May 2008
For professional investors and advisors only. Not suitable for retail clients.
Schroders
Real Estate Does Exactly What it Says on the Tin?
Mark Callender, Head of Property Research
Alex Krystalogianni, Head of International Property Forecasting
Neil Turner, Head of Property Fund Management
Executive Summary
The traditional property investment strategies have usually been specified in terms of geography and
type of real estate and an assumption that the way in which the strategy was executed allowed the
investor to gain access to the underlying behaviours of well diversified real estate portfolios. In
reality, however, very few investors can afford to buy a well diversified portfolio of direct property in
each of their preferred segments, particularly if they are investing on an international scale and they
have to rely on indirect routes, such as Real Estate Investment Trusts (REITs) and unlisted vehicles,
to get their property exposure. Moreover, the range of indirect forms of property is expanding with
new derivative products and, until the credit crunch, the rapid growth of Commercial Mortgage
backed Securities (CMBS). The problem that arises, however, is that these alternative forms do not
necessarily perform like direct property and do not deliver some of the attributes that attracted the
investor to the asset class in the first instance.
It is critical, therefore, that the changes in the investment infrastructure that have occurred in the
past 10 to 15 years should be taken into account in portfolio construction. If we do not do this, we
run the risk of building sub optimal portfolios for clients as the new infrastructure that exists has
clearly produced a dislocation between research and strategy and execution.
In considering the issues involved in implementing a property investment strategy, we remind
ourselves about the fundamental attractions of real estate. Secondly, we examine the different ways
in which clients can gain access to real estate as an asset class and test them against a number of
criteria. Finally, we argue that investors can build better portfolios by mixing direct and indirect real
estate and taking advantage of their difference performance characteristics.
The Performance Characteristics of Direct Property as an Asset Class
Direct property, or bricks and mortar, is a chameleon asset, displaying some of the features of
equities and some of the features of bonds. For example, like equities, the income on a direct
property may grow strongly during an economic upswing, as increased demand from tenants bids up
rents. Alternatively, like bonds, real estate is to some extent a long-duration asset but property
capital values are often inversely related to changes in interest rates1. However, the crucial
difference with equities and bonds is that the leases which largely drive property investment returns
are not traded on a financial market. The only way (with the possible exception of derivatives) that
an investor can obtain the income on a lease is to buy a building.
The obvious fact that direct property is a physical asset defines many of its advantages and
disadvantages as an asset. On the downside, it means that direct property is inherently less liquid
than financial assets, which can be traded almost instantly. The amount of due diligence involved in
buying a property means that even in a bull investment market, the minimum time between putting a
building on the market and completion is around three months. In a slow market, when demand from
investors is weaker, selling a property may take between 6-9 months. In addition, because property
is immobile, it is an easy asset for governments to tax and in many countries the high level of
transfer taxes inhibits, to some extent, the liquidity of direct property.
1
Real Estate – Does Exactly What it Says on the Tin?
The other significant disadvantage of direct property as an asset is that it is relatively expensive to
manage. Negotiating leases and collecting the rent is inherently more expensive than collecting a
stream of dividends from an equity portfolio. Furthermore, properties require both routine repairs and
maintenance and periodic refurbishment to reduce the effects of physical wear and tear and of
obsolescence, as tenants’ requirements for space evolve over time. While the costs of routine
maintenance can often be recovered from tenants, depending upon the terms of the lease, investors
will usually bear the costs of capital expenditure on refurbishments and other improvements.
On the other hand, the simple fact that direct property is a physical asset also helps explain many of
its attractions:

Low volatility. One of the main characteristics of property is that its returns are relatively
stable. Long term data from continental Europe, the UK and US suggest that the standard
deviation in property total returns is lower than that of equities and of bonds. Admittedly, this
low volatility is in part a distortion caused by the reliance on valuations to measure property
returns. The low number of transactions means there is not enough evidence to determine
prices and valuers tend to be cautious and to understate both the peaks and troughs in the
cycle. If property returns are de-smoothed for valuation effects2 then the underlying volatility
of property is usually estimated to be somewhere in between that of equities and bonds.
That is consistent with long term returns data showing that property typically outperforms
bonds, but underperforms equities. However, the low volatility of direct property also reflects
the legal status of leases. Unlike equity dividends which are at the discretion of company
boards, tenants are under a legal obligation to pay the rent. Moreover, in the extreme
situation of a corporate insolvency, whereas the shareholder, or bond holder loses
everything, the landlord only suffers a temporary loss of rent, before the property is re-let.
