Author Archives: riskviewadmin

What about real estate ETF investment strategies?

There are a number of strategies used by ETFs that are not available to other real estate fund managers, which provide the ETF with more flexibility to react to market changes. ETF fund managers can follow a very passive strategy, these funds track an index, but funds can also be actively managed. There is no limit as to how actively they can manage the portfolio to focus on alpha strategies.

Figure: alpha-beta strategies road map

beta
Source: Deutsche Bank, 2012
For example the majority of real estate ETFs are passive investments, meaning they track a benchmark index. Examples for passive beta strategies are:

  • iShares FTSE EPRA/NAREIT Asia Property Yield Fund
  • iShares FTSE EPRA/NAREIT Developed Markets Property Yield Fund
  • iShares FTSE EPRA/NAREIT UK Property

Few funds use a different approach than market capitalisation, considered smart or adjusted beta such as

  • BMO Equal Weight REITs Index ETF (ZRE-TSX)
  • PowerShares KBW Premium Yield Equity REIT Portfolio

There is currently only one true active fund, which differs in the asset allocation approach:

  • PowerShares Active U.S. Real Estate Fund

Invesco’s PowerShares Active US fund uses quantitative and statistical metrics to identify attractively priced securities and manage risk.
Physical ETFs can use the full spectrum of asset allocation tools for increasing or decreasing exposure to a specific style, sector or capitalisation

  • Sector rotation strategies
  • Arbitrage strategies
  • Hedging and defensive strategies
  • Stock-lending revenue strategies (from short sellers)
  • Market neutral strategies
  • Maintaining exposure during a manage transition
  • Hedging tools for shorting
  • Transition management

Being able to sell stocks shorts, provides the ETFs with downside protection in a crisis.

Synthetic ETFs

on the other hand are not based on stocks directly. They deliver the performance of the index they track via a swap contract. This technique allows them to have a smaller tracking error than conventional funds. The ETF manager builds a so-called “substitute basket” – sometimes also called “collateral basket” – these are assets of good credit quality delivering a low but risk-free return. In addition he enters into a swap contract with a counterparty – normally an investment bank – whereby it exchanges the performance of such a basket for that of the index.

Leverage

Not all ETF’s are based on stocks. Some are based on derivatives, such as options and futures. For example commodity ETFs use futures to replicate the performance. The use of derivatives allows leveraging to do a multiple of what the market index does. Leveraged ETF’s seek to make 2 or 3 times the return of their target index, while leveraged inverse ETF’s seek to earn a multiple when the target index declines.
While these types of ETFs are much more common for commodities, there are currently only a couple of real estate ETFs using leveraged performance. Two noteworthy examples are applying a beta multiplied strategy are:

  1. Direxion Real Estate Bull 3X – Triple-Leveraged ETF
  2. Direxion Real Estate Bear 3X – Triple-Leveraged ETF

These funds deliver 300% (3x) of a selected benchmark index. They create short positions by investing at least 80% of their assets in derivatives: such as futures contracts; options on securities, indices and futures contracts; equity caps, floors and collars; swap agreements; forward contracts; short positions; reverse repurchase agreements (REPO); exchange-traded funds (“ETFs”); and other financial instruments that, in combination, provide leveraged and unleveraged exposure to selected index. The remaining is typically invested in short-term debt instruments that have terms-to-maturity of less than 397 days and exhibit high quality credit profiles, including government securities and repurchase agreements.
Leveraged ETF’s are generally used for short-term trades — not as long-term investments, since markets go up and down, so gains and losses are both amplified.
The largest provider of physical real estate ETFs is Blackrock through it’s ishare brand. Main stock exchanges are NY, London and Canada.
Figure: Fund manager and number of funds

managers

Source: Nicole Lux

Next week: AUM, how large is the investment universe, what about performance?

Week 2: Understanding real estate ETF structures

In the previous session we have established that ETFs are in principal open-ended investment companies, whose shares can be traded on the stock exchange. (for a list of real estate ETFs traded on LSE download FTSE ETF)
In general investors are seeking diversified returns when they are looking to invest in a mutual fund such as a real estate securities fund. Investing in a mutual fund provides investors with exposure to a portfolio of assets in a specific sector or region.
Since 2000 a new style of mutual fund has entered the European market, the so-called exchange traded funds (ETF). Compared to a mutual fund they offer the following advantages:

  • they have a higher liquidity and can be traded on a stock exchange just like any other share. Thus, they are yet another product that offers real estate exposure on a highly liquid basis for an otherwise illiquid asset class
  • Accessible to retail investors, require smaller initial investment amounts
  • Lower cost, typically no initial fees

