Commercial property has been a good performer versus shares

Friday 14th September 2001

"Low correlation" is the word on every one's lips in the investment world at present. The term applies to mutual independence, more or less, of returns available from different investments or asset types.

Investments that bear little relationship in their returns to dismal trends of sharemarkets are currently of interest. Since March 2000 many sharemarkets have looked rather grim, with new bottoms lately tested for many.

Advisers are having to find ways to mesmerise their nervous clients. One useful fact to know when undertaking such reassurance counselling is that it is normally coldest and darkest just before dawn.

In the meantime, an investment that has low correlation with shares could, when combined with them, produce a better average result.

Shares will of course turn around eventually and then the story to explain will be performance of bonds. The US Federal Reserve is probably at or near the low point in its interest rate cutting cycle and at some stage will revert to increasing rates to counter gathering inflation. As official interest rates rise, bond prices are likely to fall.

Low correlation with bonds as well as shares could be useful in an investment included alongside them within a portfolio. Such an investment would produce returns more or less independently of what was going with the markets of shares and bonds.

The combined result would be the smoothing or averaging out of overall portfolio returns. Volatility within asset classes would be dampened across them taken as a group.

A couple of investment categories present themselves as low correlation possibilities: hedge funds and commercial property. I will consider the latter this week and the former next.

The investment world uses the term "commercial property" as shorthand for a range of categories recognised by real estate agents: industrial (factories and warehouses), retail (shops and shopping complexes) and commercial, or office and general (offices).

These different categories of property tend to display their own cycles through the swings and roundabouts of the economy. Common to all, however, is that if they are leased to a sound tenant, the income, paid as rent, comes in regularly despite changes in returns on bonds or shares.

Of course, if the economy gets sick enough, the result could be declining rents and departing tenants, but as a general rule good quality commercial property as an asset class is capable of holding up its end.

There is some evidence abroad that commercial property is showing low correlation with sharemarkets. Last week NBR carried a survey of commercial property in the Asia Pacific area by Campbell McIlroy. Quoting real estate company Jones Lang LaSalle, the report indicated that despite economic decline across the region, vacancy rates were still fairly tight in many main centres throughout the region. Low vacancies tend to support rental levels and keep up the earnings of buildings.

The commercial property sector of our local stock exchange has been a good performer against the broader sharemarket as investors chase stable yields. Looking overseas, analyst Brent Sheather has argued that listed real estate investment trusts (REITs) have put up a creditable showing in the US.

He quoted research by Ibbotson Associates to show that in the US over the last 10 years there has been low correlation between REITs and stock returns. Overall, returns on property in the US have come in about midway between bonds and stocks.

Just as diversification across asset classes is sound policy, especially when it encompasses assets of low mutual correlation, so too does it make sense to diversify within assets classes to avoid over-dependency on the performance of individual investments or economies.

It is probably unwise to place too much emphasis on commercial real estate within New Zealand, considering the small size of our economy. At the very least there should be some diversification into Australia and better still further afield into even bigger and more prosperous countries.

Another consideration with commercial property investment is liquidity or ability to sell out. REITs, listed property companies and managed funds usually offer reasonable liquidity in contrast to direct property ownership or investment in unlisted property syndicates. The latter may offer secondary markets for liquidity purposes but may not permit ready exit or a good price to be obtained for the seller.

The popularity of property syndicates has tended to decline locally as awareness of their limitations sets in.

A trend is emerging for property syndicators to amalgamate their various funds to compensate for poorer performance among some of them and produce more liquidity in the process.

Not every one agrees that listing is the right approach to property investment. Syndicators such as Melbourne-based MCS argue that listed property investments frequently get caught up in sharemarket trends. MCS guesses about 70% correlation between listed property in Australia and the broad sharemarket there.

On that basis, the sought-after low correlation between shares and property is markedly diluted. The claimed trade-off between liquidity and low correlation needs to be weighed up by investors.

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