Download The value of illiquidty

UBS Asset Management
The value of
illiquidity
The case for alternative investments - Real estate
Real estate, real assets, real
benefits
The period of low growth, low inflation, and ultra-low interest rates following the
global financial crisis has been a positive one for real assets, including real estate.
Investors, some new to the asset class, continue to seek risk reduction through
diversification, and this implies a reduction of exposure to the traditional asset classes.
Investors also continue to look for yield in a low interest rate environment.
With yields on sovereign bond markets at record lows in many cases, and the outlook for further capital growth
likely to be limited, income return is expected to be a key driver of investment returns. Real estate is benefiting
from this tilt in global portfolios towards yield-based asset classes. This enhanced allocation will continue to drive
the advancement of real estate as a global asset class.
Real estate is benefiting from this tilt in global portfolios
towards yield-based asset classes.
Relatively low volatility
Looking at the published private real estate indices, the volatility of real estate appears low compared to other
asset classes. Using historic estimates of the sector’s volatility can result in large allocations to the asset class due
to the issue of smoothing. These theoretical allocations should be viewed with caution. To compensate, estimates
of real estate’s volatility are adjusted upwards in an asset liability model (ALM) framework. Depending on the
assumption used for liabilities, the resulting hypothetical allocation falls but remains significant, with a typical
range of 10% to 20%
Diversification
Figure 7 shows historical correlations amongst the asset classes of unlisted property, equities, real estate equities,
and government bonds. With correlations below one, the addition of property to a portfolio of equities and
bonds can lower an investor’s portfolio volatility and boost risk-adjusted returns. The level of diversification
available depends upon the route used to gain exposure. Real estate equities are more correlated with the
performance of the wider stock market than the private real estate exposure and therefore offer lower levels of
diversification (at least over short investment horizons). When the effects of smoothing and gearing are accounted
over long term investment horizons, real estate equities have characteristics that are more closely aligned to the
unlisted market.
Fig. 7
Correlations between asset classes
2001–2016, local currency, total returns
Global Equities
Global Gov’t Bonds
Global Listed Real Estate
Global Unlisted Real Estate
Global
Equities
Global
Gov’t
Bonds
Global
Listed
Real Estate
Global
Unlisted
Real Estate
1.0
-0.8
0.7
0.4
1.0
-0.3
-0.2
1.0
0.6
1.0
Source: Thomson Reuters Datastream, MSCI, UBS Asset Management, REPM, Real
Estate Research and Strategy. Correlation: Statistical measure of the linear relationship
between two series of figures (e.g. performance of a security and the overall market).
A positive correlation means that as one variable increases, the other also increases.
A negative correlation means that as one variable increases, the other decreases. By
definition, the scale of correlation ranges from +1 (perfectly positive) to -1 (perfectly
negative). A correlation of 0 indicates that there is no linear relationship between the
two variables. Please note that past performance is not a guide to the future.
Fig. 8
Proportion of total real estate return expected from income in the long-term
91%
74%
70%
69%
Eurozone
US
UK
Australia
Source: UBS Asset Management, REPM, Real Estate Research and Strategy.
Chart is for illustrative purposes only and refers to long-term equilibrium assumptions for core, unlevered real estate.
As at end December 2016. Please note that past performance is not a guide to the future.
The link between output and investment demand implies
a relatively high correlation between economic growth
and capital returns.
High and stable income return – capital return linked to economic growth and structural shifts A particular
feature of real estate is the high proportion of total return which is derived from the contractual rents paid by
tenants; e.g. the income return. Over the long-term, it is expected that core real estate will deliver the majority of its
total return (70% – 80%) from income with the remainder from capital growth. The relatively stable income return
associated with core investment is particularly attractive in a low interest rate environment where yields on other
asset classes remain depressed relative to historical averages.
Upward pressure on rents typically occur during the cyclical upswings of the economy as corporates expand capacity
by hiring more labour and leasing additional space. This feeds directly to offices and indirectly, via wages and travel,
to retail and tourism, and via trade, e-commerce, and manufacturing to industrial/logistics. In theory, the link
between output and investmentdemand implies a relatively high correlation between economic growth and capital
returns. Yet, how much an improving business cycle affects demand for space and property investment depends on
a number of factors including the time horizon of the investors involved.