However, in some other aspects they are more similar to Property Unit Trusts (PUTs) than real estate securities funds.
Any investor who has mastered the understanding of Property Unit Trusts, will see the similarities and find the ETF structure easy to understand.
Just like the PUT, the ETF issues or creates units based on the NAV of the underlying portfolio. The difference is that the shares of an ETF can be traded throughout the day on the exchange and the portfolio does not consist of physical properties but shares of property companies or REITs.
Figure: Physical ETFs
physical
Source: N. Lux, 2013
This also means that the price of an ETF share on the stock exchange is subject to the forces of supply and demand and the trading price can be different to the fund’s NAV.
When the ETF creates new units it issues bundles of shares, which  are being bought by the “authorised participant”. This participant can be a market maker, broker, large institutional investor etc, who is then trading individual shares on the stock exchange.
Because the trading price does not completely reflect the NAV, ETFs behave more like an individual share than a mutual fund, which is investing in property company/REIT shares. However, ETFs have different liquidity levels themselves and the more liquid ETFs are expected to trade very close to their NAV.
Table: Example trading price vs NAV
Example
Also for mutual funds there are differences in pricing, for example an open-ended fund (i.e. PUT) will trade equal to its NAV while a closed-end fund can trade at a premium or discount (discounts are expected to be larger than for ETFs).

Portfolio setup and strategies

The ETF itself originates with a sponsor, meaning the company or financial institution which chooses the investment objective of the ETF. In the case of an index-based ETF, the sponsor chooses both an index and a method of tracking its target index. Index-based ETFs track their target index in one of two ways.
1. A replicate index-based ETF holds every security in the target index and invests its assets proportionately in all the securities in the target index.
2. A sample index-based ETF does not hold every security in the target index; instead, the sponsor chooses a representative sample of securities in the target index in which to invest. Representative sampling is a practical solution for an ETF that has a target index with thousands of securities.

Target indices include:

US Indices

  • Cohen & Steers Realty Majors Index
  • Dow Jones U.S. Real Estate Index
  • Dow Jones U.S. Select REIT Index
  • FTSE EPRA/NAREIT North America Index
  • FTSE NAREIT All Mortgage Capped Index
  • FTSE NAREIT All Residential Capped Index
  • FTSE NAREIT Industrial/Office Capped Index
  • FTSE NAREIT Real Estate 50 Index
  • FTSE NAREIT Retail Capped Index
  • IQ US Real Estate Small Cap Index
  • KBW Premium Yield Equity REIT Index
  • Market Vectors Global Mortgage REITs Index
  • MSCI US REIT Index
  • S&P United States REIT Index
  • Wilshire U.S. Real Estate Investment Trust Index
  • Morningstar Real Estate Index

Other Indices

  • FTSE EPRA/NAREIT Developed Europe ex UK Dividend+
  • FTSE EPRA/NAREIT UK Index
  • FTSE EPRA/NAREIT Developed Asia Dividend+ Index

Both of these replication methodologies are called physical ETFs. In addition to the physical ETF there are so-called “synthetic” ETFs, which deliver the index performance via a swap contract. The total return will then be delivered by the swap contract, while the cash in mainly invested in low risk collateral such as zero coupon bonds, which were acquired at a discount or government bonds.
Figure: Synthetic ETF
synthetic

Source: N. Lux, 2013
Real Estate ETFs are currently mostly physical ETFs, meaning they invest in a basket of physical securities. We will analyse the different risks related to these strategies in the next session.

Downloand PDF Property ETFs week 2

Next week 3: Understanding the risks of ETF Structures vs real estate REIT funds

Real estate ETFs – A new investment product to gain real estate exposure?

Follow this weekly blog to broaden your knowledge on real estate ETFs.
The following series of six essays/notes will discuss structures, risks and investment quality of property ETFs and assess their suitability to gain real estate exposure from an investor’s point of view.

Week 1

Introduction

Week 2

Understanding the differences in real estate fund vs real estate ETF structures

Week 3 Investment strategies of real estate ETFs
Week 4 The investment universe (AUM, specialisation & fees)
Week 5 Investment quality and performance
Week 6 Trading strategies and risks

Week 1: Introduction

Over several decades now it has been one of the primary goals of the real estate investment industry to find new ways to make real estate investments more liquid. Efforts started with increasing market transparency for the physical asset and fund investing directly in the physical assets by

  • Introducing performance/benchmarking measurement
  • Making transaction data more available through databanks
  • Making portfolio data including valuations available in fund prospectus and fund audit reports

Multiple ongoing discussions have also been held on finding the optimal fund structure.

