Commercial Real Estate Investment

Transcription

1 Prelims:Prelims 6/4/09 11:42 Page i Commercial Real Estate Investment A Strategic Approach Second edition Andrew Baum 2009 A division of Reed Business Information Estates Gazette 1 Procter Street, London WC1V 6EU

2 Prelims:Prelims 6/4/09 11:42 Page ii Andrew Baum, 2009 ISBN Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the UK Copyright Designs and Patents Act 1988, this publication may not be reproduced, stored, or transmitted, in any form or by any means, without the prior written permission of the Publishers, or in the case of reprographic reproduction, only in accordance with the terms of the licences issued by the Copyright Licensing Agency in the UK, or in accordance with the terms of licences issued by the appropriate Reproduction Rights Organisation outside the UK. Enquiries concerning reproduction outside the terms stated here should be sent to the Publishers. The Publishers make no representation, express or implied, with regard to the accuracy of the information contained in this publication and cannot accept any legal responsibility or liability for any errors or omissions. The material contained in this publication constitutes general guidelines only and does not represent to be advice on any particular matter. No reader or purchaser should act on the basis of material contained in this publication without first taking professional advice appropriate to their particular circumstances. The Publishers expressly disclaim any liability to any person who acts in reliance on the contents of this publication. Readers of this publication should be aware that only Acts of Parliament and Statutory Instruments have the force of law and that only courts can authoritatively interpret the law. Copying in any form (including all hard copy and electronic formats) is strictly forbidden without written permission from the Publishers, Estates Gazette, a division of Reed Business Information. Typeset in Palatino 10/12 by Amy Boyle, Rochester Cover design by Rebecca Caro Printed by Short Run Press, Exeter

3 Prelims:Prelims 6/4/09 11:42 Page iii Contents Foreword to the first edition Preface to the first edition Preface to the second edition Part 1 Introduction to the market 1 Commercial real estate the asset class Property a global asset class? What makes property different? Property depreciates Box 1: Depreciation and its impact Lease contracts control cash flows The supply side is inelastic Valuations influence performance Valuation accuracy Client influence Property is not liquid Large lot sizes produce specific risk Leverage is commonly used in real estate investment Is property an inflation hedge? Volatility and risk appear to be low Real estate cycles control returns Developments Rents Yields and capital values Returns Cycles: the result of market inefficiency? Diversification the evidence iii

4 Prelims:Prelims 6/4/09 11:42 Page iv Commercial Real Estate Investment 1.14 Challenges The limitations of direct real estate investment Securitisation and globalisation The market and who makes it The global property investment universe The value of the UK real estate market Box 2: The UK property market sectors Market players Investors Fund managers Advisors Funds and vehicles A property performance history the UK : from low inflation to a boom : a small cycle, high inflation : high inflation, another boom : deep recession, low inflation and globalisation : boom Box 3: A bubble in UK property prices? : bust Conclusions Part 2 The investment process 3 Building the portfolio Introduction to portfolio management Absolute and relative return objectives The top-down portfolio construction process The relative return target The absolute return target Setting investment objectives Criteria for investment objectives Return and risk Benchmarks Time horizons Strengths, weaknesses, constraints: portfolio analysis Recent performance iv

5 Prelims:Prelims 6/4/09 11:42 Page v Contents Current portfolio structure Strengths, weaknesses, constraints Structure and stock selection Structure Stock selection Passive and active strategies Using forecasts and valuation models Forecasts Valuation models Box 4: Portfolio construction a case study Pricing real estate: the purchase and sale process Introduction Sourcing stock Due diligence: the building purchase process A property appraisal model Introduction: the excess return The initial yield a simple price indicator The Fisher equation A simple cash flow model Gordon s growth model (constant income growth) A property valuation model including depreciation The model components The risk-free rate The risk premium Inflation Real rental growth Depreciation Correct yields A real analysis Box 5: Correct asset class yields The required return: additional analysis The risk-free rate and the yield curve The risk-free rate: bond and equity components The subsector and property risk premium Example Forecasting rents and yields v

6 Prelims:Prelims 6/4/09 11:42 Page vi Commercial Real Estate Investment The origin and uses of property forecasts Forecasting national rents Forecasting at the local level Forecasting yields Forecasting property cash flows Modelling the portfolio risk and return The portfolio model Example Performance measurement and attribution Return measures: an introduction Definitions The future The present The past Example: IRR, TWRR, total return or MWRR? Capital expenditure Reduction in income Increase in capital invested Timing of expenditure Risk-adjusted measures of performance Attribution analysis: sources of property returns Introduction What is a required return? What is the delivered return? Why are delivered returns different from required returns? Summary Example Attribution analysis for the portfolio: an introduction The choice of segmentation Style Themes City selection Calculating attribution scores Two or three terms? The formulae Results from different attribution methods Attribution and portfolio management Top-down portfolio building vi

