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Chapter 1
Introduction
| 1.1 | The changing context for property investment |
Property is one of the main investment assets, the others being shares and bonds. Shares (also known as stocks or equities) and property (also known as real estate) entail ownership rights and are known as real assets. In contrast, bonds are financial assets. Shares represent a claim to a proportion of a company and, so, are a form of joint ownership. Direct property investment involves the rights of ownership to a piece of land, typically with a building. Bonds are debt vehicles and a distinction can be made between government and corporate bonds. The importance of the two types varies substantially from country to country. In the UK, where they are known as gilts, government bonds are by far the more common; in the USA, company bonds represent one-third of the market; and in Switzerland, corporate bonds are more important.
Property comprises both commercial and residential investments. There are a number of different meanings of the term ‘commercial’. In some countries it means offices and shops, with industrial as a separate category; in others, it also includes industrials; and in the USA, commercial refers to income producing (as opposed to owner occupied) property and includes offices, shops, industrials, rented apartment blocks and hotels. In this book, the term commercial property is taken to mean offices, shops and industrials and it is distinguished from residential property. Where clarity requires, ‘property’ is used to refer to the aggregate investment class and ‘building’ to refer to an individual property. Elsewhere, the term property is used in either an aggregate or individual sense which should be clear from the context.
The types of property which constitute the investment market and their financial characteristics vary from country to country. In the UK, the dominant form of property investment is commercial, while in other countries, such as the Netherlands and France, residential property is an important investment vehicle.
Property as an asset class exhibits distinctive characteristics, such as fixed location, heterogeneity, high unit value, illiquidity and, often, the use of valuations rather than prices for market information. There is also substantial government intervention, particularly in the housing sector. These factors and longer holding periods, partly as a result of lower liquidity, mean that, in terms of market turnover, shares and bonds are the predominant investment assets. However, in terms of value, property – including ownership by government, companies and individuals – represents by far the most important asset class. The relative importance of these owners, and of owner-occupation compared to investment ownership, vary substantially from country to country.
Property investment management has changed substantially in the last 20 years with its increasing integration with that of the other main investment classes. There have been two important consequences for the investment analysis of property. First, it has expanded from the selection of individual buildings to include a portfolio perspective in which portfolio structures are set relative to a benchmark and property is traded more frequently. Second, analysis has developed to consider property more explicitly in the context of the capital markets and the wider economy.
This integration has also made some of property’s distinctive features more problematic. Dissatisfaction has developed about illiquidity, large lot size and the use of valuations to measure returns. This has been one factor in the development of indirect vehicles to gain exposure to the property market. The management of property investments has also been affected by the trends of globalisation in economic activity and investment. Property markets, particularly in major cities, have become increasingly international in terms of both occupiers and owners.
Thus, investors in property, particularly major insurance and pension companies (the institutions), have to make choices among the different investment media, and increasingly in different countries. These choices have to take into account the characteristics of the various asset classes and the linkages among them.
Data to analyse the property investment market are much more limited than in the share and bond markets. Aggregate data for property returns have been available since the late 1960s in the UK and 1978 in the USA, but in other countries such data are typically available for only a few years or not at all. This information is an important input into the comparison of property with other asset classes and for property portfolio construction. Its non-availability may help explain why property was for so long analysed and managed as a separate asset class and why most textbooks on investment ignore property.
A related explanation for the separation of property from other asset markets is the existence in many countries of a separate property investment profession. In the UK and the British Commonwealth, chartered surveying has until recently dominated investment analysis and buying and selling in the commercial property market. In the USA, the real estate profession is well-organised and several professional designations exist. In contrast, in mainland Europe, the property specialists are often architects or economists.
There are two models for the academic study of property. In the UK and the British Commonwealth, there is a separate education based on valuation, law, construction and urban economics, and typically separate from housing. Particularly in the UK, the study of finance has expanded in these courses to meet the demands of a changing market. In the USA and mainland Europe, it is more common to study property in the context of finance, often with urban economics and including housing.
The availability of sufficient time series for the analysis of property investment is an important explanation of the dominance of the USA and the UK in professional and academic property research. The top property journals covering investment research are produced in these countries: Real Estate Economics, The Journal of Real Estate Finance and Economics and the The Journal of Real Estate Research in the USA and the Journal of Property Research in the UK.