Table 1: Long Term Total Returns and Volatility, 1987-2007
Total Returns, % per year
Direct Property
Equities
Bonds
Standard Deviation %
Direct Property
Direct Property – unsmoothed
Equities
Bonds
Continental
Europe
UK
USA
8.9
11.9
6.4
10.1
10.8
8.6
8.8
11.6
7.2
4
17
21
10
9
15
19
11
7
14
18
9
Source: IPD, NCREIF, Schroders

2
Excellent diversifier of equity risk. The second major attraction of real estate is that
property returns are unrelated to equity returns and can therefore significantly reduce the
overall level of volatility (i.e. risk) in a multi-asset portfolio. Long term data for continental
Europe, the UK and US suggest the correlation between property and equity returns is
universally low at 0.12, 0.29 and 0.04, respectively. (For an explanation on correlation
coefficients, see the note at the end of this paper). In short, the reason why direct property is
a good diversifier of equity risk is that rents are largely a function of the current health of the
“real economy” and property is therefore a coincident indicator of the economic cycle. By
contrast, equities are generally driven by expectations for future economic growth and
profitability and they tend to act as a lead indicator of the economic cycle. The relationship
with government bonds is also very low across many markets.
Real Estate – Does Exactly What it Says on the Tin?

Potential for active management. The flip-side of the fact that property is vulnerable to
physical wear and tear and obsolescence, is the potential to add value to older properties
through refurbishment, changing tenants, change of use, redevelopment, etc. Property is
exceptional in this regard, because in most asset classes investors cannot intervene directly
to affect the value of an asset. The nearest equivalent is probably venture capital.

Long term income growth in line with inflation. The fourth major attraction of real estate
is its ability to deliver income growth in line with inflation, over the long term. This attribute is
particularly valuable to pension funds, because their liabilities are often index-linked.
Although in the short term the relationship may break down, perhaps because of a recession
hitting tenant demand, over the long term the relationship has tended to hold in most
countries, because low rents will deter development and ultimately, result in a shortage of
space. One way of rationalising the relationship is that there is no obvious reason why rents
should fall relative to the price of other goods and services over the long term unless, as
occurred in the Netherlands office market, there is a major relaxation of planning policy and a
big increase in new building. (Please note that while the income from property may be a
good hedge against inflation, over the medium term the same does not necessarily apply to
property capital values and total returns, because of their sensitivity to interest rates)3.
Chart 1: Netherlands Property Income Growth, Inflation and Wage Growth
1994 = 100
160
150
140
130
120
110
100
1994
1996
Retail
1998
Office
2000
Residential
2002
2004
CPI Inflation
2006
2008
Wages
Source: EuroStat, IPD, end 2007
The Performance Characteristics of Direct Property as an Individual Asset
Clearly, direct property has a number of desirable characteristics which make it attractive to
investors. Executing a direct property investment strategy can be frustrating, however, for three
reasons. The first is illiquidity (as discussed above). It can take 12-18 months before an allocation to
direct property is fully invested.
The second complication is that the performance of individual properties is very heterogeneous and
each asset carries a high degree of specific risk. That in turn means that investors need a sizeable
portfolio of properties before they can be confident that they have a well diversified portfolio which
will track the market. Research by Schroders, Investment Property Databank (IPD) and the
University of Aberdeen4 into the UK market indicates, for example, that in order to reduce average
tracking error to 3 percentage points and to have a portfolio where 70% of the return is explained by
the market, an investor requires 20-25 commercial properties.
3
Real Estate – Does Exactly What it Says on the Tin?
If that result is then scaled up to western Europe, then it suggests that an investor would need at
least 150 direct properties to get a reasonably well diversified exposure to the five major economies
(France, Germany, Italy, Spain and the UK) and the Nordic region and more than 400 direct
properties to get a reasonable exposure at the global level, including Asia and North America.
The third headache in executing a direct property investment strategy is that assets are usually
owned by a single investor, so there is little possibility of reducing specific risk through multiple
ownership. The implication is that investors are more concerned with keeping full control over their
properties than spreading specific risk. Given an average lot size for commercial properties in
Western Europe of €18.5 million at end-2007 (source: IPD) that suggests an investor would need to
commit a minimum of €3 billion ($4.5 billion, £2.25 billion) to get a reasonably well diversified
exposure to the region. Following the same logic, an investor who sought to construct a meaningful
global portfolio would need to invest a minimum of around €8 billion ($12 billion, £6 billion).