7 Prelims:Prelims 6/4/09 11:42 Page vii Contents Backing selection skills Specialist portfolios Alpha and beta: a new attribution approach Sources of alpha and beta Previous studies An attribution model Part 3 Investment vehicles 6 Listed real estate What is listed real estate? Public equity real estate the background REITs and REOCS (property companies) Listed funds and mutual funds Exchange traded funds (ETFs) Do property shares offer the ideal property vehicle? Tactical asset allocation Strategic asset allocation The US REIT experience Distributions Performance Box 6: Case study: have US REITs been beneficial for US investors? The UK REIT REIT pricing: introduction Earnings or asset values? Market capitalisation and net asset value Premium or discount to NAV? Explaining the premium/discount to NAV Instant exposure Liquidity/divisibility Asset values are higher than the reported NAV Projected asset values are expected to exceed the reported NAV Other issues Box 7: What next for US REITs? Public debt and mortgage-backed securities (CMBS) vii

8 Prelims:Prelims 6/4/09 11:42 Page viii Commercial Real Estate Investment 7 Unlisted real estate funds The explosion of unlisted real estate funds The appeal of the unlisted fund The global unlisted property market universe What is a real estate fund? How much global real estate is in unlisted funds? Unlisted fund structures Limited partnerships Property Unit Trusts (PUTs) Property Authorised Investment Funds (AIFs) Managed funds Funds of funds Characteristics of real estate funds Style Domicile and structure Sector focus Open or closed? Target equity and permitted gearing Liquidity and valuation issues Liquidity Valuation Real estate as an asset class How market prices are estimated The case for and against unlisted real estate funds The case for unlisted real estate funds The case against unlisted real estate funds Performance measurement and return attribution for property funds The asymmetry of performance fees An attribution system for funds Alpha and beta in property funds: a case study Unlisted fund performance: conclusions Property derivatives The search for the perfect vehicle A short history of the UK real estate derivatives market Introduction FOX, PICs and REIM The new market viii

9 Prelims:Prelims 6/4/09 11:42 Page ix Contents 8.3 International developments Introduction The US A global property derivatives market? Total return swaps Total return swaps: an introduction How can swaps be used in portfolio management? Single (specific) property swaps Property sector swaps Multi-asset level swaps International index swaps The mechanics of property swaps Pricing property derivatives Introduction A simple pricing example Dealing with risk Backing out the implied market return Box 8: Derivatives as leading indicators of the market Swap pricing principles and real estate Real estate swap pricing model Reconciling theory and practice Structured real estate index notes Box 9: Using derivatives to outperform the index Property derivatives: pros and cons Property derivatives: advantages Property derivatives: disadvantages and risks Property derivatives: spin-offs Hedge funds Derivatives funds Managing development risk Box 10: Using derivatives to manage development risk Strips and exotic swaps Traded property futures and options Conclusions Part 4 International Real Estate Investment 9 International real estate investment: issues Introduction ix

10 Prelims:Prelims 6/4/09 11:42 Page x Commercial Real Estate Investment 9.2 The rise of cross-border capital The case for international real estate investment: diversification Index replication Currency Taxes and fees Leverage Box 11: Have US REITs been beneficial for UK investors? The case for international real estate investment: enhanced return Other drivers Liability matching Lack of local product Fee generation Fashion Currency risk Introduction A currency overlay Using leverage Hedging Political and title risk Specific risk Other problems Fees and costs Global cycles, converging markets Loss of focus and specialisation Taxation issues Introduction Tax case 1 a French property fund, late 1990s Conclusion Box 12: A detailed tax case Building the global portfolio Introduction The global real estate market Core, developing, emerging Transparency The limits to globalisation Risk and return x

11 Prelims:Prelims 6/4/09 11:42 Page xi Contents 10.3 Building a strategy Pricing Pricing models and currency A total return model The positive effect of leverage Using local excess returns Leverage, tax and fees Box 13: A cross-border comparison Portfolio construction The top-down process A case study Box 14: How robust is your strategy? Afterword References Further Reading Index xi

