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Property as an investment can yield attractive returns over the longer term, and adding property to your equity and bond portfolio can make it more effective and less risky. Direct property investment, however, comes with several disadvantages, including high capital outlay, lack of diversification (and therefore increased risk) and illiquidity. You also do not know how much your asset is worth until you agree a price with a buyer. Property funds avoid many of these problems, but funds which invest in direct property still present some disadvantages. The solution is often to invest in property shares, often referred to as real estate securities, usually via a fund like a Real Estate Investment Trust (REIT).

Following a period of strong returns for commercial property and global real estate securities over a number of years, the asset class has seen declines since the middle of last year. Investors have been particularly worried about the US sub-prime mortgage market and its impact on the residential property market, both in the US and globally.

This anxiety has meant that global real estate securities in particular are trading at significant discounts to the values of their properties. What may be seen by many retail investors as an uncertain market environment and therefore possibly a poor time to invest, could in fact be an excellent buying opportunity.

For those investors who do not have existing real estate diversification in their portfolio, this should be seen as the opportunity to achieve it at desirable discounts.

The advantages of global real estate securities

REITs are listed entities which hold direct property assets for income or development purposes. They are generally free of corporation taxes provided that earnings are substantially distributed to investors. REITs are normally actively managed meaning their returns are driven not only by property prices but also the value added by developing the property or managing it more efficiently.

One of the most attractive advantages of REITs over direct property funds is the liquidity that REITs offer. Since REITs are traded securities they can be sold very quickly, whereas direct property funds will normally need to sell property, a process that can take many months, before cash can be returned to investors. In declining markets these properties may need to be sold at fire sale prices. This will also mean that REIT prices are impacted by investor sentiment and usually fall sooner than the value of the underlying property in times of negative sentiment, allowing investors to gain exposure to property at a discount and benefit more rapidly when markets recover.

Property shares are quoted on the stock exchange and so have an exact value on any given day, rather just an assumed worth. REIT fund managers can quickly sell shares to move into other countries/sectors, either to avoid falling markets or when they identify better opportunities.

As an asset class, real estate has the potential to offer higher income and also greater stability than equities because rental streams are backed by medium to long term commercial agreements. Real estate companies can also provide inflation protection through upward rental revisions.

Real estate investing is an area which helps investors create a more diversified portfolio and is attractive because it has a relatively low correlation with other assets such as equities and bonds, i.e. the returns do not move perfectly in line with each other. This means that investors can reduce their total portfolio risk either by diversifying their bond portfolios or allocating a portion of their equity exposure to this asset class.

Recent Market Volatility

In the second half of 2007, turbulence in the US financial markets led to a world-wide financial crisis as multinational banks were forced to write down large amounts of debt that were backed by weakening assets, in particular sub-prime mortgages. REIT stocks were not unaffected by this turbulence, with the FTSE EPRA/NAREIT Global Real Estate Securities Index declining by 8.3% in the last quarter of 2007, and by 5.8% during the first quarter of 2008.

The result of these events is that we have entered a period of great uncertainty. Credit has become much more expensive. The fall in equity markets this year can be seen as a 'catch-up' on the part of stocks. Greater uncertainty is also commonly characterised by heightened market sensitivity to any news, good or bad, leading to high market volatility. Short-term market fluctuations are always driven by sentiment, but in such environments market sentiment can oscillate rapidly and fundamentals can temporarily be obscured. However, in the long-term, fundamentals remain the drivers of markets.

Looking at recent instances where the FTSE EPRA NAREIT Global Index (we should explain what this is) has fallen significantly, we see that in the 12 months following the end of the bear market real estate securities recovered strongly. On average, the total return was 40.7%.

So should we now be looking to increase exposures to real estate? Real estate certainly looks to be an attractive buying opportunity at the moment. If you look at global REIT markets and compare the values of REITs with the values of their underlying assets (Net Asset Value or NAV), most are trading at a discount (data at end first quarter) i.e. the value of the REIT is less than the value of the underlying holdings. Globally the discount is 13%, with the UK and continental Europe trading at discounts of 24% and 15% respectively. If an investor bought into UK REITs and the REIT price reverted to the value of the assets, they would make a 24% profit.

This mismatch in REIT prices versus asset valuations means that the market is pricing in further falls in the property market, whereas in more benign markets REITs often trade at a premium. It is likely to be driven by overselling of REIT stocks as the general market sentiment and volatility in other sectors influences the value of REIT stocks. Given that REITS are trading at a discount, many REIT managers view this as an opportune time to invest in this market.

Conclusion

In times of heightened volatility and greater uncertainty, it is even more important to maintain investment discipline. In particular, diversification ' across asset classes, regions, investment styles and securities ' maximises the chance that investors will participate when asset prices recover. It can also provide some protection should some asset classes experience further falls.

A globally diversified REIT fund offers the opportunity to obtain exposure to non-domestic markets, which can offer varied return characteristics. Real estate cycles in different markets and sectors are driven to a large extent by local factors such as gross domestic product growth, taxation policies and government initiatives. A globally diversified fund therefore provides greater stability for investors and a wider opportunity set for active managers than would be available in a single market/region.

If you have Real Estate as part of your portfolio, this is the time to maintain investment discipline; if you do not, perhaps this is the best time to take a closer look at this asset class.

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