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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? This document and its contents have not been reviewed by, delivered to or registered with any regulatory or other relevant authority in all Asia Pacific jurisdictions. This document is for informational purposes and should not be construed as an offer or invitation to the public, direct or indirect, to buy or sell securities. This document is intended for limited distribution and only to the extent permitted under applicable laws in all Asia Pacific jurisdictions. No representations are made with respect to the eligibility of any recipients of this document to acquire interests in securities under the laws of all Asia Pacific jurisdictions. Using, copying, redistributing or republishing any part of this document without prior written permission from UBS Asset Management is prohibited. Any statements made regarding investment performance objectives, risk and/or return targets shall not constitute a representation or warranty that such objectives or expectations will be achieved or risks are fully disclosed. 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The information in this document does not constitute advice and does not take into consideration your investment objectives, legal, financial or tax situation or particular needs in any other respect. Investors should be aware that past performance of investment is not necessarily indicative of future performance. Potential for profit is accompanied by possibility of loss. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Source for all data and charts (if not indicated otherwise): UBS Asset Management. © Copyright UBS 2017. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.