So the fact that property indices score well (low volatility, low correlation and high income return) is
mildly interesting. However, it is not an awful lot more than that to the vast majority of institutional
investors who aspire to hold a reasonably diversified property portfolio.
So the important unit of analysis becomes:
Given a sensible level of equity, what type of real estate investment can I make, and how does it
score on the above attributes?
Indeed, recognition of portfolio construction problems in direct investing has led to the dramatic
interest and rise in the indirect (both non-listed and listed parts) route to property investing.
But to what extent do those indirect forms behave like the real thing?
Unlisted Real Estate Vehicles
This category refers to pooled funds which invest in properties on behalf of a number of investors
and which are not listed on a stock exchange. Examples include Luxembourg FCP funds,
Netherlands BV funds, UK property unit trusts and limited partnerships and US co-mingled funds.
According to Property Funds Research there were around 2,000 unlisted real estate vehicles
globally at the end of March 2008 with a total GAV of $1,000 billion (€700 billion, £500 billion). The
obvious advantage of pooled funds is that they can provide investors with a well diversified property
exposure at a fraction of the cost of assembling a direct portfolio. Fund of funds structures further
amplify the diversification effect, albeit at the cost of higher fees. In addition, during periods of strong
investor demand, pooled funds may provide greater liquidity than the underlying direct market via
the secondary trading of units, although investors might pay a premium to the unit price. However,
this cannot be guaranteed and the liquidity of units in pooled funds tends to quite cyclical.
In general pooled funds with no debt which adopt a balanced strategy (i.e. investing across all
sectors) should track the direct property market quite closely. They should also provide the same
benefits of low volatility and good diversification against equities that investors expect from real
estate. For example, total returns from property unit trusts in the UK over the past ten years have
been virtually identical to the direct market as measured by IPD and only marginally more volatile.
4
Real Estate – Does Exactly What it Says on the Tin?
Chart 2: Total Returns UK Direct Property and Unlisted Real Estate Vehicles
Return percent
30
25
20
15
10
5
0
-5
-10
Direct Property
08
Ja
n
07
Ja
n
06
Ja
n
05
Ja
n
04
Ja
n
03
Ja
n
02
Ja
n
01
Ja
n
00
Ja
n
99
Ja
n
98
n
Ja
Ja
n
97
-15
Pooled Funds
Source: IPD, March 2008
The complication from an investors’ viewpoint, however, is that many pooled property funds have
significant levels of debt and this can produce quite volatile returns. According to INREV, (the
European Association for Investors in Non-listed Real Estate Vehicles), the average level of gearing
among the funds in its database was 57% of gross asset value (GAV) at the end of 2006. While
gearing will boost the returns to investors when the returns on the underlying portfolio are above the
cost of finance, the reverse is true when property returns fall below the cost of finance. Charts 3 and
4 illustrate the impact of gearing on returns, by comparing the downside value at risk (VAR) for a
fund with no debt (on the left hand side), against the VAR for a fund with 50% gearing. Underlying
market returns are assumed to be 7%, the long-term standard deviation in market returns is 8% and
finance costs are assumed to be 5%. Over the long term the geared fund benefits from its debt and
out-performs the ungeared fund with total returns to investors of 9% per year and 7%, respectively.
However, for investors in the geared fund there is a 5% chance that returns in a single year will be
worse than -17%, whereas the 5% worst case scenario for investors in the ungeared fund is -6%.
Chart 3: Hypothetical Fund with No Gearing
Chart 4: Hypothetical Fund with 50% Gearing
Return percent
Return percent
50
50
40
40
30
30
20
20
Market Average 7%
10
0
0
-10
-10
95% VAR
-20
-20
-30
-30
0
1
standard deviation
Source: Schroders, May 2008
5
Geared Fund Return 9%
10
2
95% VAR
0
1
standard deviation
2
Real Estate – Does Exactly What it Says on the Tin?
Listed Property Securities
The other major route for investors seeking a real estate exposure is listed property securities. At the
end of March 2008 the global market capitalisation of listed property companies and REITs was
$742 / €468 billion according to NAREIT / EPRA (measured by free float). The key advantage of
listed property securities is that they provide immediate liquidity. In addition, in the short term
investors avoid the upfront costs and taxes of buying direct property. Like unlisted vehicles, listed
property securities also solve the twin problems of specific risk and the single ownership of direct
property, so that an investor with less than €1,000 can gain access to an underlying real estate
portfolio valued at €25 billion (e.g. Unibail - Rodamco).