Inflation protection characteristics
For investors seeking protection from inflation, real estate has delivered strong historical real returns over
medium to longer-term holding periods. In part, the strong performance is due to the relatively high and stable
income returns generated from core investments.
Over shorter investment horizons, real estate’s inflation protection characteristics are mixed. Low and negative
correlations between real estate performance and inflation suggest the asset class only provides a partial hedge
against inflation, where a ‘hedge’ is defined as moving at the same time and in the same direction as inflation,
rather than just keeping pace with it over long periods. And that correlation can change over time, as other factors
drive real estate, e.g. supply, which are not influenced by inflation.
Real estate performance can be negatively correlated with rising inflation, particularly where higher inflation is
driven by higher costs such as rising commodity prices. In the absence of increased sales, higher costs tend to
reduce profit margins thereby limiting the ability of occupiers to pay higher rents. For example, global real estate
returns turned negative in many markets during the financial crisis due to recession in the economy, lower risk
appetite and the fact that investors shunned illiquid investments during that period; however, headline inflation
rates continued to rise due to increasing oil prices.
Overall, while the academic literature in this area is inconclusive, income and valuations do not generally adjust
quickly enough to protect investors against unexpected shocks to inflation, at least in the short run. Nonetheless,
as returns have outstripped inflation on an ex-post basis – in other words, based on actual results rather than
forecasts – real estate is generally accepted to provide some protection against inflationary pressures.
Impact of rising interest rates on real estate The monetary stimulus of central banks since 2009 has clearly
supported valuations across all asset classes (equities, fixed income, credit and real estate). In the real estate
sector, low policy rates and quantitative easing have helped to push cap rates and liquidity levels back towards
pre-crisis levels in developed markets as investors increased their allocations to higher yielding asset classes to
maintain income returns of their portfolios.
Since the US election, the yield curve has steepened sharply with yields on 10-year US Treasuries rising and
equities have rallied as investors bet that Trump’s infrastructure spending plans will trigger higher inflation and
stronger earnings growth over the medium to longer term. Increasingly, the market is of the view that the limits of
monetary policy have been reached and policymakers are moving towards fiscal policy to support growth
(particularly in Japan, US and UK).
Clearly, in an environment of higher risk free rates, the scope for further cap rate compression for core real estate
in global gateway markets is limited. On the flip side, assuming that Trump’s infrastructure plans and corporate tax
cuts are successful in pushing US GDP growth back towards 3% p.a. and the rise in long term risk free rates is
gradual, then this can only be a good thing for real estate fundamentals.
• Stronger leasing demand for real estate space
(across all sectors) and a delayed supply response
following the global recession will be a positive for net
operating income growth as rents reset at higher levels
and occupancy levels continue to improve.
• Elevated real estate yield spreads and positive net
operating income should support real estate
valuations and offset any outward movement of
cap rates.
Fig. 9
Real estate returns and inflation (2000-2016, % p.a., local currency)
10.51
10.44
8.60
7.98
Real Estate
Inflation
2.80
Australia
Canada
Source: Thomson Reuters Datastream, IPD, UBS Asset Management, REPM.
2.20
2.00
1.90
UK
US
References
• Jain, S (2016) “Investment Considerations in Illiquid Assets” Alternative Investment Analyst Review
• Ilmanen, A. (2011). ”Liquidity Factor and illiquidity premium” from Expected returns: An investor’s guide to
harvesting market rewards. pp. 359–374. John Wiley & Sons
• Preqin Private Debt Database 2015, Bank of America Merrill Lynch.
• Rajan, Amin (2015) ”The rise of Private Debt as an Institutional Asset Class” for ICG
• UBS Hedge Fund Solutions (2015) ”The Hedge Fund Illiquidity Premium”
• Harris R, Jenkinson T and Kaplan S (2013) ”Private Equity Performance: What Do We Know?” Journal of Finance
• Jensen, Michael C (1989) ”Eclipse of the Public Corporation” Harvard Business Review
• Harris R, Jenkinson T, Kaplan S, Stucke R (2014) “Has Persistence Persisted in Private Equity? Evidence from
Buyout and Venture Capital Funds”
• Blackstone: ”Patient Capital, Private Opportunity. The benefits and challenges of illiquid alternatives”
• UBS Asset Management, Investment Insights (April 2017), Liquidity: does less equal more?
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