In this article we discuss the outlook for the Irish commercial property market and the benefits of diversifying your property investments internationally, over the long term.
The extent of the dynamism and recovery of the Irish economy has surprised us all. Ireland has punched above its weight when it comes to attracting and retaining tech giants, major pharmaceuticals players, and financial and business services companies. The Celtic Tiger has roared once more. Indeed, expectations continue to be exceeded in what has become an unusually long Indian summer for the Irish market.
The reasons for this are broad and well documented. A quick browse on the Irish Development Agency (IDA) website shows there is no shortage of positive factors to shout about. It pulls no punches when it comes to Brexit either. Ireland will soon be the only English speaking country in the European Union, and come 1st April 2019, that fact will be a considerable advantage for potential Irish economic development prospects.
But why does this matter to commercial property investors? Property is driven by the economy and financial liquidity, both of which have remained healthy in Ireland. In 2018, Ireland retained its position as one of the fastest-growing economies in Europe and indeed in the developed world. This is tangibly supporting demand for business space. For example, business services company Salesforce recently announced it was recruiting a further 1,500 employees in Dublin – a scale of recruitment that is not always so common in other European cities.
For investors, though, total return momentum is an important consideration. Irish commercial property returns appeared to be slowing after the MSCI/SCSI index reported the 37% peak in 2014, and with the stamp duty hike in 2017 further removing momentum in 2017. The latest data shows returns have stabilised at just below 10% in 2018. Drilling into the market data, it appears that the prospects for the best of Dublin’s prime standing investments (which are now quite core in their nature) are peaking. Yields are now largely stable at low levels close to 4% at Q4 2018, with rents also now rising more slowly according to data from Cushman & Wakefield.
However, outside St Stephens Green, Dublin 2, and outside prime offices in particular, we believe prospects are perhaps more interesting. The private rented residential market is displaying attractive fundamentals for investors. Housing demand is in excess of supply and the development pipeline is unlikely to catch up this year or next. The stable cash flows from the growing rented residential property sector are attractive to long-term, low-risk investors, and the prospects are attractive. Industrials are also receiving structural support from the shift to online retailing and on-shoring of manufacturing as robotics replace labour-intensive functions.
There are emerging risks to the central scenario, though. The Irish economy is linked to the UK and the nature of the future relationship with the EU is still unknown. This has specific implications for Ireland and risks lie to the downside. In addition, the growth of technology companies has been staggering in recent times, yet the sector has also proved highly volatile and Ireland is all too familiar with the risks of an over-reliance on one industry. It can have painful repercussions as seen with the overinflated banking sector prior to the global financial crash.
So what can domestic investors do to harness the best of what Ireland has to offer, while embracing the advantages of taking a broader perspective?
Why a broader perspective makes sense
Property has long been considered a mainstream asset class for institutional investors. But for most, there has been a strong bias for property investments in their own country, with exposure to domestic markets of up to 100%. While we see some interesting opportunities in Ireland, we believe that diversification makes sense to fully benefit from the attractive characteristics of property investing.
In the hunt for investment returns, there is a wide range of options for investors. According to IPD/MSCI’s Global Property Fund Index, an index of property funds diversified across different global regions has produced fund level returns of between 7.8% and 15.0% per annum over the last ten years. While these returns could appeal to many investors, the key is in the volatility – the amount of risk associated with those index returns. Irish direct property market returns were four times more volatile than the blended performance of the property funds in the global index according to the data from MSCI.
While investing internationally is clearly not appropriate for all investors, we believe there are four theoretical reasons why a broader perspective can have its advantages.
- Access to sector and strategy opportunities
Not all domestic property markets offer a balanced range of opportunities. In some countries, it is not possible to invest across all sectors. To create a balanced portfolio without buying assets that don’t fit minimum criteria, investors can benefit from looking abroad. The clearest example of this is the residential sector where prospects and the diversification benefits are considered substantial, yet the opportunity to invest domestically is often limited. Germany, Netherlands and Scandinavia have far more developed residential markets than even the UK or France. The same can be said for the logistics markets, where the best locations to invest are often not those closest to home.
- Higher returns
While too binary to fully explain why an investor would consider investing internationally, higher returns is a potential important factor. In the short term, experienced investors may think that their domestic property market offers poor value; this often starts the drive to look for opportunities outside of their home country. Implicit in this is the use of the domestic return as the hurdle rate for non-domestic investment. We believe that this demand for a risk premium has led to some of the disappointment that investors have experienced when investing elsewhere.