However, on the downside, listed property securities, like unlisted vehicles, also tend to carry
significant amounts of debt. Schroders estimates that the average level of gearing in listed property
company securities at the end of 2007 was 25% in Asia, 45% in Europe and 40% in the USA,
measured as percentage of GAV. As a result, their returns are more volatile than those of the direct
market. Moreover, this extra volatility is further compounded by their listed status which has two
consequences. First, although the underlying portfolios of REITs and listed property companies are
valued conventionally on a regular quarterly, half yearly or annual basis, investors can buy at any
time and so share prices reflect investors’ latest estimates of the value of the portfolio. This means
that the share prices of listed property securities are probably more sensitive to price movements in
the property transactions market than the values of direct property portfolios, or the unit prices of
unlisted vehicles and the result is a premium or discount to the last declared net asset value (NAV).
The second consequence of listing is that the share prices of listed property securities can be
heavily influenced in the short term by broader movements in stockmarket sentiment. So if equities
in general enjoy an upswing, then the share prices of listed property securities will tend to rise with
the tide. Alternatively, on a bad day, the share prices of listed property securities may fall, even
though the fundamentals of the underlying direct property market have not changed. Unfortunately,
this extra layer of stockmarket “noise” adds so much volatility that in the short term the performance
of listed property securities may be more closely related to equities than the direct market. Evidence
from the UK suggests that it is only after listed property securities have been held for 1-2 years – so
that investors have foregone some liquidity – that they start to perform like the underlying direct
market. (See Appendix Table A1). The dilemma for investors therefore is that although listed
property securities may be liquid, their performance is relatively volatile and they may compromise
the goal of diversification against an equity portfolio which is one of the main rationales for holding
real estate.
Chart 5: Total Returns US Listed Property Securities, Direct Property and All Equities
Return percent
Direct Property
06
D
ec
04
D
ec
02
D
ec
00
D
US Listed Real Estate
Source: EPRA / NARIET, NCREIF, March 2008
6
ec
98
D
ec
96
D
ec
94
D
ec
92
ec
D
D
ec
90
70
60
50
40
30
20
10
0
-10
-20
-30
-40
S&P 500
Real Estate – Does Exactly What it Says on the Tin?
Real Estate Derivatives
There are currently two types of real estate derivative. A Property Income Certificate (PIC) is
essentially a bond, where the coupon is the income return on a property index and where the capital
which is repaid at redemption is adjusted according to the cumulative movement in capital values on
an index. A swap is a contract for difference where the buyer receives the total return on a property
index, but pays the seller, usually a property investor, LIBOR plus a margin. The volume of
derivatives swaps has grown rapidly since 2005 and according to IPD the total notional value of
outstanding contracts on the UK index was €12 billion at the end of March 2008 and there were a
further €1.8 billion of contracts outstanding on the French and German indices.
However, while swap contracts may be useful for property investors to hedge their exposure, they
cannot, by definition, provide the actual market return. If they are priced efficiently, so that the price
paid by the buyer (LIBOR plus a margin) equals the expected total return, then the net return to the
buyer is simply the difference between the forecast return and the actual return on the index. (See
Appendix Table A2). In short, property derivative swaps give investors the unexpected return.
It is not possible to short sell physical real estate, so it is not possible to hedge property derivative
contracts in the underlying physical asset. Furthermore, real estate is generally considered to be a
longer term investment, so prices of physical assets do not move instantaneously with news flow on
a daily basis. Formally, poor price discovery exists in real estate indices. Therefore, an arbitrage
position is created between spot physical prices and what various participants think will happen to
the index.
However, the price of the property derivative is determined by supply and demand in the market as
well as the underlying index. The price of property derivatives changes on a daily basis, much faster
than the price of the index, which is published once a year, as investors anticipate changes in the
underlying valuations in exactly the same way as investors in public property equities do. At the
moment, for example, we believe property derivatives are clearly trading below the index price and if
purchased and held to maturity we believe they will deliver higher returns than IPD. So whilst the
instrument is designed to deliver a market return, the actual return can be significantly affected by
the market price of the instrument.