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13 Prelims:Prelims 6/4/09 11:42 Page xiii Foreword to the first edition For investors, property has been something of a puzzle. Against its large share of national wealth, the representation of property in multiasset portfolios is not only low, but has fallen to one-third of what it was 20 years ago. On the available evidence (its accuracy in turn a subject of debate), property s risk and return history refuses to fit neatly into the framework of modern portfolio theory through which investors view the world. Still worse, through much of the last 20 years property has failed to meet, either in absolute terms or relative to alternative investments, the simple return thresholds investors need to beat. And, in an era obsessed with the globalisation and transparency of investment, property markets are still heavily divided by national differences in statute, regulation and culture; accurate international comparisons are at best expensive, at worst impossible to come by. Property has, indeed, looked in danger of becoming an afterthought in the asset allocations of major investors. There is, fortunately, a brighter, more interesting side to the picture. A run of satisfactory rates of return through the last five years in the UK and many other countries has revived flagging investor interest. And, thanks to a burgeoning, perhaps even blossoming, in commercial property research since the mid-1980s, property investment is far better understood and far better managed than it was 20 years ago. Many of the problems that were associated with property investment at that time have found workable (if rarely ideal) solutions. We can now say that the measurement, benchmarking, forecasting and xiii

14 Prelims:Prelims 6/4/09 11:42 Page xiv Commercial Real Estate Investment quantitative management techniques applied to property investments are comparable with other asset classes. If other problems are less fully resolved the correct interpretation of valuation and price evidence, the relationship between the performance of unlisted and listed investment vehicles advances in property research have at least put the ongoing debates onto a footing of solid evidence, and produced a clear formulation of the issues. That position has been reached through many different strands of research from academics, specialist commercial researchers and research-minded portfolio managers in different countries, not always easily communicated between those spheres. Much of it, indeed, remains private rather than public confined to the top levels of major investors and their advisors. Having held senior positions in all those fields of research, Andrew Baum is singularly well qualified to draw the strands together into a coherent and accessible statement of the state of the art in applied property research. In a world swept by radical change globalisation of investment markets, financial engineering of investment vehicles, the collection and dissemination of information we can be sure that the state of the art will be transformed again over the coming decade. Here too the book offers a clear view of the next steps in the evolution of the industry, which will be read with keen interest by all those involved in it. Tony Key Research Director Investment Property Databank London, May 2000 xiv

15 Prelims:Prelims 6/4/09 11:42 Page xv Preface to the first edition This book is the result of the author s recently varied experience of applied property research, UK property fund management, international property investment and academic research. The many challenges and questions prompted by this varied experience have led to a varied set of thoughts and writings, some previously published and some not. The book is therefore something of a set of sketches. Nonetheless, they share a common subject matter, which can be described broadly as institutional investment in real estate, and a common foundation, broadly an international and capital markets context viewed with the perspective of a UK property professional. The picture painted is of a major industry that is going through a period of rapid modernisation, facing challenges as economies and markets become more global in character, as financial and investment markets become more and more creative, and as the world is swept by a wave of technological change. Creativity is at a premium, but at the same time this is an industry requiring and developing discipline, processes and measurement. The text concentrates on UK institutional real estate, mainly retail, office and industrial, although residential is growing in importance as a UK sector and is included in the portfolios of most non-uk institutional investors. It is designed for practitioners facing the challenges described above, and those who may have to design solutions to tomorrow s problems. It is hoped that it provides a more straightforward and integrated view of the key issues in UK real estate than will be found elsewhere. xv

16 Prelims:Prelims 6/4/09 11:42 Page xvi Commercial Real Estate Investment I am very grateful for the many fortunate partnerships that have made it possible for this material to be produced. Over the past decade, colleagues at the University of Reading, Prudential Portfolio Managers and at Real Estate Strategy (RES), later Henderson Investors, have been responsible either for the better ideas or the more accurate analysis contained in these pages. In particular, I would like to thank Professors Neil Crosby, Colin Beardsley, Colin Lizieri and Charles Ward at Reading, John Partridge and John Hammond at RES/ Henderson, Paul McNamara at Prudential, and Andrew Schofield, Guy Morrell and Professor Bryan MacGregor with whom I was fortunate to work at both Prudential and RES/Henderson. Andrew Schofield deserves particular mention. He was responsible for much of the analysis and some of the ideas in chapters 3 and 4, and our joint work at RES in the 1990s has influenced much of the book s content. Tony Key has also allowed me to reproduce some of our joint work in chapter 5, and Freeman Publishing has also allowed me to reproduce parts of my work with Peter Freeman for Freeman s Guide to the Property Industry in chapter 2. Some of the ideas in chapter 8 are based on the work of Charles Ward and Colin Beardsley, my colleagues at Reading. I am grateful to them all. In addition, Tony Key (then of IPD and now at City University and IPD) and Richard Barkham (now of Grosvenor) acted as expert reviewers of the first draft of the text, and produced many suggestions for improvements. Tony Key proposed a much improved structure to the original book and Karen Baum acted as an expert copy-editor. Any remaining errors are my own. In the text, he/his is meant to imply he or she/his or hers. The place of real estate as an investable asset class is secure. The same cannot be said of existing vehicles, companies or managers, which and who will survive only through education, innovation and professionalism. I hope this small book makes at least a small contribution to their future success. Andrew Baum London May 2000 xvi