  • Closed-end property funds
  • Open-ended property funds (i.e. Property Unit Trusts)
  • Fund of funds
  • Investment trusts, Real estate investment trusts (property companies, investment companies)

There are two main types of fund structures: open-ended or closed-ended. Closed-ended funds include investment trusts, real-estate investment trusts (REITs) and property funds traded. The closed-ended structure makes life simpler for fund managers, as they do not have to deal with inflows and redemptions (avoiding forced selling in a falling market). Closed-ended funds also allow higher gearing levels (debt-equity ratio) to boost returns, although gearing exacerbates losses in a falling market, as seen during the last crisis 2007/08. The major downside of the closed-ended structure is that a fund’s shares can trade at a discount or a premium to their true net asset values (NAVs), and there is typically hardly any secondary market to trade these shares. Open-ended funds include property unit trust or OEIC (open-ended investment companies).  The fund manager creates or cancels units that investors buy or sell. The pricing of units typically happens ones per day and directly reflects the value of the underlying assets. Fund-of-Funds are fund managers who invest in other closed-ended funds. They can offer superior diversification, but are more passive as they don’t directly manage the underlying assets. They also belong into the category of closed-ended funds.
Both closed-ended as well as open-ended fund structures have been criticised at different points in the property cycle. Closed-ended funds have been found too illiquid and inflexible as it is difficult for investors to exit from them. Open-ended funds, which are supposed to be more liquid also had their problems managing redemptions, and some were found to close due to large money outflows in a down-market. However, from 2000 onwards it wasn’t just about different fund structures but totally new products have also emerged in the European market:

  • commercial mortgage backed securities
  • property derivatives
  • property notes
  • property ETFs

Like unit trusts and OEICs, ETFs are open ended investment companies, meaning that you can buy or sell their shares, however the shares are much more liquid as they are being traded on the stock exchange on an intraday basis.  Hence, the difference to a property securities fund or PUT is that their trading price differs from the underlying NAV. The price of an ETF share on a stock exchange is influenced by the forces of supply and demand.
Figure 1: Basic ETF structure
ETFF2
Source: Nicole Lux 2013
The market of ETFs has especially grown in other sectors such as commodities, equities, fixed income, currencies. They are used by retail and institutional investors alike.

Next: Understanding the different structures of ETFs

Download pdf Property ETFs week 1

New European CMBS issuance rules 2.0

The April issue of Real Estate Capital confirms investor interest in reopening and reviving the European CMBS market.

Changes to the new style CMBS demanded by investors are around information disclosure, independence of advisers and most importantly control rights in events of default.

While some suggested changes are helpful such as the ability to sack property managers without cause after a loan default, with managers obliged to transfer information, selecting and negotiating with a new property manager can be a lengthy process and requires in-depth knowledge of what is needed to transform the assets into a performing loan.

Many requests address rights of the controlling class, noteholders should be aware though that where only a portion of the loan has been securitised this controlling party is often the B-noteholder or subordinate lender, who has different interests from the senior bond holders. In addition the senior noteholders are in most cases not real estate professionals.

Of course terms of engagement of rating agencies are not a secret and follow defined fee structures. It is up to investors to enquire.

http://www.crefc.org/Global/CMSA-Europe/Committees/European_CMBS_2_0_Committee/European_CMBS_2_0_Committee/

Commercial real estate risk news

What’s new in risk modelling?

A timeless, comprehensive and practical reference tool and self-study guide

After more than 10-year of professional experiences, I decided, it was time to share my knowledge. Today, there are strong forces in the financial industry pushing for the less developed commercial real estate market to adopt more complex quantitative approaches in assessing real estate risk. However, knowledge is often not passed on and materials available have not kept up to include new models and concepts to ensure they become common practice and general industry knowledge.
My answer to the problem was a book that is a practical guide for those wishing to gain further skills and knowledge in financial modelling for real estate investments not only in Europe, but all around the world. The book is aimed at professionals and graduate students of real estate investment, real estate finance, surveying and land economics who do not have a comprehensive mathematical, statistical and programming background. But it will also give students from other finance and accounting courses an understanding of how to apply models from equity and fixed income analysis to real estate as an alternative asset class. By using an interdisciplinary approach it closes the gap between real estate and other financial asset classes and shows how market and credit risk models from these areas can be adopted and adapted to analyse real estate investment. In addition, it bridges the gap between the pure quantitative financial modeller and the professional analyst. It provides financial modelling for real estate debt, equity and derivates to underpin investment and credit decisions.

What are the key features of the book?
– Summary of key concepts featured at the beginning of each section
– Each model or tool described is accompanied by a working example using excel or VBA
– Step-by step guide to set up new models
– Useful links for data sources and analysis tools at the end of each section
– Summary of literature suggested for further reading at end of each section

To find out more:
http://www.euromoneybooks.com/product.asp?PositionID=search&ProductID=16171&Catalog=EMB&results_per_page=10&search=Real estate risk analysis&SearchTypeID=&SearchInterestID=

or for more information on the author and other latest articles:

http://www.nlux.co.uk