Over the long term, higher returns are only available by taking on more risk; investors who keep their domestic market return as a hurdle are typically pushed up the risk curve when they invest elsewhere. A higher return is required in order to deliver a return net of higher fees and taxes associated with cross-border investing – and those higher target gross returns mean taking on more risk. Focusing on just the return side of the equation seems likely to deliver potentially unwelcome outcomes.
- Higher risk-adjusted returns
Investing internationally gives rise to the potential for higher risk-adjusted returns within the property portfolio. The theory is straightforward: investors can harness higher returns per unit of risk as a result of the stabilising effects of diversification. If the correlation between the domestic and non-domestic portfolio was 1, there would be no rationale for investing internationally. However, the correlation between domestic and international markets is less than 1. Furthermore, the correlation reduces further when adding more markets as the covariance between multiple moving parts becomes much more significant. In general, home bias is unlikely to completely disappear as there are tangible advantages. Yet, it is logical that far higher risk-adjusted returns are possible for a combined portfolio of domestic and international allocations than for the domestic-only portfolio.
- Scale brings diversification
A larger portfolio also leads to diversification. The smaller the portfolio size, the greater the asset-specific risk that drives the return of the portfolio. Empirical evidence shows a domestic portfolio of only 20 assets results in an R2 of over 95%. A portfolio of 100 assets results in an R2 of over 99%. As an international portfolio is structured to be spread across multiple countries, the overall blended performance typically shares a much weaker relationship to the timing and range of returns of any particular market or asset within the portfolio. Essentially the sum of the parts means considerably more than just that.
Allocations should deviate from benchmarks and deliver higher risk-adjusted returns
Furthermore, by tilting the balance of a portfolio to sectors, segments and geographies that have strategic and performance advantages can help increase the risk-adjusted return. This might involve a strategic allocation to help with structuring and tax implications; a tactical allocation to a market due to short-term pricing arbitrage that is identified through the investment process; or, lastly, a thematic allocation to a segment of the market offering strong performance or diversification benefits.
Risk reduction within a property portfolio
The benefits of investing in direct commercial property include attractive risk-adjusted total returns, a high and stable income return, and diversification benefits when held in a portfolio with equities and bonds. While these features are valid for the overall market, they don’t always hold true for individual assets or smaller portfolios. As asset-specific risks (location, sector, tenant, building etc.) are high for individual properties, a relatively small number of assets are required in a portfolio in order to replicate the favourable characteristics of the overall market.
A low cross correlation of total returns between assets (given differences in location, sector, tenant type, lease structure) results in significant risk reduction. An allocation across multiple regions, rather than specific to a particular country, should lead to greater risk reduction benefits (exposure to varying local economic conditions, interest rates cycles, and property lease structures). Based on analysis of the UK property market (see IPF, Individual Property Risk, July 2015), a portfolio of over 100 assets eliminates most asset-specific risks. But even a portfolio of just 20-30 assets can provide significant risk reduction. Adding additional geographies logically adds layers of additional diversification.
The risk that you might not achieve the desired risk-adjusted returns also manifests itself in the potential to incur higher costs or face complications. These items can come in the form of four factors: tax, fees, currency, and leverage (although the unscrupulous use of leverage can add risk beyond that for which you are rewarded). These four factors need expert management and controls to reasonably restrict the risks and negative effects, which can be substantially greater than those derived from bricks and mortar. Crucially, investors can decide how much they are exposed to these factors through hedging, swaps, leverage restrictions and through reasonable financial structuring.
Ultimately, while returns might not always be higher, the risk taken to achieve them can be considerably less by investing internationally. Taxes, fees, currencies and market knowledge make it more challenging for property investors to invest abroad. Despite the hurdles, there is a clear advantage for most investors to explore these opportunities as they can improve portfolio performance by increasing absolute returns and/or risk-adjusted returns. Regardless of the cycle or the prospects and risks in a domestic market, be it Ireland or any other country, we believe there is a strong rationale for diversifying across countries over the long term.
Author: Craig Wright, senior real estate investment analyst, Europe at Aberdeen Standard Investments. To find out more about Aberdeen Standard Investments contact your financial adviser.
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