The case for unlisted property in a multi-asset portfolio
By Thando Sishuba, CEO of Sanlam Direct Property
Unlisted (physical) property represents an important asset class within a multi-asset, balanced portfolio. In portfolio construction theory, assets are selected due to their contribution to the maximization of returns and reduction of risk along the risk-return spectrum. Each asset class is assessed or evaluated using the efficient markets hypothesis contained in modern portfolio theory or the capital asset pricing model (CAPM) in terms of its risk-return characteristics and location along the efficient frontier. The unlisted property asset class’s low correlation of returns to other asset classes is, thus, a major consideration.
The assets that produce the highest return, with minimal attendant risk, are the ones most favoured for inclusion in an efficient portfolio as they help to diversify risk. Risk is expressed in terms of the standard deviation of returns and other measures like Sharpe ratios or tracking errors, depending on the specific context. Given the risk aversion of most investors, it follows that the most important consideration in portfolio construction is reducing risk through the selection of assets that are either negatively correlated or at least less than perfectly correlated. The most important considerations in this equation are those concerned with the investor’s expectations: asset prices at the time of the initial investment; ongoing risk considerations and mitigation strategies; and the overall return over the holding period. It is, therefore, clear that an asset that contributes positively to portfolio diversification will likely secure its place in a multi-asset portfolio whilst simultaneously enhancing its price and maintaining its value.
Investors’ risk appetite/tolerance and return expectations further define the suitability of the specific asset or investment to their portfolio. Retail investors and smaller investment funds might be more risk-averse, with higher yield, cash flow and liquidity requirements in the short term, making them better suited to investments listed on a recognized stock exchange. Conversely, there are sophisticated institutional investors, such as pension funds and insurance companies, that are better suited to unlisted property investments whose underlying investment structure is more long-term in nature. These investors rely on long-term, cash-generative assets that have capital growth characteristics that match perfectly with their long-term liabilities.
It takes time to realise the full value of an investment in physical property and not all investors can afford to be in a market with relatively low liquidity. Different liquidity preferences and the associated risk tolerance levels cause one group of investors to embrace risks that the other group would find unfathomable. Investors concerned with relatively short-term holding periods will require liquid investment products or instruments, capable of conversion into cash at short notice; those that require longer-term holding periods and higher growth would be more prepared to pay a higher price due to the higher risk premium applicable over the longer term. The latter’s main concern is having assets that grow in line with inflation and maintain their real value, producing real returns over the long term.
Unlisted property is worthy of inclusion in a multi-asset portfolio due to the following positive characteristics:
1 High and rising income yield: Unlisted property offers ongoing income earning potential for investors due to a relatively high and rising income yield. This high yield emanates from various factors, such as good quality tenants with quality covenants; relatively long leases; and rising income due to lease escalations.
2 Inflation-hedging: The inflation-hedging qualities of property are phenomenal and better than cash and bonds. The main reasons for property’s ability to keep up with and beat inflation are annual lease escalations and other active-management or higher-return strategies that maximise capital growth and thereby total returns.
3 Lower volatility: The asset class displays lower variability of returns compared to other listed assets, such as listed equities, bonds and listed properties, particularly if it is on an ungeared basis. This, coupled with low correlations with other asset classes, improves property’s diversification benefits and its appeal to a wider investor base.
4 Proven counter-cyclical behaviour: Most institutional investors like pension funds and insurance companies, are concerned with asset-liability matching over the longer term. These investors are not unduly bothered with year-to-year correlations between assets but are more concerned with the co-incidence of the assets’ performance with the performance of other competing asset classes. In terms of its return profile, property has proven itself to be a counter-cyclical performer in most time periods and is still a prized asset in helping to reduce or diversify portfolio risk.
5 Enhanced returns from value-adding activities: An investment in unlisted property benefits its investors more directly, due to enhanced returns from value-adding activities and active-management strategies, such as timely asset acquisitions and disposals in dislocated and inefficient markets, embarking on refurbishments, and exploiting development and redevelopment opportunities within the portfolio.
6 Economic and social significance: Investment in property serves a dual purpose, which is important for any economy. The investment provides a financial return and it’s an operational asset that underpins key economic activity, acting as a factor of production. This could be most relevant in the era of impact investing, where most investors want to see a closer relationship between economic and social returns.
7 Reduced systematic risk: Pension funds and life assurance companies account for an overwhelming majority of the assets held by the personal sector (non-corporate and non-government sector). It is, therefore, critically important for these assets to be held in vehicles that are either uncorrelated or lowly correlated to the listed markets that house most of their retail investments as this could bring down the systematic risk during times of economic slumps, crises and widespread pandemics, thus creating a platform for market stability. These are the periods within which other financial institutions, like commercial banks, tend to experience severe balance sheet stress, so this systemic underpin could be very helpful to the economic system.
8 Direct influence: Most long-term investors that deploy significant amounts of capital into a particular asset class prefer to either own such assets directly, control the fund’s investment strategies and management actions, or at the very least directly influence the economic activities of the underlying fund. This is a common practice regarding most directly held and unlisted real estate assets.