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Multi-manager view – John Kelly

Looking at multi-manager as a one-stop solution to meet a client’s investment needs, there is some debate as to whether commercial property has a place within the overall asset allocation.

Recent returns from the asset class have certainly brought this issue into sharper focus. According to the Investment Property Databank, 2004 was one of the best years for commercial property investors in an unbroken series of 12 positive years for the sector. Overall, commercial property returned 18 per cent, with the retail sector providing the strongest performance at 21 per cent. Even the weakest sector, offices, produced an attractive 14 per cent contribution.

It is understandable why commercial property has returned to favour, given the long-term consistency of returns and an overall disappointing performance from equities. Arguments for including the asset class within an overall allocation are that it can provide a stable income flow as well as the potential for capital growth. It is also a good diversifier which is lowly correlated with other asset classes. These arguments have held sway among institutional investors, with pension funds increasing their weightings considerably over the past few years, boosted by relative outperformance as well as cashflows.

There are, however, a number of reasons for questioning the suitability of commercial property as an asset class for individual investors, either within or outside a multi-manager structure.

A key question is whether the expectation of a low correlation of returns with equities and bonds is actually correct or whether it is instead a reflection of valuation practices.

A feature of the property market is that there are many more valuations than actual transactions. In fact, many properties which are confidently valued each quarter do not change hands for many years and sometimes never trade. Instead, the value is based on assumptions and estimates. What is the current rental and will it grow? What is the correct yield? What is the risk of default, the strength of covenant, the chance of void and of reletting? All these factors – and others – are considered in a valuation and a best estimate is made.

If we consider the price trends of the quoted property sector, we can see that it is actually correlated quite closely with the overall equity market. The question then arises as to whether the valuation of property companies can be so far out of line with the values placed on the sector. Clearly, logic dictates that they cannot be, so what we observe when we compare the apparent difference of returns between equities and property is not a significantly different pattern of returns but rather a reflection of the significant difference in pricing regime. Just as with-profits funds, with their smoothing mechanism, were for a time thought to be lower risk than managed portfolios with similar constituents, so real estate is somehow able to resist the trends of the real economy.

There are two other important considerations – liquidity and costs. Multi-manager portfolios have a far shorter timeframe than the typical pension fund and, therefore, look for a level of trading freedom which illiquid sectors such as commercial property cannot provide. If investors exit the multi-manager fund and property cannot be sold – which can take months in difficult market conditions – then other assets must be sold despite quality, return expectations and the property weighting.

Property is not cheap to buy. Those who blanche at stamp duty on equities will swoon at the 4 per cent on real estate. Round-trip costs of 6 per cent are a huge burden to place on return expectations. The multi-manager has to consider carefully whether they are sufficiently confident of property returns that they will give equities a 6 per cent headstart.

John Kelly is head of multi-manager development at Abbey


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