Get Real with Real Estate ETPs

Investors who haven't been scared off by the weak fundamentals could benefit from the diversification and liquidity benefits of real estate ETFs

Morningstar ETF Analysts 28 February, 2011 | 2:00PM
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Most investors are aware that real estate is one of the five broadly recognised asset classes, along with equities, fixed income, cash, and commodities. And if you purchase your own home, real estate will likely be the biggest financial investment of your life. However, many investors will be surprised to find out how important real estate is to the global economy: according to FTSE, 50% of global wealth is tied up in real estate. While many homeowners and other real estate investors may never want to look at real estate again after the crash, there are multiple reasons why investors may want to consider real estate-related equities as part of their diversified portfolio.

Historically, real estate has offered attractive returns. The FTSE EPRA/NAREIT (European Public Real Estate Association/National Association of Real Estate Investment Trusts) Developed Europe index had a compound annual return of 6.2% for the past ten years, while the MSCI Europe equity index could only muster a return a shade greater than 1% annually from 2001 to 2010. Of course, this period included a great bubble in property values, and even after the crash it may take years for the commercial property market to resume growing again.

As many investors with recent real-estate experience can probably guess, the asset class has been riskier than both equities and fixed income over this time period. The standard deviation of returns for the MSCI Europe Real Estate index has been 20% over this timeframe, compared to 17% for the MSCI Europe Index and only 6.5% for the Barclay's Capital Global Aggregate Fixed-Income Index.

Even relatively volatile securities or asset classes can be suitable portfolio additions, especially if they exhibit low correlations with the components of an existing portfolio. Such volatile assets could potentially reduce a portfolio's overall level of risk. However, any risk-reducing benefit from adding real-estate to an equity portfolio has massively decreased since the financial crisis hit in 2007/2008. In recent years the correlation between real estate and equities shot up, as measured by the relevant MSCI indices. While the ten-year correlation between the MSCI Europe Real Estate index and the MSCI Europe index is 0.83, merely looking at the ten year figure masks a large increase from a low of approximately 0.5 early in the decade to a high of greater 0.9 in the past year. Generally, in a systemic crisis correlations tend to approach one (especially in this case as the real estate crash precipitated the crash in equities), and there is no way of knowing if or when the correlations between real estate and other asset classes will revert to pre-crisis levels.

Current Fundamentals
While each market is different, commercial property in the developed world has been beset by many of the same issues that famously plagued the residential market in places like the U.S. and Ireland over the past few years, most notably weak lending conditions and elevated levels of debt, as well as overall sluggish economic growth. Banks are reluctant to lend to investors looking to buy property as they have seemingly learned from their recent mistakes, at least temporarily. This issue is likely to persist as the banking industry cleans up its balance sheets in order to meet the stringent capital adequacy requirements of Basel III. As it has become difficult to borrow money to make purchases, demand has decreased, dragging down property prices. With many existing owners struggling to service their high levels of debt, banks have been forced to either foreclose (thus increasing supply) or renegotiate terms with borrowers. Tenants are also able to take advantage of the glut of property built during the boom years to demand concessions on rent, thus further putting a cap on any potential price appreciation.

A recent global survey from PricewaterhouseCoopers shows that there appear to be signs of life in the market, particularly in Asia. However, the survey also surfaced respondent's fears that the non-prime market is a ticking time bomb, as demand is concentrated among upper tier properties. And emerging markets may not be a place to hide, as the Chinese property market demonstrates many of the classic signs of a bubble, with anecdotal reports of vast amounts of property being bought purely for speculative purposes, and recent rate hikes and increases in reserve requirements by the Chinese central bank doing little to curb speculation. Prospective real estate investors should tread carefully, as inevitably interest rates will begin to rise from their current lows in many countries, increasing the cost of borrowing, and putting a further crimp on sales.

Advantages of Investing in Real Estate using ETFs
Investors who haven't been scared off by the weak fundamentals may find it advantageous to invest in a real estate fund compared to investing directly in property. Many investors don’t have enough capital to purchase even a single piece of real estate, much less a diversified portfolio of property. Investing in a real estate fund also diversifies your investment among multiple properties. Funds investing in real estate-related equities can offer geographic diversification as well as diversification across various types of property including industrial, office, residential, retail, or other specialised properties such as hotels or storage units. Liquidity is another advantage to owning a fund rather than investing directly in property, as you can enter or exit the investment at a moment's notice with relatively few transaction costs. You'll also avoid the burdens of ownership; there are no maintenance or insurance issues to worry over. Finally, those looking for a regular income stream may also consider a dividend-paying fund advantageous, as you don't have to find a tenant to pay rent as you would if you owned property directly.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.

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