Real estate as an asset class

SUNDAY, 11 SEPTEMBER 2011 19:18

(First of three parts)

It is clear that in the years leading up to the crisis, real-estate values became significantly detached from fundamentals, leading to asset bubbles in many markets. Values became far more sensitive to capital flows than to the underlying operating performance of the assets. The core characteristics of real estate, such as a reliable income stream and close correlation to GDP, were eclipsed in the majority of developed economies by speculation on liquidity and leverage-fueled repricing of the asset class.

The legacy of the crisis continues to impact on the industry; its effects are likely to be felt for some time given the lack of an imminent solution for plugging the debt liquidity shortfall in Europe and North America. One direct consequence is that institutional investors have become increasingly risk-averse, refocusing on underlying asset-fundamentals, and perhaps becoming more sophisticated in their consideration of volatility, risk and return. This topic has featured on the agenda of nearly every industry event in the second half of 2010, and remains high on the agenda of chief information officers across the industry.

Some forward-thinking research departments are already well-advanced in defining new approaches to assessing real-estate risk, return and portfolio volatility. We expect that communication between fund managers and investors will increasingly include this type of information. Funds adopting investment strategies and performance reporting based on this may well be the winners in attracting new investment into the sector.

Real estate needs to compete effectively with both the mainstream asset classes of equities and bonds, as well as with the alternatives such as private equity, hedge funds and infrastructure. Those more experienced investors are demanding far greater disclosure of the risks faced from the markets within which the underlying assets operate, through to specific property risks and the portfolio mitigating effect.

At one level, the challenge is one of communication. Fund managers need to learn to communicate using familiar investment language and terms, rather than the real-estate language of “core,” “core plus,” “yields,” “ERVs,” etc. In short, investors want to understand, for a real-estate portfolio, the expected return range and its risk profile.

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Second of three parts

INVESTORS are reconsidering their asset-allocation strategy. One public example is that of the California Public Employees’ Retirement System (CalPERS) which recently announced its realignment of assets into five major groups on the basis of their function in high- or low-growth markets and the prevailing inflation environment. CalPERS publicly noted in their statement that they had, in the past, “focused on assets and returns, but not enough on the risk of our allocations.” The re-categorization is said to be aimed at providing a better way to look at risk, the performance of the markets and the fundamentals of the assets.

To this end, CalPERS has separated its various investments into “real,” “growth,” “income,” “inflation” and “liquidity” assets, with each group expected to contribute to the overall success of the pension fund.

Real estate sits within the “real” group, together with infrastructure and forestry assets. These assets are expected to provide long-term income returns that are less sensitive to inflation risk. A fund manager looking to attract their capital would need an investment policy directed to meet these specific aims. With the large pension funds looking to shore up their income streams there is competition for the right types of assets. However, not all investors are looking for the same risk and return profiles. For example, the opportunity funds will have an important role in recapitalizing the secondary and tertiary markets and generating high returns to compensate the higher risk. In essence, the funds compete with private equity and hedge funds for investment capital.

Continued uncertainty, arising from difficult debt markets and the uncertain impact of new regulation, may foster further caution in the capital markets of the developed economies. The impact of this sustained caution will depend on how investors approach their allocations and whether they are making decisions based on short-, medium-, or long-term strategies.

Throughout the developed economies, we expect there to be a move towards portfolios designed to achieve absolute risk-adjusted returns, rather than capital flowing into the sector chasing a cyclical relative return. As a result, we expect real estate will continue to play a significant role in investment portfolios, whether the investor is a high-return opportunity fund or a pension fund. However, in order to attract the capital flows, investment managers will need to clearly communicate their investment strategy and their ability to identify, manage and mitigate risk while also committing to additional reporting in order to satisfy investors’ increasing information requirements.

(To be continued)

This article is written by Jonathan Thompson, global chairman for building, construction and real estate, KPMG UK; Raymond Milnes, head of real estate Americas, KPMG US; and Andrew Weir, head of real estate Asia Pacific, KPMG China. This article was taken from the publication “Frontiers in Finance,” April 2011,” produced by KPMG’s Financial Services Practice.

For comments or inquiries, please email Roberto G. Manabat at rgmanabat@kpmg.com or manila@kpmg.com.