Investing in property potentially offers some relatively simple things: a durable income stream, the potential for long-term growth and some diversification away from other asset classes. Typically, one does not expect property to deliver double-digit returns. Nonetheless, there have been quite a few good years for property in the US and the UK, for example. In the US, the NCREIF Property Index has increased by 45% since its low point in Q1 2010 through the end of 2015. In the UK, values are 42% higher than the trough in 2009, according to the MSCI UK Monthly Index as of 2015.
Things have turned out well and the tide has truly come in, at least for some parts of the market. Clearly, this can’t last forever. But when will it stop? I am often asked this question — and the answer is that I don’t know.
So what should you do? Enjoy the ride? Or take some chips off the table? A focus on return (the “fun” option) would suggest the former and a focus on risk (the “boring” option) the latter.
Having good risk control in place feels pointless when the market is rising. But it is very useful when it falls. And it is crucial to have this risk control in place when the market is rising so that it pays off when the market falls.
You can’t manage returns, but you can manage risk. So selling risk (assets for which the market is prepared to pay too much given their fundamental characteristics) when the market is rising and holding a low risk position (and buying quality cheaply) as the market falls should mean either higher returns for the same level of risk (alpha) or, better still in my book, the same level of returns for lower risk. Delivering a long-term target return for lower risk than it requires is often underrated compared to the search for alpha.
With property investment, the biggest risks are relatively straightforward: buying or holding poor quality properties, or overpaying for good ones. Compared to the equity market, the property market is pretty illiquid, so taking the time with an investment decisions is very important.
For long-term investors the biggest risk right now is being fooled into thinking a poor quality property is a good quality property. The easiest way to be fooled is to focus on long(ish) leases with reasonable covenants on property in marginal locations. Typically, these assets have been refurbished; accordingly, they are probably in as good a condition as they are likely to be for the next 10 years. But what happens at the end of that lease? Will you be faced with a cycle of being unable to lease it, a sale, refurbishment and renting on a longish lease with a reasonable covenant?
The biggest risk right now is being fooled into thinking a poor quality property is a good quality property
Risk is a strange concept. When you don’t experience it, it doesn’t seem very important to take notice of the possible outcomes that didn’t happen. The more this goes on the less likely you are to take note.
Think of risk management as an insurance policy; we all try and avoid risks in the first place. We lock the doors when we leave our house, turn on the lights, turn the water off when we are on holiday or maybe even install a burglar alarm. If we don’t get burgled or have a water leak for five years, do we cancel our insurance policy? No. Sacrificing some of the upside of performance in recognition that markets will fall seems like a sensible piece of insurance to have in place, all the time.
Alpha is a risk-adjusted performance measure, comparing the price risk of a fund and the risk-adjusted performance of its benchmark. Positive alphas represent outperformance of the benchmark, while negative ones represent underperformance.
Indices are unmanaged and are being provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
This article was originally published in Estates Gazette on February 27, 2016.