UBS estimates that the core private real estate investable universe grew from $6200bn (€5000bn) in 2003 to $6600bn (€5400bn) in 2004, with the global public real estate market increasing 27 percent in 2005 to $644bn (€528.3bn).

Institutional investors have a long tradition of investing in real estate but the development of the property funds sector has resulted in a different approach when it comes to implementing a real estate strategy in their portfolio, involving a move away from direct holdings in property to a more diversified and global indirect exposure to the asset class.

More sophistication

“If you see the move from direct holdings into indirect holdings through funds as a sign of sophistication in the market, then the clear leaders in that shift are the Dutch,” says Charles Foster Taylor, managing director, real estate at UBS Global Asset Management. During the 1990s, the small domestic property market in the Netherlands forced Dutch institutions to sell parts of their direct property holdings and instead develop indirect portfolios.

Mr Foster Taylor mentions the UK and Scandinavia as other areas where investors are becoming more and more sophisticated in their approach to real estate. “Also there is increasing interest coming from Germany which has, in some quarters, been perceived as an unsophisticated market but where we increasingly see more sophistication in institutional investors’ behaviour.”

In general terms, investors have been reassessing the role of real estate in their portfolios by not only increasing their exposure to the asset class but also by increasing their international outlook. “The euro has been a big change in that. Whereas before a lot of our real estate clients had only a domestic portfolio, now they are looking more broadly at Europe as the market they are investing in,” Mr Foster Taylor adds. This has pushed investors to consider investing in funds as the only option for them to gain exposure to all the markets they want to invest in.

Performance of real estate investments has been another aspect attracting investors to the asset class. Compared to equities and fixed income, returns in property have been very competitive recently.

“Obviously, the performance of the [real estate] public markets is very easy to measure and has been extremely impressive and that has encouraged investors to put more money into listed securities,” he says. “The development of tax efficient Reit [real estate investment trusts] structures has also been another incentive to do this.”

Stronger demand

He points out that even though interest in real estate has been there for decades, the type of demand currently being seen is much stronger. “In previous market cycles you’ve seen a lot of money being pushed into real estate but it’s been on a slightly speculative basis and what we are seeing now is that people are making seriously thought out asset allocation decisions through much more concerted and planned strategies than probably was the case before.”

This demand has contributed to the explosion of the global real estate funds market. Launched for the first time at the end of the 1980s, the last couple of years have seen a huge increase in new products coming into the market and assets under management. According to data from the European Real Estate Association (EPRA) in January there was a total of 68 global real estate funds available. Most of the funds analysed by EPRA are global Reits.

Jon Lekander, head of investment strategy at Aberdeen Property Investors, comments: “I think the taste for international diversification started to come on screen five years ago among mainstream European investors and in the past two years I would say this international diversification has ballooned.”

Mr Lekander says that one of the main drivers behind the internationalisation of property portfolios has been the need to improve diversification across the asset class and the return enhancement opportunities that this can bring.

He also notes pension funds and institutional investors in general have been increasing their allocations to real estate. “It is becoming increasingly difficult for institutions to get exposure to the domestic market through direct acquisitions,” he says. “This can be facilitated by using funds.”

“You need to be extremely large to acquire and manage a justifiable international exposure,” Mr Lekander says. “If one goes back and looks at domestic exposure, funds typically do not appeal to larger investors because they have the capacity and the critical mass to create a well balanced exposure.”

The Reits market has indeed grown rapidly with existing Reits acquiring more properties and increasing in value, and new ones being created in different markets. As EPRA points out, the US, the Netherlands and Australia have well established REIT markets, whereas in other countries these vehicles have only recently been introduced or, in same cases, they are still awaiting legislation allowing for their launch.

According to the UBS research, there are several reasons why investors favour Reits over other types of listed real estate. First of all, investors like the high payout ratio of property operating income that Reits must distribute in the form of dividends. They are also attracted to the fact that Reits must deal nearly exclusively in real estate and offer tax transparency. In addition these vehicles have low correlation with other asset classes, and even with private real estate indices.

The huge demand for Reits across the world and the increasing number of vehicles on offer is forcing some already well developed markets to consider implementing changes in order to remain competitive. UBS points that this is the case of the Netherlands where Reits structures were first established in 1969. The country is currently discussing ways to increase flexibility to attract more money from foreign investors after losing some investment funds to Luxembourg. Proposed Reit structures in the UK and Germany will also be more flexible than the current Dutch funds putting extra pressure in implementing changes to remain competitive in the near future. UBS expects Reits to be launched in Germany and the UK some time in 2007.

All these developments within the real estate industry have resulted in higher competition among investment management houses offering such products. Mr Foster Taylor says that one of the big changes in the industry is the current higher level of professionalism. “I think the products and the level of expertise and sophistication that are offered today with the real estate sector reflect a huge improvement compared to 15 years ago.” Many asset managers have put a lot of time and effort in building up their businesses “so clients get a lot more confidence in the abilities and sophistication of their managers”.

Big player dominance

He says that even though there is an increasing dominance of some of the largest houses in the real estate sector, there is still room for niche players who operate in particular geographical regions or types of assets. “You are seeing a growth of mega-managers, although we are talking relatively small numbers compared with equities, and also strong growth of niche players,” he comments. “I think it is the middle market which will find it a bit more difficult when the current rush of capital slows down a bit.”

More professionalism among investment managers and greater demand and expectations from investors are factors driving real estate managers to come up with new strategies to exploit the potential of the asset class.

Currently, the market for property derivatives is also growing. These instruments bring flexibility in gaining and reducing property exposures without any physical transfer of assets.

“They involve investors making bets on the performance of real estate versus the performance of an interest rate or fixed income,” explains Mr Foster Taylor. “They can be very interesting for investors who want to hedge their real estate exposure or considerably increase it over a short period of time. But in the end they are only as good as the indices on which they are based” he says.

The UK is the market where more work has been done in order to develop the market for property derivatives. ‘The absence of indices in a large number of markets, or the relative small sample that these indices represent, means developing those derivatives outside the UK is going to be a process that will take a long time,” Mr Foster Taylor. “I don’t see the growth [in property derivatives] as being explosive but I think that as that market evolves and develops it will be a growing sector.”

^{Source: UBS Global Asset Management, Real Estate Research
based on data obtained from UBS Investment Bank as of December}

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