In principle, PICs should provide investors with the market return on the underlying direct property
market. However, there are two drawbacks. First, only a few PICS have been issued. Schroders
estimates that no more than £1 billion of PICs are currently in issue in the UK and we are unaware
of any issues in other countries. Second, although PICS are not listed on a stock exchange, their
price will be sensitive to price movements in the property transactions market. As a result, the
returns on PICs will be more volatile than those on the reference property index, at least to some
extent.
7
Real Estate – Does Exactly What it Says on the Tin?
The Property Investor’s Dilemma
The table below summarises the main characteristics of the different property investment routes.
Table 2: Characteristics of Different Property Investment Routes
1
2
3
4
5
6
Direct
Property
Unlisted
Vehicles
Listed
Securities
CMBS
Derivatives
PICs
Derivatives
Swaps
Transaction price, or valuation
Gearing inside asset
Stockmarket / capital market “noise”
Liquidity
Multiple ownership
Investor can add value
val.
no
no
no
no
yes
val.
no / yes
no
no
yes
no
trans.
yes
yes
yes
yes
no
trans.
no
yes
yes
yes
no
val.
no
yes
no
yes
no
val.
no
yes
yes
yes
no
(Reflect characteristics 1-4)
Returns track direct property market
Volatility
yes
low
yes
low / high
no
high
no
low
yes
low
no
high
Source: Schroders, May 2008
What is the Solution?
What is the aspiring international real estate investor to do? If direct property carries too much
specific risk, if listed property securities are highly correlated with the wider stockmarket and if the
returns on unlisted funds are heavily distorted by leverage, how do we invest in real estate? We do
not believe the answer is simply to dismiss the asset class as too difficult. Any investor who ignored
real estate over the past decade would have paid a high opportunity cost in terms of missing out on
strong performance and on the potential to reduce volatility in a multi-asset portfolio.
Instead, we strongly believe the solution is to recognise the different performance characteristics of
direct property, listed property securities and unlisted vehicles and to construct a real estate portfolio
which takes advantage of those differences to minimise the risk for any given level of return. At
Schroders, this approach relies upon Schroders Multi-Asset Risk Technology (SMART), a model
which has been developed by the multi-asset team at Schroders to create optimal portfolios using
different combinations of equities, bonds and alternative assets. The real estate version of SMART
uses Schroders conventional direct property forecasts for retail and office markets in Asia, Europe
and North America. However, in addition it includes forecasts for listed properties securities and
unlisted vehicles in each country where they exist. The model does not currently cover CMBS or
derivatives, but these types of real estate will be added in future.
The forecasts for unlisted vehicles have been compiled by adjusting the direct property forecasts for
the impact of gearing, based upon the average level of debt in the vehicles in each country and
forecasts for finance costs. The forecasts for listed property securities are also derived from the
direct property forecasts, but in addition to being adjusted for gearing, they also assume that the
current discount or premium to NAV in each country will revert to its long term average over the next
three years. As a sanity check, Schroders has used the same methods to compile synthetic
historical returns for unlisted vehicles and listed property securities and compared them against the
actual data from INREV and EPRA (European Public Real Estate Association).
SMART requires three further inputs. First, it requires correlation coefficients across all the property
series. A key aim of the model is to minimise the volatility of returns (i.e. risk) and to that end
SMART will tend to bias the portfolio towards those direct property markets, securities or unlisted
vehicles which have relatively low correlations, subject to the condition that the overall portfolio must
meet the target rate of return. For example, in a hypothetical portfolio of just two assets, the ideal
solution would be to find a pair of real estate assets which had a correlation coefficient of -1,
because this would indicate that their cycles were the mirror image of each other and that as one
rises, the other falls and vice-versa. In reality, negative correlations are unusual, but they do exist
(e.g. UK retail vs Singapore office).
8
Real Estate – Does Exactly What it Says on the Tin?
Instead, the main emphasis is on avoiding making large allocations to groups of property assets
which are strongly positively correlated with each other (e.g. major financial office markets such as
London, New York and Tokyo). In general, the coefficients were calculated automatically by SMART
from the historical and forecast property data in the model, but in a few instances where the data
only covered a short period, or where there were discontinuities, we adjusted the figures guided by
correlations based upon national GDP series.
Second, SMART can accommodate future changes in exchange rates and can calculate optimal
portfolios either on the assumption that exchange rates will be fully hedged, or that they are
completely unhedged. The forecasts for exchange rates are taken from Schroders’ economics team.
