They’re all under one roof.
Who sets the price?
Historically, the real estate sector, and in particular the listed real estate, was regarded as a single asset class and generalist investors (ie, not real estate specialists) typically increased weightings ahead of what they perceived to be the next upswing in the real estate cycle, with a view to trying to exit at or close to the top of the cycle before the tsunami of leverage-induced value destruction wiped out their previous gains. As a result, the influence of (active and passive) generalists entering, or exiting, the sector en masse has led to them becoming de facto price setters. This flow of funds can result in temporary dislocation of pricing away from the traditional anchor of NAV, as they are more concerned about the real estate weighting relative to the other 10 equity sectors rather than the pricing of real estate securities, relative to the underlying assets (the parallel asset pricing model). That is the domain of the property specialists who are looking at the relative valuation of each stock to its forecast NAV, adjusted for idiosyncrasies such as goodwill. They will then adjust the weighting of their holding in that stock relative to their fund’s benchmark (typically EPRA) index. They will typically have a very informed and nuanced view of each underlying portfolios growth prospect and their own adjusted NAV forecast will be the most common valuation tool.
“If you speak to a generalist, their view is that whatever the nuances, aggregate demand for new office space is unlikely to increase”
When two worlds collide
The views of generalists and specialists can be aligned (eg, logistics and residential since 2017) or they can differ widely (eg, offices post lockdown – though whether we are post pandemic remains a moot point). If you speak to a generalist, their view is that whatever the nuances, aggregate demand for new office space is unlikely to increase, the outlook is uncertain and the slightest hint of further Covid-related restrictions would hit sentiment, therefore it is for them a sector best avoided due to a lack of clear line of sight.
If you speak to a specialist, you will receive a much more detailed and granular response regarding potential winners and losers in the space based on the company’s strategic response, price setting power and financial strength/flexibility. Given as mentioned that generalists are the price setters, in this case either by selling or not buying, the prices of listed office landlords has drifted away from the value of their underlying assets. In this case this relative mis-pricing is starting to be addressed by M&A activity, most notably from Brookfield’s Pacman approach to hoovering up the (unwanted by generalist) office sector at attractive prices (for a specific real estate investor).
Permanent, but specific and dynamic allocations?
However, it should be noted that there is an increasing trend (many multi-asset funds have always adopted this approach) from generalists, driven by the move towards solutions and theme-based investing to think of the sector not as one, but as a series of investment characteristics, all with asset backing. Obviously, as we speak, inflation protection is the current priority, but there are many others, such as secure cash flows (long income REITs), beneficiaries of demographic trends (healthcare and residential REITs), future-proof/tech-related stocks (data centre and cell tower REITs). As a result, many generalists are now maintaining a more permanent , but dynamic, allocation to the sector by virtue of a bottom-up approach, identifying individual, specialist stocks for exposure to certain themes and characteristics, rather than allocating a weighting to the largest diversified stocks merely for exposure to the sector. It should be noted that weighting to these themes will alter according to how it is playing out in terms of relative equity market importance and performance, rather than specific company pricing relative to NAV.
Implications
So, what does this all mean? I think there are a number of conclusions:
Some companies will increasingly focus on identifying the ‘investment solution’ they are providing and the key drivers to their performance in their presentations rather than assuming that a historical collection of diversified real estate assets which may or may not have outperformed MSCI/IPD is an attractive proposition to generalist investors.
As we move away from pure buy and hold capital growth strategies towards cashflow/income-based strategies which require operational input and CapEx there are likely to be additional valuation measures used in conjunction with NAV. This would allow comparison of real estate stocks with other equity sectors in the same themed cluster.
As we have seen with the growth of alternative sector REITs, particularly in the US, capital raising will not be a problem for those REITs which have a strategy, which is easy to understand for generalists and can be linked to, and valued alongside, non real estate stocks with exposure to the same area.
There is work to be done on demonstrating to generalist investors how all (OK, let’s be conservative, most of) their investment criteria can be met within the listed real estate sector, by identifying individual stocks rather than allocating a general allocation.
Next time I will examine how some of these strategies have performed in absolute and relative terms and the benefits they bring to a generalist investor.
