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Real estate: the development of a 'new' asset class
Listed real estate markets put in a brilliant performance in 2003 and 2004 with returns of over 30%, but according to a recent UBS study they are still not overvalued. Returns expected by UBS experts over the next few years are based on long-term trends, however - i.e. 6-8% per year - and are thus considerably lower. The markets thus appear to be settling down. In the increasing similarity between the characteristics of listed real-estate investments and the underlying direct markets and the unstoppable global development of real estate investment trusts (REITs), the experts see two further trends that will make acquiring real estate via the stock exchange preferable to direct ownership as a form of investment in the future.
The UBS Real Estate study published today focuses on the wide range of aspects of real estate as an asset class. The perceived picture of a secure - i.e. non-volatile - investment is put into perspective with regard to direct ownership of real estate, and the characteristics of listed real estate are compared to those of direct investments. We believe that, in an appropriate comparison, listed real-estate investments will not only have similar risk/return features to direct ownership in future, but - thanks to declining correlation to other asset classes - will also have similarly positive effects on the overall portfolio. Furthermore, the UBS experts anticipate that listed investments will in future be able to offer similar protection against inflation due to convergence with direct investments, but with the additional advantages of high levels of liquidity and transparency and low transaction costs.
According to the study, these attractive benefits of listed investments are the reason why cross-border investments have already become established as an important factor on the real-estate markets and why investors are increasingly placing their money internationally. The latter is due also to the attractiveness of REITs, which were launched in the US in 1961 with the aim of enabling investors to participate in diversified real-estate portfolios in a tax-efficient manner. Various countries have since taken on this status and contributed to the huge growth of this sector, with many other countries set to follow suit. The UBS experts believe that pressure on the remaining countries to introduce similar vehicles will increase continuously with the aim of minimizing the risk of a constant outflow of capital to foreign real-estate markets. The study also shows, however, that the level of attractiveness of the individual national real-estate markets based on dividend yields is different when the currency-hedging costs are taken into account. From the point of view of a Swiss investor, for example, the 7% income return posted in Australia will be more or less eaten away by currency hedging, bringing the return in Swiss francs down to less than 3% and making Swiss real-estate investments look extremely attractive in comparison.
Although the high inflow of funds into indirect real-estate investments has been largely absorbed by the rapidly growing market of indirect investment opportunities, surplus demand has nevertheless arisen and the investment vehicle has accordingly increased in value. With the exception of a few housing markets, however, no irrational bubbles have occurred according to the UBS experts. They believe that the high valuations that occur now and again are a consequence of the generally low expected returns on the capital markets and thus attributable to fully rational investment decisions. According to the authors, the risk of rising interest rates for the real-estate markets cannot be ruled out, but due to the rather moderate interest-rate forecasts at the long end and the fact that real-estate investments are suitable to some extent as inflation hedging, they consider the level of risk to be rather low at the moment. Thanks to foreseeable regulatory improvements for listed real-estate investments (launch of REITs), European and Asian markets in particular are considered highly promising in the medium term. This assessment is supported in Asia by the above-average growth potential.
The authors raise the question as to whether the race to build the highest skyscraper is an indicator of the general state of economic affairs. A majority of the current 200 highest skyscrapers were completed during the peak of a real-estate boom and/or in periods of far-reaching economic change. Conclusions of corporate euphoria in times of relaxed monetary policy do not seem so unrealistic after all. According to the UBS experts, however, such indicators are naturally rather playful, but it could still be worthwhile for today's investors to closely follow current developments in Taiwan, which is currently home to the world's highest building, and Dubai, where an 800-metre skyscraper is under construction.
The authors also advise anyone making a long-term investment in real estate not to ignore the structural risks associated with demographic developments and the globalization of the economy, and the related shift in the focuses of growth. In Europe in particular, the UBS experts see new challenges set to confront the real-estate markets. Not only population levels, which are currently stagnant overall and set to decline, but also the shift of jobs will intensify competition between locations in general and providers of usable space in particular. According to the UBS analysts, this will result in an increase in property-related risks, with limited growth potential for rental prices. They see tenants above all as the long-term winners, and with regard to location they see large urban centres which, thanks to their infrastructure and the broad range of leisure and employment opportunities, should remain a major attraction to populations of other regions.
As a consequence for the investor, the UBS analysts envisage an allocation of 5 to 15% in real estate. According to their calculations, it should therefore be possible to optimally exploit the advantages of this asset class. Due to the bond-like character of real estate, the proportion is likely to fall when risk appetite increases. In order to avoid unnecessarily high property risks, investments in indirect, broadly based vehicles are generally to be preferred to direct investments.
Zurich/Basel, 25 April 2005
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