Property as an Investment Asset Class
As with all equity-type assets, the performance of property as an investment is ultimately linked to some extent to the performance of the economy, and like all assets its performance is linked to the capital markets.
The economy is the basic driver of occupier demand, and, in the long term, investment returns are produced by occupiers who pay rent. However, in the shorter term say up to 10 years returns are much more likely to be explained by reference to changes in required returns, or yields.
Required returns do not exist in a property vacuum but are instead driven by available or expected returns in other asset classes. As required returns on bonds and stocks move, so will required returns for property, followed by property prices.
Nonetheless, history shows that property as an investment is a true third asset, distinctly different from equities and bonds. The direct implication of property being different is its diversification potential, and hence the justification for holding it, within a multi-asset portfolio.
Generally, the impact of the real economy and the capital markets on the cash flow and value of real estate is distorted by several factors.
- Property is a real asset, and it wears out over time, suffering from physical deterioration and obsolescence, together creating depreciation.
- The cash flow delivered by a property asset is controlled or distorted by the lease contract agreed between owner and occupier. For example, rents in the India are commonly fixed for a-year or two, after which they can only be revised upwards.
- The supply side is controlled by planning regulations, and is highly price inelastic. This means that a boom in the demand for space may be followed by a supply response, but only if permission to build can be obtained and only after a significant lag, which will be governed by the time taken to obtain a permit, prepare a site and construct or refit a property.
- The returns delivered by property are likely to be heavily influenced by appraisals, rather than by marginal trading prices.
- Property is highly illiquid. It is expensive to trade property, there is a large risk of abortive expenditure, and the result can be a very wide bid-offer spread (a gap between what buyers will offer and sellers will accept).
- Property assets are generally large in terms of capital price. This means that property portfolios cannot easily be diversified, and suffer hugely from specific risk.
- Leverage is used in the vast majority of property transactions. This distorts the return and risk of a property investment.
- Property rents appear to be closely correlated with inflation in the long run, producing an income stream that looks like an indexed bond over the long term. But rents can be fixed in the short term, producing cash flows that look like those delivered by a conventional bond, and the residual value of a property investment after the lease has ended exposes the owner fully to the equity-type risk of the real economy. Hence property is a hybrid asset, with similarities to all other assets, but different.
- The risk of property appears low. Rent is paid before dividends, and as a real asset property will be a store of value even when it is vacant and produces no income. Its volatility of annual return also appears to be lower than that of bonds. This is distorted somewhat by appraisals, but the reported performance history of real estate suggests a medium return for a low risk, and an apparently mispriced asset class.
- Unlike stocks and bonds, real estate returns appear to be controlled by cycles of eight to nine years.
Category : Flatons Advisors Blog