The third input is the client’s strategy and objectives. Clearly, different investors will have different
target rates of return and by association, different appetites for risk. However, even individual
investors may separate their property allocations into a low return / low risk “core” component and
complement that with a high return / high risk “opportunistic” property portfolio. Moreover, there is a
significant variation in the importance which investors attach to tracking the direct market and on
providing diversification against equities. Some investors are seeking to buy the market, albeit with a
margin of outperformance and they are therefore reluctant to allow any allocation to property
securities, derivatives, or cash. These investors will typically ask the fund manager to follow a
relative benchmark, where one exists. By contrast, other investors are less concerned about tracking
the property market and they may regard listed property securities as a useful way of creating
liquidity in the portfolio. These investors will typically specify an absolute benchmark. There is also a
third set of investors whose first priority is to achieve a minimum rate of income return and for whom
achieving a particular target rate of return, is of secondary importance.
Another dimension is the geographic scope of the portfolio. In general, investors with a small
allocation will usually specify a regional portfolio (i.e. just Asia, Europe, North America), while
investors with a large allocation will operate on a global level, but the worldwide growth in unlisted
vehicles, fund of funds and REITs means that the threshold at which investors can “go global” has
declined significantly in recent years. Five years ago, only the largest investors with an allocation of
at least €5 billion could consider investing on a global scale. Today, we think the threshold is around
€150 million.
Finally, different investors will have different policies regarding currency risk. Some investors wish to
hedge all currency risk, or may automatically be required to do so by their regulator (e.g. German
Bafin). Conversely, other investors may feel that investing in property is a strategic decision which
should be viewed over the long term and they may choose to leave their international property
portfolio either completely unhedged, or only hedge a percentage of the exposure.
Chart 6 shows an optimal portfolio for an investor with a global property mandate. The only
constraint on the portfolio is that it must have a minimum allocation of 10% to each of the three
major regions.
Inevitably, the optimal portfolio varies from investor to investor depending upon their objectives. We
encourage investors to sit down with us so that we can fully understand their priorities and they can
appreciate the issues involved in portfolio construction. However, certain common themes and
patterns have emerged from our work with SMART:
9

The higher the level of return and risk, the smaller the number of different direct property
markets, unlisted vehicles and property securities in the optimal portfolio. Lower return
portfolios are typically composed of 12-15 different markets / forms of property and this
diversity helps to smooth out returns and reduce risk. By contrast, high return portfolios tend
to be concentrated on just those 5-7 different markets / forms of property which meet the
target rate of return and accordingly, they carry a much higher level of risk.

In most countries, office property is generally more volatile than retail property and a
portfolio’s exposure to offices will usually increase, as the target rate of return increases.
Real Estate – Does Exactly What it Says on the Tin?
Chart 6: Optimal Portfolio for an Investor with a Global Mandate
Percent of total portfolio value
100
INREV - Norway Office
INREV - Belgium Office
90
Unlisted - US industrial
Direct - US industrial
80
Unlisted - Other Asia
Unlisted - Singapore Retail
Unlisted - China Retail
70
Direct - Other Asia
Direct - Australia Office
60
Direct - China Retail
Unlisted - Other Europe
Unlisted - Italy Retail
50
40
30
Unlisted - Germany Retail
Direct - Other Europe
20
Direct - UK Retail Warehouses
Direct - Spain Retail
Direct - Italy
Direct - Germany Offices
Direct - Germany Retail
10
0
7
9
10
12
13
15
16
18
19
21
22
24
25
total return, percent
low risk
high risk
Listed - Other
Listed - USA
Listed - Australia
Source: Schroders, May 2008
10

Portfolios where the currency risk is hedged will generally have a higher allocation to offices
than unhedged portfolios, where movements in exchange rates also generate volatility.

Based upon Schroders’ current set of forecasts, SMART generally prefers unlisted vehicles
to direct property and property securities. However, this bias could easily change in the
future in favour of direct property, if interest rates rise and gearing started to have a negative
impact upon the returns of unlisted vehicles. Alternatively listed property securities could
become more attractive if a further fall in their prices in 2008 (after the first quarter) were to
result, paradoxically, in a larger favourable reduction in the discount to NAV in 2009-2011.

There are a few quirky property markets around the world which offer good diversification
benefits and which merit inclusion in many property portfolios. These markets tend either to
be dominated by one particular set of occupiers (e.g. Brussels offices, Oslo offices, Perth
offices), or to be in the grip of a particularly powerful process of structural change (e.g. China
retail, Italy retail, US port logistics), which means that they are relatively immune to short
term economic cycles.
