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Investment in direct real estate
Ting Kien Hwa 
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Since 2010, several institutional investors from Malaysia have invested in direct real estate in overseas property markets, particularly the UK and Australia. They include the Employees Provident Fund (EPF), Retirement Fund Inc (KWAP), Lembaga Tabung Haji, Permodalan Nasional Bhd and life insurance companies. Direct real estate is now playing a greater role in their investment portfolios and is treated as an asset class of its own.

Real estate as an investment has distinctively different characteristics from bonds and shares. It has its own unique strengths and weaknesses.

Real estate is lumpy, capital intensive, illiquid, indivisible and difficult to create a well-diversified property portfolio. Real estate also requires management and suffers from depreciation.

Despite these disadvantages, real estate continues to be favoured by institutional investors for its positive characteristics that could help provide consistent and higher returns to their portfolio.

Firstly, stable and consistent rental cash flows are a hallmark of investment in real estate. Real estate could deliver strong cash flows to an investment portfolio from rental payments through lease and tenancies. A landmark commercial office building is able to attract blue-chip tenants which are able to pay rentals on time with little risk of rental default. This is particularly evident in matured property markets such as the UK where the leases are usually for 15 to 25 years with rent reviews every five years. The rent reviews are normally upwards-only, meaning if market rents have increased, the rent will rise, but if the market rents have fallen, the rent remains the same.

Direct real estate is also able to provide higher absolute returns above the risk-free rate. Investment in direct real estate provides a favourable risk-return trade-off compared to shares and bonds. The risk-adjusted returns of direct real estate is higher than those for large/small-cap shares, and investment-grade and high-yield bonds.

In addition to the consistent income, real estate provides the benefit of capital preservation. It provides greater preservation of capital and value compared to shares which are tied to business cycles and bonds which are highly affected by inflation and interest rates.

 

Bond and equity-like features

Secondly, real estate has returns that have both bond and equity-like features. This is one special feature that many investment options do not have. The bond-like feature is the constant rental income from the leases of the property which fixed the rental at a pre-agreed level until the next rent review. During the rent review, the rental can be reviewed upwards to the prevailing market rate, thereby giving an equity-like feature.

Thirdly, the returns of real estate have low correlation with other main investment asset classes. The lower the correlation, the greater the diversification benefits of adding real estate with shares, bonds and other asset options. This makes real estate a good diversification tool for a mixed asset portfolio to provide a different type of systematic risk and return than shares and bonds. The reason for the low correlation is the lagged property cycle in relation to the economic cycle.

 

Hedge against inflation

Real estate is also able to provide a good hedge against inflation. It means that real estate return is able to match the inflation rate over the long term. This is unlike shares and bonds which do not provide any inflation hedging capabilities.

Interestingly, plantation and property shares also do not provide a hedge against inflation. Property owners are able to pass on inflation costs in the form of higher rentals from tenants. This is particularly true for retail properties as inflation increases the net operating income much faster than the outgoings and expenses of the retail properties.

At the portfolio level, the inclusion of real estate in a mixed asset portfolio will be able to expand the efficient frontier of the portfolio.

This means its inclusion is able to provide a higher return and at a lower level of risk for the whole portfolio. An added advantage is that the drivers for real estate returns are different from shares and bonds and are low or negatively correlated with them.

In the case of the EPF, its initial investments in offices were made in Australia and the UK. Investments in real estate increased from 0.4% in 2011 to 3.2% (property and infrastructure) in 2016. With more funds being allocated by the EPF for real estate investment, the contribution of property rental income from real estate is expected to increase in the future. (Table below shows the EPF’s asset allocation in various investment options.)

Real estate is a fundamental asset class that should be included in every diversified portfolio of institutional investors. It can also be seen as an alternative asset class in addition to commodities, private equity or derivatives meant to provide diversification to a mixed asset portfolio.

In view of the current uncertainties in the share and bond markets, more institutional investors will view real estate as a viable alternative investment option which could value-add to their portfolio. We can expect to see this group of investors making more real estate transactions, especially in offices, in the near future.

Professor Sr Dr Ting Kien Hwa is a fellow of the Royal Institution of Surveyors Malaysia (RISM) 



This article first appeared in Focus Malaysia Issue 267.