European Reits: volatile but cheap

Although property shares made great headway in the first half of 2011, returning 13.6 per cent in comparison with 6.9 per cent from European equities, the market was sent sharply downwards just after the mid-year point as concerns mounted over the European sovereign debt crisis and evidence that the global economy was not as robust as previously thought.

European-listed real estate did not escape the turmoil in the markets, but it certainly held up better.

It was the threat of falling earnings that made investors drop equities like hot cakes. Income from listed property, however, is much more secure and defensive than other shares, which might explain why they have not fallen as far.

Income from property comes from rent, which is protected by a lease. The legal nature of a lease means that tenants can’t just stop paying rent when times get tough. As a result, listed real estate is a good investment option if you like stable earnings.

Continental-listed property companies can offer a superior income return to their UK counterparts and also to the wider European equity market. UK-listed real estate stocks only pay a dividend in line with UK equities, in spite of being invested in a high income part of the market.

This is because continental real estate investment trusts (Reits) have much higher payout ratios than the UK. As the UK market is more cyclical with peaks and troughs, UK companies will tend to hold back some income to develop and exploit the peaks in the cycle. Capital growth is, therefore, a greater component of total return for UK stocks than for continental property companies. Valuations on the continent tend to be less cyclical and more stable.

In addition, the superior income returns from European-listed securities excluding the UK mean their returns are more akin to those from direct property.

The correlation between individual stocks in any single country is high, which makes it difficult to add value if investing in a single sector like listed property, or in a single market like the UK. A pan-European strategy means that investors can enhance returns above those from a single country.

Sometimes, property shares are perceived to be more risky than holding direct property. Indeed, over one month, listed property is more closely correlated to equities than direct property. This is mainly because short-term performance is often driven by investor sentiment and the effect it has on share prices (see chart).

However, over the medium term, this relationship changes and listed property becomes increasingly correlated to the direct property market. The same political and economic influences drive both parts of the property market and, over time, this means returns will, in the end, follow almost identical trends. Assuming a hold period of two years, the correlation between listed and unlisted is high at 0.8. As such, assuming these assets are held for a reasonable length of time, holding listed property is no more risky than holding direct property.