Global property forecast 2007 - the REIT way to go

April 10, 2007 07:46

In 2006, global property markets provided 26.5 percent euro-denominated returns versus 8.3% for global equities and a -5.1% return from global bonds.

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In 2006, global property markets provided 26.5 percent euro-denominated returns versus 8.3% for global equities and a -5.1% return from global bonds. It was the seventh consecutive year that this asset class outperformed equity and bond markets. Global property markets advanced on mergers & acquisitions (M&A) activity, increased money inflows (primarily through REIT IPOs) and improving underlying fundamentals. As we move into 2007, we can expect increased securitization of property worldwide. Why is this happening? Surprisingly, both institutional and individual investors are significantly under weighted in real estate. Real estate investing has traditionally been available through professionally managed, single-property investments. In recent years, private equity real estate funds have offered high net worth individuals, family offices and institutional investors a vehicle to invest in a professionally managed diversified portfolio of properties with characteristics including multi-sector (e.g. residential, commercial & industrial properties) cross border investments. An investment in these vehicles has required the ability to hold an illiquid investment for a significant amount of time (typically seven to 10 years). These investments may be structured with limited liability (you can only lose your investment) or unlimited liability - much like one has in owning a primary residence. Unlimited liability means the possibility of losing more than your investment through the need to add additional funds for property repairs, lawsuits (someone is injured on your property), being sued by a tenant, etc. Most investors have preferred structures that provide limited liability. In this case, the property management company/general partner assumes unlimited exposure while the limited partner/investor concedes control to management. The issues of significant management fees, liquidity, transparency and high minimum investment levels have served to constrain exposure to real estate even among the largest institutional investors. Listed property companies are an emerging and rapidly growing segment of the real estate sector. Listed properties may either be publicly traded companies that hold real estate as their underlying asset or REITs (Real Estate Investment Trusts). Property companies may be involved in development while REITs may not. This can be advantageous because the potential return is greater in real estate development than investing in existing properties. However, the risk will also be greater should there be negative change in the market environment at the time a project is completed. Another issue with a listed company is that it will pay taxes on profits before distributing any realized gains or income revenue to investors. These distributions are taxable resulting in a double taxation on profits. In addition, property companies tend to behave more like equities; offering less diversification from equities value for investors. REITs are an increasingly attractive real estate investment alternative. Why REITS? REITs offer investors several advantages over previously mentioned less liquid investments and listed property companies. REITs trade the same as equities. They are highly liquid, thereby enabling investors to shift their asset allocation, or access funds, daily. Secondly, by law, they are required to distribute between 80%-95% of their net income and capital gains in order to be exempt from taxes on profits. This means there is only one tax on gains - at the investor level. REITs may not invest only in established properties. As public companies, they are fully transparent to investors and investors have voting rights as registered shareholders. REITs can be diversified by geographic location, sectors or both. REITs provide the added advantage that their returns closely mirror those of private equity investments with higher liquidity. REITs have a lower correlation than listed property companies to the broader equity markets. Currently, 6% of global properties are securitized. Only in 2006, UK securities legislation allowed for the formation of REITs. REITs have been launched in Germany only this year. Other countries are introducing legislation to encourage the growth of REIT investments. Global property investing can be achieved through global real estate funds that manage a portfolio of REITs and listed property companies or through Global REITs whose underlying assets are a basket of geographic REITs. So what about 2007? As of the end of the first quarter of 2007, listed global real estate investments provided a USD 6.6% return compared to 2.04% for global equities and 1.29% for global bonds. So where is real estate headed for the rest of the year? We expect real estate markets to provide lower returns than 2006, albeit higher than global equities and bonds. The structural securitization of property is in its early stage of development as an asset class. As this sector grows, more institutional money will enter this market providing greater liquidity and acting as an engine for growth. Continued M&A and IPO activity will also propel the property market higher. Improving fundamentals and rental income cycles in many countries should support higher valuation levels. Commercial properties from malls to office space are experiencing strong growth. High-end residential properties, as well as luxury store space, are also experiencing increased demand worldwide. Even many sectors of the US real estate market continue to demonstrate strong demand. As long as the US economy continues to grow, even at a projected 2-2.5% rate for 2007, real estate will continue to offer attractive returns. Our view is that the global economies will continue to grow and inflation will remain within manageable levels. We are forecasting a 9%-15% return for global property markets in 2007. The author is Global Investment Strategist at Tandem Capital

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