Home runs

Investors should head for property hedge funds which fish in markets inefficient and deep, experts say

"Property is the dream asset class," says Paul Ogden, head of property derivatives development, CBRE-GFI in London. It is inefficient and it is deep. GFI brokers over-the-counter (OTC) property derivatives for hedge funds and others wishing to gain exposure to the asset class. It says it routinely does deals for hundreds of millions of pounds, with uncertainty of tens of basis points. The arbitrage opportunities are, therefore, substantial.

New Star's Global Property Fund invests directly in property, predominantly in Europe and Asia. Its rental income outperforms funding costs, says Robin Carr, New Star's European property acquisitions manager. Using around 60%-70% gearing further boosts income.

Its income derives from the rental and the capital growth on its holdings, explains Carr.

New Star's fund invests in Europe ex-UK and Asia because this is where it sees the most value. The UK, alongside the US, are two of the most overpriced markets in the world, Robin Carr explains.

On the other hand, Raymond Lahaut, portfolio manager at Swiss Finance & Property Corporation's SFPC Long/Short Real Estate fund, invests in listed property managers globally. The fund can gain exposure to different markets and sectors, gaining alpha through picking the best management teams and companies able to make the most profitable developments.

It also focuses on managers actively adding value to their portfolios by redevelopment, renegotiating rental contracts, decreasing vacancy and selling off mature assets for better opportunities in the market.

SFPC is involved predominantly in commercial real estate, including retail and industrial, and a small amount of residential properties.

Around 70%-80% of its portfolio is in long-term investments, taking sector views that take time to play out. The remainder of its portfolio is reserved for more opportunistic deals, such as IPOs.

Around 75% of CBRE-GFI's property derivatives business involves commercial property. Hedge funds are more active in this area than in the residential property market, Ogden notes. Contracts are structured as total return swaps on IPD property indexes on one hand and Libor plus a spread on the other.

Hedge funds are taking both sides of OTC transactions. Ogden believes such derivative exposure of property makes perfect sense for hedge funds. "There is only one reason I can think of for acquiring actual property, and that is alpha generation; for example, property redevelopment to add value," says Ogden. Such activity is more likely for private equity funds than hedge funds, he adds.

"That is the classic view of the non-property specialist," says Carr. He notes there are a multitude of other ways of playing property, to which derivatives do not deliver exposure. There are re-letting, restructuring and light-refurbishment possibilities, for example. There are many ways for active managers to extract value out of property, he states.

Property derivatives are good products but they're simplistic," says Lahaut. He believes there are other reasons to play the sector directly. "Derivatives are good for tactical allocations, but you miss the opportunity for active management, or pairs trading countries and sectors."

Using derivatives also allows funds to take quite sophisticated sector views, Ogden notes. Linking the structure to a UK high-street retail index allows hedge funds to play a view of high-street shopping against web-based shopping, the property of which is classified as industrial, he explains. Derivatives can easily be structured in many locations and on many sectors for which IPD has an index.

Lahaut says there is a high level of diversification in real estate, both between different sectors of property and between different regions. The UK office market is particularly strong, he notes. Residential property there has peaked, - though he does not expect it to fall, due to continuing favourable demographics and supply factors - and commercial property shows decreasing vacancy and increasing rental levels.

German commercial property is weak, Lahaut believes. It is also the one country in Europe where he sees a favourable market for residential property.

Carr notes that the German market is very fragmented. In Berlin and Frankfurt, for example, he concedes commercial property is weak, although the fund is active in these areas in the expectation they will appreciate over time.

In Munich, however, the market is already on the ascent.

SFPC conducts a pairs trade, selling UK commercial property managers long and German managers short. In Germany, it is also interested in private developers acquiring real estate from city councils, developing them and selling them on to tenants.

Outside Europe, Lahaut points to Singapore and Hong Kong as particularly attractive markets for long investments. Having bottomed out for years after the Asian default, commercial property in these markets is making a comeback, especially in Singapore.

The yield spread - the difference between property yields and bond yields - is also still quite high. Australia and the US are overvalued, he says, and the fund is waiting for the cash to finish coming in before it will short them.

For companies that do wish to take physical delivery of property, derivatives can be a useful bridge between taking the decision and acquiring the property, Ogden says. "Execution on the property spot market is T+3... months," he adds.

Ogden notes GFI's residential property business, around 25% of the overall, has minimal hedge fund involvement, if any. Although he does believe it has prospects to capture managers' imaginations in the future. Contracts for difference are based on the Halifax House Price Index All Buyers All Properties Month On Month Non Seasonally Adjusted. It is the biggest asset class in the UK, with significant inefficiencies and scope for hedge fund involvement, he says.