The Case for Property

Many funds recognise that property provides essential diversification benefits. It combines the characteristics of both bonds (with a steady and rising income flow) and equities (with the potential for capital appreciation) but has a low correlation with these asset classes. This low correlation greatly aids portfolio risk management. For mature funds the relatively high yield cash return derived from property is also of real benefit in meeting pension obligations. But do these advantages still apply now property's 15 year bull run has come to an end? We say, emphatically, "Yes".

Investors should reconsider the advantages of direct property investment as a defensive strategy, whilst recognising that some properties are more defensive than others. The standard deviation of the IPD index over the period 1981 to 2006 (around 10%) suggests UK real estate has been less risky than gilts (14.1%) and much less risky than equities (30.3%).  However, the risk attached to specific properties produces considerable tracking error. Previous research by Wilky Fund Management and Property Funds Research suggests, for example, that almost £200m is needed to assemble a portfolio of London offices with a tracking error below 5%.

Income return has been much less volatile than capital growth.  While the latter is around 10% income return volatility has been as low as 1%.  So, buying property for income (which many pension funds need) rather than for capital growth is a low risk strategy.  For example a 50 basis point rise in yields will reduce the value of a property yielding 3.5% by 12.5% while the value of one yielding 7.5% will fall by just half that.  Such performance can be found in industrials, where yields averaged 2% over offices and 2.5% over retail during 1970 to 2006.  High yields will also come from many secondary retail and office assets.

Diversification also cuts risk. Better to have 20 small properties than 3 large ones for the same money. Smaller properties also often have higher yields, because larger investors have sold them to reduce management overheads, thus depressing market demand. They are perceived as "difficult" because of short leases and perceived weak tenants but these can provide extra yield, whilst not necessarily creating unacceptable risk.

Hence a portfolio with low gearing and smaller assets should offer more defensive performance than 'trophy' assets.