Real Estate – Does Exactly What it Says on the Tin?
Of course, although SMART is very helpful in providing a set of investment signposts, it is no more than a
guide and ultimately the decisions on portfolio construction rest firmly with fund managers. For example, at
present SMART treats all markets / property types as equally liquid, whereas in reality there is a significant
variation in the liquidity of direct property, unlisted vehicles and property securities. Neither does SMART
make allowance for differences in political risk and transparency between mature markets such as Australia,
the UK and US and emerging markets such as China, India, or Turkey. We also need to further develop the
real estate version of SMART to factor in the impact of different tax regimes (e.g. FIRPTA in the USA).
Finally, SMART only deals in market averages and in an imperfect investment market such as property, there
is still a lot of money to be made by identifying properties which are mis-priced, or by selecting managers of
unlisted vehicles with superior asset management skills.
Conclusions
There are many new and exciting ways to invest in real estate as an asset class. Indeed the fact that
there is such diversity demonstrates a simple truth - there is no perfect solution. If there were, then it
would prevail and other forms of real estate investing would become redundant.
The direct route poses the problem of too much specific risk. The unlisted vehicle route may solve
the problem of specific risk, but returns can be heavily distorted by gearing, while the listed property
securities route may expose investors to movements in the broader equity market. Investing on an
international scale adds further complexity.
In our opinion the solution is not to focus exclusively on one route or the other, but to recognise that
they all have something to offer. Looking forward, the best real estate portfolios will be those that
mix the various forms of property and exploit their differences to meet client’s objectives. Fund
managers and investors who ignore those differences run the risk of constructing portfolios which
are sub-optimal and which ultimately will disappoint.
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Real Estate – Does Exactly What it Says on the Tin?
References
1. Property: It’s Role in Liability Driven Investing. Julia Felce, Neil Turner. Schroders Property,
2006
2. Index Smoothing and the Volatility of UK Commercial Property, Investment Property Forum,
2007
3. Inflation and Property Performance. Jenny Buck, Mark Callender, Neil Turner. Schroders
Property, 2007
4. Risk Reduction and Diversification in Property Portfolios. Callender, Devaney, Key, Sheahan.
Journal of Property Research, 2007
Correlation Coefficients Explained
The correlation coefficient (R) measures the relationship between two data series. The coefficient
can vary between +1 and -1. The square of the correlation coefficient (R2) shows what proportion of
the variation in the first series is explained by the second series.
A correlation coefficient of +1 shows that the two series rise and fall together. A correlation
coefficient of -1 shows that the two series are the exact mirror image of each other and when one
rises, the other falls and vice-versa. A correlation coefficient of zero indicates that there is no
relationship between the two.
In practice an investor who is seeking to smooth out returns at the portfolio level should select
assets which are negatively correlated with each other, or which have only low positive correlation
coefficients with one another. Assets which have strong positive correlation coefficients (i.e. over
+0.5) will not provide significant diversification benefits.
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Real Estate – Does Exactly What it Says on the Tin?
Appendix Chart A1: UK Listed Property Securities, Direct Property and All Equities
Correlation coefficient
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
1 Month
6 Month
1 year
2 years
Correlation with IPD Monthly
3 years
Correlation with FT All Share
Source: FT, IPD, Schroders, May 2008
Appendix Table A1: UK Listed Property Securities, Direct Property and All Equities
Holding period
1 month
6 months
1 year
2 years
3 years
Correlation Real Estate Equities
vs Direct Property Market
0.18
0.37
0.46
0.66
0.65
Correlation Real Estate Equities
vs FT All Share Index
0.61
0.60
0.56
0.44
0.39
Source: FT, IPD, Schroders, May 2008
Appendix Table A2: Performance of Hypothetical Real Estate Derivative Swap
The chart and table shows the payments on a hypothetical derivative swap contract (ignoring the role of
intermediaries) when the market expects a total return of 7% on the property index and LIBOR is 5%.
LIBOR (5%) + Spread (2%)
BUYER
SELLER
Property Index Total Return (7%)
Scenario 1
Scenario 2
Scenario 3
LIBOR %
Spread %
Actual Index
Total Return %
Net Return to
Buyer %
5
5
5
2
2
2
7
8
6
0
1
-1
Source: Schroders, May 2008
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Real Estate – Does Exactly What it Says on the Tin?
At May 2008
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