At the European Real Estate Society (ERES) conference in Stockholm last week I sat on a panel discussing international real estate. We were each invited to speak for five minutes on the theme before the debate was opened up to the floor. This is, upon mature reflection, what I meant to say.
Real estate has experienced significant levels of internationalisation in its market activities over the last decade. These range from the growth of key market players such as real estate service providers and investors to the increasingly cross-border nature of a wide spectrum of real estate activities.
Property is an illiquid, inelastic investment that often comes in inconveniently large lot sizes. Therein lies its potential to diversify investment away from, for example, equities. Investing in property directly requires specialist knowledge and expert assistance. For this reason investors tend to be experienced in the sector and have a clear idea of the risk/return ratio that can be expected. Because of this reliance upon localized, specialist knowledge investors were, by nature, somewhat parochial in their selection of stock, leading to a number of strong national markets but with relatively weak cross-border flows of capital.
The figure above shows som different real estate investment types. Shares in property companies have always provided an indirect route to investment in property as have retail funds of different kinds. The growth of Real estate Investment Trusts in the US and more recently in Europe provide an additional route, albeit one with more tax complexity and there have been various vehicles that attempt to securitise the income stream provided by property investments.
In recent years we have seen the growth of Mortgage Backed Securities and Property Derivatives completing the full spectrum from simple direct investments to complex indirect vehicles. From a risk perspective, this spectrum runs from an expert investor, keenly aware of the characteristics of the asset to a naïve investor who relies entirely upon a rating agency to classify risk. In other words the investor has lost contact with the underlying asset.
In some respects this is not a bad thing. It means that it is no longer necessary to employ real estate specialists to oversee the investment process; it means that property assets can be compared wherever they are located and, although some of the diversification potential has been lost, it has become far easier to trade the asset. So, provided that valuations accurately reflect the risk being taken everything in the garden is rosy!
In an environment where remuneration is heavily geared towards transaction it seems incongruous that, in many cases, valuations are undertaken by the same companies that buy and sell the assets under consideration. That is, of course, assuming that the properties are valued independently at all.
Ratings agencies have picked up significant criticism about their performance in this recession although it is difficult to see how they could have performed better, short of being more prescient. The real issue here is the investor’s lack of understanding of the ratings system itself.
To process the volume of products requiring rating and to monitor them continually, ratings have to be based upon modeling potential performance against highly standardized benchmarks. It is an industrial scale process a world away from the hands-on, bricks and mortar approach of direct investment because it simply could not be done any other way. It is flexible, reactive and it can change ratings quickly. Typically, the ratings agency is paid by the seller rather than the investor.
Models, of course, are only as effective as the data they use. For much international property, transparency of data is a big issue, even in mature, sophisticated markets like
Germany
. Where there is no standardized data collection of, for example, transaction data, those involved with the transactions themselves have the opportunity to colour the data in their favour.
Good quality research should flush this out, however, there is a tendency to assume a level playing field between markets and make direct comparisons between markets and sectors where the quality and quantity of data are vastly different, increasing the potential for volatility.
Where do we go from here? Clearly there has been a breakdown in trust that needs to be addressed. Already more regulation of indirect investments is being mooted by the EU particularly. Some of this is fully justified, but you can’t regulate against investors making bad decisions. What you can do is ensure that they make informed decisions.
To get there we need three things:
· Increased transparency throughout the entire process. Investors need to be able to see the full data picture and regulators need to know where the assets are held and by whom;
· Increased independence with respect to valuation and research. Valuations need to be mandatory and independent of process. Investors need to be aware that free research is accurately valued;
· Different remuneration models. Bonuses need to be tied to long-term performance rather than to the transaction itself and investors need to pay for the rating of vehicles rather than being spoon fed ratings selected by the seller.
If we achieve all that – and I fear it is unlikely in the medium term – we will be able to start taking an holistic view of risk that is linked to the real values of the asset class and make informed decisions about international property.