Alan Thompson, Cleo Folkes
On January 6th David Stevenson penned the FT article “Are Reits as attractive as we all first thought?”, highlighting recent work on REITs. Mr Rabener, a former hedge fund manager, for example has systematically challenged many of the main arguments in favour of holding REITs.
UK-REITs were launched in a fanfare with the Telegraph headline “Brown gets REITs right”. However, the results have been somewhat disappointing. FT author Stevenson points out how the FTSE NAREIT All REITs Index suffering a 47% decline during the crisis year June 2008 to June 2009 whilst the FTSE All-Share fell 25% in that period. An horrendous set of performance numbers, albeit this might have been expected given the reliance on debt by REITs.
But it is actually the performance in the recovery period which has been surprisingly poor. The MSCI World Index achieved returns of 212% over the last 10 years, whereas UK-focused commercial real estate funds recorded a lacklustre 162%, and UK listed property funds notched-up a paltry 105%, or an annual return of just 7.5% per annum. A remarkably poor return for an asset class in the recovery and growth phase of the cycle, especially taking into account the use of leverage, magnifying returns.
Many might have acted differently with hindsight. Hindsight is great for naval gazing, and always has an element of “fantasy”. Yes, I could have attended the primary school disco in 1990 rather than picking up my bicycle, and so prevented, Emma, my first girlfriend, from snogging Matt Green. But alas, it was not to be.
An investor could have lowered holdings in UK property and invested in global equities instead. We do not possess perfect foresight, and we have to recognise the probability of a range of potential outcomes. Should we assess a person who does not buy house insurance as clever because his house did not burn down? The answer is a resounding “no”: it is nothing short of fool-hardy. And so it is with investment mandates which have remits and rules, all specifically aimed at constraining large off-benchmark tactical positions.
Property has long been the ‘pin-up’ of diversification, but listed property appears to offer less diversification than direct or non-listed property holdings. Former hedge fund manager Rabener argues that the correlation of REITs with the overall stock market is extremely high with some researchers putting this as high as +0.8. But correlations over the longer term seem to decline, which is perhaps more important for institutional investors.
Correlations have taken on disproportionate importance in recent years, largely because of Harry Markowitz’s portfolio theory. Applying this, Rabener argues that a barbell holding of small-caps and bonds would achieve the same exposure as holding REITs.
Conversely, we feel this highlights the academic frailties of Markowitz rather than the weakness of REITs. Portfolio theory reduces portfolios to correlations, volatility and expected returns, but when this is applied in asset management it tends to be a limited historical sample including some distinctly dodgy numbers. Apologies for calling a spade a spade!
The question is whether it seems likely that a property would have the same return as a ‘barbell’ holding of ‘small cap’ shares and bonds in all eventualities. Again we have a resounding “no” as an answer.
A long dated nominal bond has a high duration like property investment, but its sensitivity to prolonged high inflation is markedly different. This is a feature apparently forgotten because of the low inflation environment of the previous 30 year. High persistent inflation would lead to sharp declines in the price of nominal bonds, just as they did in the 1970s. Property may be an imperfect inflation hedge and its price may decline, but its value is likely to remain much greater than a bond.
Post-event naval gazing also fails to consider the enormous changes faced by the retail sector. In 2009, the retail sector may have already witnessed the death of Woolworths, but it was generally accepted that wages would return to real growth, and that, although cheap fashion was on the rise with Primark, the fundamentals of shopping would remain unchanged.
Move forward ten years, and real wage growth has been negative for much of the period. Mobile phones have been revolutionised into portal shopping devices. Wifi has become ubiquitous across the UK. Illustrating this trend is internet ‘newbee’ Boohoo, a mere teenager, which has already gained a market capitalisation greater than M&S.
All these changes have led to the largest changes in the retail sector in over 100 years, which has undoubtedly been negative for retail landlords. We would pose that it is the high weighting of retail in the REITs index which has led to the perception that this is a property story.
Will history repeat itself? The real question for investor is whether such a structural change in the retail sector is likely to occur again in the next 10 years. This seems unlikely with real wages recovering and internet shopping having picked all the low hanging fruit whilst facing the challenges of convenience, speed and niche knowledge.
Stevenson’s article questions whether it is time to re-examine the tax cuts attributed to REITs, because the wealthy 1% dominate equity ownership. Whilst we’re nit-picking: in terms of taxation, REIT structures do not remove tax, they avoid double taxation putting poorer members of society on an equal footing with richer members who can operate as sole-traders.
Indeed, the introduction of REITs removed a flat tax on property companies and replaced it with a progressive tax based on income. The notion of the 1% benefiting from REITs is good for newspapers, but the largest beneficiary of REITs are the 9.9 million people who have an occupational pension which attracts a nil tax rating.
Taking it all together, it’s best not to leap to overreactions when naval gazing. A poor 10-years should not change structural allocations, with gold performing poorly between 1980 and 2000, before rebounding sharply. Likewise, your ex-girlfriends decision to snog Matt Green at the school disco in 1990, should not lead you to detest all discos, just him!
Alan Thompson is a finance lecturer at Abertay University. He previously worked as deputy head of market and liquidity risk at Virgin Money, as European Economist at Aberdeen Standard, as Chief UK Economist at Pantheon Macro-economics and as Euro-area economist at the Bank of England. He is a CFA charter holder. Alan teaches An Introduction to Property for Property Overview in Edinburgh.