17 Prelims:Prelims 6/4/09 11:42 Page xvii Preface to the second edition If the first edition of this book was a set of sketches this new edition is more ambitious. This time, I hope we have produced a coherent and continuous book, which successfully brings together theory and practice. The global financial crisis of 2008 had its roots in property speculation. The ability of property investors and homeowners to take on debt secured on the value of property, coupled with the ability of lenders to securitise and sell those loans, created a wave of capital flows into the asset class and a pricing bubble. London and New York had become the main centres for creative property structuring through REITs, unlisted funds, property derivatives and mortgage-backed securities, and became the eye of the financial storm that followed. When the first edition of this book was published in 2001, property had been somewhat unfashionable as an investment, but advances in property research had put the ongoing debates onto a footing of solid evidence, producing a clear formulation of the relevant issues. The last decade has seen a near-frenzy of product creation and leveraged speculation, together with true advances in the range of indirect products, in the face of which the advances in research of which we were so proud were not enough to avoid a crash. The approaches described in these pages are intended to provide a foundation for a new wave of creativity for use by the next generation of investment managers, advisers and analysts, and to encourage a responsible and professionally guided recovery. xvii

18 Prelims:Prelims 6/4/09 11:42 Page xviii Commercial Real Estate Investment In the last decade the author has again been immensely fortunate to have worked with a series of high-quality partners in business and academic life, as well as with many generous and thoughtful students in executive education classes, MBA electives and other postgraduate classes in many countries, all of whom have made a contribution to this text. In particular, chapter 1 has used the work of Professor Neil Crosby and Dr Patrick McAllister of the University of Reading, and the input of Peter Struempell, research analyst at Property Funds Research Chapter 2 includes work produced by the Property Funds Research team, including Professor George Matysiak and Jane Fear, who also contributed to chapters 4 and 7. Professor Bryan MacGregor, now of the University of Aberdeen and a former colleague and partner at Prudential, contributed material on forecasting in chapter 4. Alex Moss, Head of Global Property Securities Analytics at Macquarie Capital Securities, helped with chapter 6, and Gary McNamara, Associate Director at DTZ, did a similar job on chapter 8, which leans heavily on work undertaken with Professor Colin Lizieri and Dr Gianluca Marcato, with Paul Ogden, at the University of Reading. CBRE Investors has been very helpful, providing access to a wealth of research and data resources. In particular, the global multimanager, global real estate securities and research teams have been unfailingly generous. Kieran Farrelly was instrumental in developing parts of chapters 5 and 7, and Jani Venter parts of chapter 8, while Jeremy Plummer gave me most of the good ideas in chapters 7, 9 and 10. Students at the Amsterdam School of Real Estate and on IPD executive education courses jointly contributed much of the tax material in chapter 9. Thanks to these partnerships, I am fortunate to feel as the back cover suggests well qualified to summarise the impact and likely future of global innovations in property research and fund management in the context of the third real estate crash I have observed over a long career. As we said in the preface to the first edition: In a world swept by radical change globalisation of investment markets, financial engineering of investment vehicles, the collection and dissemination of information we can be sure that the state of the art will be transformed again over the coming decade. Creativity is at a premium, but at the same time this is an industry requiring and developing discipline, processes and measurement. xviii

19 Prelims:Prelims 6/4/09 11:42 Page xix Preface to the second edition It is also thanks to these partnerships that this book offers a unique theory/practice perspective of the evolution of the international real estate investment industry at a time when the asset class has become critically important to the world economy. Again, any remaining errors are my own, and in the text he/his is meant to imply he or she/his or hers. This edition was completed in January 2009, in the eye of a perfect storm in the global real estate market. However, analysis and data tables use different periods depending on when they were undertaken. This is deliberate, as updating them all would not have achieved the objective of illustrating market conditions and behaviour at the relevant point in time. Nonetheless, I apologise for any lack of clarity that results. Andrew Baum London January 2009 xix

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