Professional practice, education and the academic study of property have developed substantially in the last 20 years. In most countries, property investment analysis requires consideration of the wider context of the capital markets and the economy, and research and education have developed to accommodate this. This book is a contribution to these developments.
| 1.2 | The approach of the book |
A number of general themes are pursued throughout this book: property investment is considered in a multi- or mixed-asset context; the investment management of property is viewed from a portfolio perspective; alternatives to investment in the direct domestic market are considered; and there is a strong applied, but theoretically rigorous, emphasis.
As it is necessary for investors to make choices between the different investment media, senior decision-makers require investment analyses for property which are comparable with those available for other investments. These decision-makers, with overall responsibility for investment decisions in the major investment institutions, are not property specialists but have backgrounds as actuaries, accountants and economists. Accordingly, they require analyses which use the vocabulary of investment and finance rather than the specialist terms that have developed in the property market. An approach is required which considers the other major asset classes, the linkages between assets and the linkages between the property market and the wider economy.
While property is different from the other main asset classes, this does not justify its being considered in isolation. The differences between the property market and other asset markets have been used as a justification for specialist knowledge and special and separate treatment of property. This book rejects such a stance and shows how techniques which are widely used in other asset markets can be modified and applied to property. To do so requires an understanding of these other markets and of the differences between them and the property market. Such an understanding should enable a more successful integration of property investment analysis with that prevalent in other markets.
The traditional focus for property investment has been the building specific level rather than the aggregate portfolio level. However, most investors hold portfolios of property and these have features different from a simple sum of their component parts. Thus, the main focus of the book is on the consideration of property in a portfolio perspective rather than at the individual building level. Larger investors have been developing this strategic approach to property portfolio management in which performance is judged against a market benchmark.
The portfolio perspective requires consideration of the drivers of property returns through links to the capital markets and the wider economy. The book develops these relationships and shows how they can be modelled.
The main focus is direct property, that is ownership of actual buildings, but indirect ways of gaining exposure to the property market are also considered. These have developed partly in response to concerns about the direct market, including illiquidity, large lot size and the use of valuations to measure returns. Gearing (leverage) to improve performance is covered in the context of indirect property investment vehicles, but not for direct property portfolios in which it is not an important factor. The growing importance of international property investment, both direct and indirect, as an alternative to domestic investment is considered.
Throughout, there is a strong applied focus, but it is soundly based in theory and techniques. The latest research findings are integrated into the discussions throughout the book and detailed further readings are provided.
The book is divided into three main parts. Part I (Chapters 2 to 4) covers background material which is essential for an understanding of the multi-asset context and the differences between property and the other asset classes. The main investment classes, including the concept of a risk-free rate of return, and the main types of investors are considered (Chapter 2). Also considered are the measurement of return and risk (Chapter 3) and performance indices (Chapter 4).
Part II (Chapters 5 to 9) presents the analyses necessary to develop a property portfolio strategy. First, a pricing framework for property is set out (Chapter 5). Next, the various inputs are considered: the expected income growth rate (Chapter 6); a risk premium (Chapter 7); and a depreciation rate (Chapter 8). Finally, much of the material is applied to the practical management of property portfolios (Chapter 9). Part III (Chapters 10 to 12) examines property in a wider context. This covers the role of property in multi-asset portfolios (Chapter 10), alternative ways of gaining exposure to the property market (Chapter 11) and international property investment (Chapter 12).
In order to understand the property market, it is essential to set it in the context of the other investment markets with which it competes for investors. In Chapter 2 the characteristics of shares, bonds and property are discussed and compared. The links between these markets and from them to the wider economy are considered. Government bonds are introduced as an asset from which can be derived a riskfree rate of return. Other assets which bear risk must be priced to deliver the riskfree return plus a premium for risk. Finally, different types of investor and their investment requirements are examined.
Chapter 3 considers the measurement of return and risk. Measures of return are then discussed and it is shown how two types of investment yields, common to all asset classes, are linked. The conventional measure of risk (that is, the standard deviation) is also considered. Finally, the trade-off between return and risk, risk-adjusted returns and diversification of risk are examined.
To measure the return and risk at the asset class level, property indices are needed. The various ways of constructing property indices are the focus of Chapter 4. In the commercial property market, the lack of data on transaction prices has led to the construction of indices based on valuations of a sample of properties. Methods based on transaction data (averages of transaction prices, the hedonic method and the repeat sales method), which are mostly used in the h...
