Property securities have traditionally been favoured not only for their income but for their diversification qualities as part of a broader portfolio. Real estate investment trust (REIT) dividend yields tend to be higher than bond yields over long time periods—a factor that is particular pertinent given the current economic climate, but while global property securities offer a broad level of diversification across geographies and real estate sectors, they may not offer as much diversification from equities as you might think.
The Real History of Real Estate Investments
Although we call it the original alternative, in many ways real estate was simply the original institutional investment. Land was the main store of wealth and the measure of power for centuries before the industrial revolution and its contemporaneous creation of debt and equity markets. As the Dutch were developing the modern corporation in the 1700s, religious foundations and universities managed countless acres of countryside and some of the choicest urban real estate for the rental yields. Equity or debt stakes in wealth-generating companies came to dominate the investable universe through the 20th century, but real estate rents remained an important contributor to the portfolios of institutions large enough to own and manage entire properties. The stability of rents and their fairly low correlations with other investments made land a valuable anchor for those who could afford it.
The great democratisation of real estate investments started in 1960 when the US Congress created the REIT structure, allowing individuals to buy shares of real estate portfolios traded on public exchanges. The concept was followed by Australia a little over 10 years later with the creation of Listed Partnership Trusts (LPTs). But it wasn’t until the Finance Act 2006 came into effect in the UK at the start of 2007 that UK companies began converting to REIT status.
Returning to the REIT forefathers, US REITs mostly owned mortgage debt in their first couple of decades, providing steadier returns at the cost of potential price appreciation. The US Tax Reform Act of 1986 allowed REITs to manage their own properties, encouraging a new boom in real estate equity investments to come on the market. Australia mirrored the secular wave of real estate securitisation in the US during the 1990s. Australia's wave was fuelled by the impact of the collapse of the unlisted property trust sector in the early 1990s and the introduction of the Superannuation Guarantee in 1992, which required employers to start paying a proportion of employees' salaries and wages into a superannuation fund.
In theory, these moves should have made real estate returns open to all investors, as they could now buy a portfolio directly invested in buildings and land managed for the rental yields. Instead, we found that the very act of listing real estate on an exchange just made REITs behave like stocks.
The real strike against the diversification benefits of REITs comes from their high correlation with small-cap value stocks. Again looking at the more substantial US history, while the performance of exchange-traded real estate and the S&P 500 diverged massively in the early 2000s, REIT returns maintained a fairly high correlation with the Russell 2000 Value Index. This shows the early-decade diversification benefits of REITs came almost entirely from avoiding the tech boom and bust. Going back to the early 1990s, correlations of 0.80 with small-cap value have hardly been unusual, and we’ve since seen trailing correlations over 0.90 in more recent years.
Property Investment Returns Versus Risks
So, in a nutshell, though a REIT has to distribute 90% of its income into the hands of shareholders, this return could be mitigated by the fact that the security as a whole may be just as volatile as other equities investments.
Still, local income seekers may be heartened to discover that UK commercial property has the highest yield of all mainstream assets with the exception of high yield debt. Using IPD data the yield on UK All Property is around 6.5%, whereas by contrast UK 10y gilt is 3.75%. Obviously there is some risk of capital loss when investing in property—both directly and indirectly—but the futures market and many pundits see this as being around 2%. The income stream from UK property is fairly predictable and in recent years it has ranged from 4.6% at the top of market in 2007 to 7.4% at the bottom in 2009. Longer term, UK property has averaged 6.2% per annum over the last 10 years, 6.9% over 20 years, and 6.6% over 30.
Of course, as with all investments, there are risks as well as potential rewards. The main trouble with the encouraging yield figures quoted above is that these are industry returns; the yields on funds investing in UK property are far lower, so while the theory might look substantial on paper, in practice it could be less substantial once in your pocket.
If you’re considering investing in a property fund it’s important to remember that these are niche players and should therefore only represent a small portion of a diversified portfolio. It must be remembered that while investing in real estate securities provides a certain level of diversification against equities, like all sector funds a property fund will be exposed to industry-specific risk and will therefore court higher volatility than broad-based offerings.
Having said that, for investors seeking income and comfortable with the levels of risk associated with equity and sector-focused investing, a property fund could fit the bill. While the global economic recovery is underway, the ongoing constraints on the supply of commercial property due to the difficulty of financing projects could act to create a beneficial supply-demand environment for investing in this area. Looking at Morningstar funds data, the current portfolios of global property funds indicate a preference for US and Australasian property securities and REITs, with Europe and the UK featuring further down the list.
