Golf courses, airports and underperformance!

Citation

Turner, N. (2002), "Golf courses, airports and underperformance!", Property Management, Vol. 20 No. 2. https://doi.org/10.1108/pm.2002.11320baa.001

Golf courses, airports and underperformance!

Golf courses, airports and underperformance!

The decision to invest in international property for institutions is, perhaps, not so controversial – plenty of empirical evidence exists to support such a strategy. However, the interesting debate concerns how investors achieve this; do they invest in direct real estate or do they choose an indirect route?

First, the case to invest internationally …In some instances it may be practical considerations that compel a fund to at least consider international property investment. Swedish and Dutch investors offer two useful examples. Both countries enjoy a very well-funded pension system which is accompanied by a small domestic investment market. This encourages overseas investment and it is no coincidence that both the Dutch and the Swedes have long histories of international property investment.

The argument that investing abroad will offer substantial diversification benefits to a domestic investor is a particularly strong one. Abundant evidence exists to demonstrate that adding international property to a domestic portfolio will enhance the risk return profile for investors. But a note of caution – this diversification must be economic and not simply geographic. Olympia and York's difficulties in the early 1990s may be seen in this light. The bulk of this former listed property company's portfolio was dominated by positions in downtown Toronto, London Docklands and New York. All three cities have office markets dominated by financial services, experienced office development booms on the back of escalating rents triggered by deregulation in the mid-1980s and suffered sharp declines in rental and capital values in the late 1980s and early 1990s. The company had achieved tremendous geographic diversity but had at the same time attained a concentration of assets that were inextricably linked to one economic sector.

A third argument to invest internationally is operational and has arisen as insurance companies, in particular, expand beyond their domestic borders. When these insurance companies start writing long-term (inflation-prone) insurance products outside their domestic borders, it is perfectly logical for them to buy assets in those countries that match those liabilities. Many of the lease structures in continental Europe with annual inflation indexation provisions are particularly useful for this purpose.

How should this international exposure be gained?History is not kind to international property investment. To the embarrassment of the international property investment community, the past is cluttered with examples of organisations that have attempted to develop an international real estate strategy by imposing their own people and their own business techniques on foreign markets. In so doing they were, of course, sowing the seeds of their own underperformance.

Quite often these international strategies included criteria such as proximity to international airport and leisure facilities. Not as fundamentals to underpin investment value but as a prerequisite to ensure the acquiring surveyor could fly in and out quickly and enjoy a round of golf during the stay!! With no long-term relationship with the local advisors (quite often local brokers received a fee only when assets were purchased), the investor really was a foreigner trying to outperform locals. Whenever this fundamentally flawed business model was followed – whether it was the Dutch move into the USA in the 1970s and 1980s or it was the Swedes in Holland or it was the Brits in continental Europe in the 1970s – substantial mistakes were made and significant underperformance in comparison to locals followed. This humiliating performance record is seared on the collective memory of the international investment community.

With hindsight this underperformance is, of course, not surprising. The idea that a British surveyor can fly to Paris and buy a property without a long-term relationship with a local partner is absurd. This is particularly unfortunate, since it has given international property investment a particularly bad press to the extent that many Chief Investment Officers now being asked to consider international real estate do so with a great deal of suspicion. Perhaps they remember the golf trips and dramatic underperformance of the past!!

So the need to rethink how investors go about gaining exposure to international property is glaringly obvious. One conclusion that could be arrived at following such a review would be to rely exclusively on indirect vehicles to gain international exposure. This negates one of the principal problems with international property – that you cannot be local everywhere – since investors would be buying a participating share of a vehicle which would be managed by local operators and fund managers.

Indeed many investors are turning to vehicles such as UK Limited Partnerships or Luxembourg FCPs (fonds commun de placement) to gain international exposure. These vehicles are co-mingled investment funds where investors buy shares or interests that are not listed on a stock exchange and for which no (or only a very primitive) secondary market exists.

These vehicles will certainly have a role to play in the future. However, a note of caution. There remain concerns as to how liquid these vehicles are and how the interests in them are valued. It is worth remembering that the criticisms often levelled at property as an asset class by investment committees usually go something like "… well, we do not like the lack of liquidity of property and this valuation process worries us … it's unfortunate you cannot mark to market." It is difficult to understand how unlisted vehicles address either of these concerns for investors. Indeed, it would take a particular type of purposeful blindness to argue that unlisted vehicles offer greater liquidity than purchasing real estate directly!

For certain investment strategies such vehicles are wholly inappropriate. If the exposure to a foreign market is a tactical play on market timing rather than structural, the argument for using unlisted vehicles is crushingly weakened given the liquidity issues discussed above. The UK Prudential's very successful move "into and back out of" the USA in the mid to late 1990s is a good example. Here the investor identified mis-pricing and captured it by maintaining control of the decision to repatriate capital. It is clearly very difficult to effect such a strategy via an unlisted vehicle.

I would also like to take the opportunity to dismiss two often-quoted arguments against developing a direct international property investment strategy – both of which are fundamentally flawed.

The first relates to the securitisation of real estate in the context of international property investment. Just a couple of years ago there was almost an evangelical call – mostly from US investment bankers – that all real estate should and would be held in listed format in the future. The reason? When institutional investors want exposure to the oil sector they go out and buy the stock of BP Chemicals and do not become involved in the direct ownership of oilfields! I have heard some pretty tenuous analogies in my time as an international property fund manager, but this is the most unconvincing of the lot. The capital commitment, technical expertise, lead-time, legal requirement issues and mineral right ownership issues required to be overcome in order to transform a natural carbon deposit into a carbon-based fuel is simply not comparable to buying a standing office investment in a transparent and well-researched property investment market.

If investors were really satisfied with holding real estate through the listed form, companies would not be exiting the public sector at the rate of knots they are doing and those that are left would not be standing on such large discounts to their underlying net asset values.

Another ill informed statement concerning direct property investment is that it takes "… 90 per cent of the people to manage 10 per cent of the assets and that this is why we advocate an indirect strategy …". Statements such as "by going indirect we reduce the number of staff and, therefore, the cost of investing in real estate" usually follow. This is nonsense! There are business models where billions of pounds' worth of direct international property is managed by a very small in-house team. How? Because it is perfectly acceptable to outsource certain parts of the real estate function to local service providers in each country. These investors usually adopt a business model that outsources the Asset Management and Property Management functions, leaving strategic decisions to be made by the principal. Holding property indirectly through unlisted vehicles may make the head office team look lean, but what are the actual costs of running the assets? Many of the funds I have reviewed charge up to three times more than buying the service direct from a local provider through separate account business. It is simply incorrect to argue that unlisted investments are a cheaper way to invest in real estate because you have fewer people working in the real estate department.

SummaryBefore centring an international strategy around unlisted vehicles, I think a question needs to be asked. Given my client's investment objectives, risk tolerance and investment constraints, and the fundamental characteristics of the property market under review, should my preference be for direct or indirect property investment? Once this is answered the investor will be guided as to how best to use the range of opportunities available to him in forming an international property investment strategy. Thankfully, to a large extent the poor practices that accompanied the direct international property investment strategies of the past are long gone. However, those investors rushing headlong into unlisted vehicles need to consider their exit strategies very carefully.

Neil TurnerAlecta Investment Management