In a stable market such as that we are currently experiencing, the divergence between the listed and unlisted sectors is somewhat insignificant. However, in a turbulent or correcting market there are often substantial pricing differentials which are intriguing given both markets are represented by the same underlying asset base.
This has been of immense interest to us as the performance differential can be attributed almost solely to ownership structure. Before we proceed any further, Forza Capital does not imply one investment medium is better than the alternative. What we do wish to identify and bring to the attention of advisers is this structural pricing differential given it has an important role to play in the formulation of a client’s investment portfolio.
For a long time now the investment market has priced an illiquidity premium into unlisted property investments relative to their liquid peers. Historically this premium has been between 200 and 400 bps over its listed alternative and is seen as recompense for a loss of control, not being able to transact in a timely manner and for being locked into an investment (often) for a fixed time period.
Whilst the logic behind the illiquidity premium is sound, what actually transpired in the market seems to challenge this. In a stable market, the liquidity of listed property investments acts as they should allowing investors to enter and exit positions in a timely manner with low transaction costs. Conversely, in the unlisted sector there are no effective secondary trading markets, entering and existing an investment has far lower liquidity and there are far higher entry and exit costs. On this basis an illiquidity premium can be justified.
However, this does not address what occurs during correcting markets. Typically such periods of turbulence or correction see liquid markets haemorrhage capital with the fall in the share price often far exceeding the actual fall in value of the underlying asset(s). Certainly this is highlighted by the divergent performance between the listed and unlisted property sectors during the GFC which saw peak to trough the unlisted space fall 20% whilst the listed sector fell 60%.
Based on the above, the “real” assets fell 20% but the liquidity of the listed investments magnified this negative outcome two fold as investors ran for the door. This is not a topic we have seen much discussion on, however the pricing impact on investors was huge.
Over and above the pricing outcome there is another important aspect to consider – the very time capital stability is required to manage the investment and ride out the cycle is the very time it is flowing out the door. Many funds learnt this the hard way during the GFC and were forced to raise additional capital at a massive discount to NTA, thereby diluting existing investors and further exacerbating their already significant losses.
Herein lies the question not often asked nor answered – how important is the liquidity and at what cost are investors prepared to retain it? Within this answer one must also consider the role investors want property property to play in their portfolio.
Classical portfolio allocation typically sees property as a defensive hedge against equity risk. Now consider that listed property performance is closely (almost perfectly) correlated to broader equity performance. On this basis the hedge is eliminated. For advisers this is important to consider and address as the changing nature of markets may mean portfolio construction needs to be reviewed.
Certainly there is an argument to suggest the liquid property markets should offer a return premium to compensate for the volatility and the reduction in the defensive portfolio hedge but the reality is there is no perfect answer to the listed versus unlisted property value proposition.
Each has an important role to play in investment portfolios, but the nature of each is shifting. Advisers need to ensure they are across the changing facets of property market structure/performance and consider whether portfolio theory and a client’s property exposures need to be reviewed and/or adjusted to reflect these changes.
By Adam Murchie, Forza Capital
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