversified manner and it provides this type of investor access to niche products, specialist managers and an ability to outsource to experienced professionals. There are also economies of scale that come with investing with a fund of funds that would not be the case if the investor went direct. Examples include the sharing of due diligence costs across various capital sources and the heightened bargaining power achieved through pooling capital which has allowed us at Schroders to consistently get better terms.

Peter Mackaness: The increased awareness and availability of global property products has inevitably made them more popular with investors. I believe that this trend that will continue. The diversification and decoupling arguments appear to have been somewhat flawed this time round, with all real estate markets being affected at roughly the same time. Going forward, however, different markets will tend to be affected by their own local factors so some diversification does make sense, even for a medium-sized fund.

Stephen Ryan: If UK investors are more willing to look abroad for property investment opportunities, where would you recommend as their starting point? Would you suggest that UK investors investing in property abroad should hedge their currency exposure? If so, should they hedge income distributions, capital values or both? Will you consider offering currency hedging within your non-UK property funds? 

Peter Mackaness: Clearly Europe is the obvious starting point for UK investors who wish to diversify, on account of its geographic proximity, the transparency of the markets and the availability of suitable products. The US and Asia may follow, but due diligence on the products is likely to be more complicated in these markets.

Institutional investors with liabilities in sterling should always consider hedging their currency exposure. Most European and American funds will be denominated in their local currencies and Asian funds are likely to be US dollar-denominated. It is not normal for fund managers to provide currency hedging solutions for investors. The individual hedging requirements by investors can vary widely. Full hedging can often be very expensive and can also have a material impact on fund returns. Depending on the risk appetite of the investor, some limited hedging or caps may be more appropriate, particularly when appreciation of the fund currency is anticipated.

Jenny Buck: Investing in overseas markets is more complex than investing in one’s domestic market, and so it is important that the risks and issues associated with a particular market are fully understood before an investment is made. The question as to which market one should start with should be determined by one’s existing market coverage, prevailing market conditions and the rationale for investing overseas; is it about diversification or enhanced performance? In our opinion, geography diversification does not necessarily equate to investment performance diversification given the globalisation of many companies and occupiers.

We make our decisions on real estate fundamentals rather than relative currency positions. For example we like the Australian market at the moment notwithstanding the relatively strong Australian dollar.  However, we recognise that currency rates can material affect investment markets. The ability to manage and hedge currency exposures is something that should be discussed in detail with a client, but ultimately it needs to be recognised that the illiquidity and long duration of real estate as an asset class does not make it an easy asset class to fully hedge, and thus investors tend to focus on capital protection rather than total return protection.