Real estate is not likely to be on the list of insurers' and reinsurers' current investment strategies, but it should be, argues Richard Major
Reinsurers' and insurers' keen interests in opportunities for increased yields and returns are well known. General insurers face uneven premium rates; in some sectors they are sufficient to sustain underwriting profits, while they are clearly not in others. Similarly, life insurers are challenged to generate yields adequate to fund the credit rates their policyholders expect. In earlier decades, real estate had occupied a more central place in insurers' thinking on investments, though liquidity issues at certain life insurers remain sufficiently recent to be instructive.
Today's real estate investments come, however, in a variety of forms with different expectations, ownership and performance characteristics such that institutional investors can take a more nuanced approach to real estate investing. Investments might include direct mortgages, real estate investment trusts, real estate operating companies and direct investments in real estate. The underlying properties can range from unimproved or under-improved land to property improved to its highest and best use, and leased under long-term contracts to highly creditworthy institutions. The latter is characteristic of institutional properties. Institutional real estate investments, however structured, tend to fall within one of several sectors: apartment, residential, industrial and office.
Each form or vehicle for real estate investment presents unique aspects of liquidity, transaction cost, return and risk, and the simple labour intensity of maintaining the investment. Straightforward extrapolation from one's personal investments makes real estate investment appear onerous, freighted with frictional costs, illiquid and subject to economic cycles. While this may be the case to a degree, by virtue of its very scale the real estate market demands attention.
Traditional thinking on real estate suggests it is either an investment sector for larger and stable life insurers or a capital-intensive means of securing office space and, perhaps, an opportunity for long-term capital appreciation that an insurer could take advantage of in a stress situation. Assessing the role of real estate in reinsurers' investment portfolios is complicated by the small number of independent reinsurers and the complexity of their businesses. The range of liabilities that Munich Re and Swiss Re fund renders obscure any fundamental link between reinsurance liabilities and real estate investments. Under Swiss Re's Admin Re programme, for instance, the enterprise acquires life-related liabilities through acquiring the direct insurer or entering into an assumption reinsurance transaction with it. The result is that Swiss Re assumes the role of direct insurer vis a vis the original insurers' policyholders.
Consequently, a more useful inquiry is to ask what role real estate plays generally in the investment programmes of insurance and reinsurance enterprises. The following charts look at this from two perspectives. Figure 1 is from the industry's leading insurers, as the members of the Dow Jones Titans Insurance 30 Index represent them - although in actual fact there are only 29 insurers, as one of the 30 is Marsh. Figure 2 considers the industry as a whole for the major regions - Europe, Asia, and North America.
Clear among US insurance concerns is the preponderance of fixed income investments, regardless of the company's primary line of business. This likely reflects managements', and much of their constituents', preference for investment yield to fund insurance obligations. Mortgage loans occupy a significant position in some insurers' portfolios, though their scheduled payment obligations bring them closer to fixed income securities than to interests in real property.
Notable among US institutions is the negligible scale of investments in real estate. The picture is somewhat different among insurance concerns outside the US. All seem to have some degree of real estate exposure, along with a relatively greater exposure to equities.
Quantifying the exact degree of real estate holdings is problematic. Companies do not necessarily segregate real estate held for investment from that held for their own use. Also, the different forms and vehicles for real estate investment may appear under different investment classifications, such as equities. Depending on the accounting conventions followed, real estate may be carried at market value or depreciated book value, with some discretion in determining the former.
A key measure of insurers' exposures to classes of riskier assets is the relationship they bear to capital and surplus. Figure 3 indicates this relationship for the sum of mortgages plus real estate as a percentage of capital and surplus. Notable are both the low percentages for the relatively more highly developed markets in Europe and North America, as well as the absolute declines in the proportions in all three markets. Real estate, whether in a "fixed income" format or as direct investments is simply not a significant allocation. Anecdotal evidence suggests the relative greater use of real estate related investments in Asian markets reflects the relative paucity of longer tenored bonds available in those markets, as well as perhaps a greater predisposition to investing in less liquid or "fixed" forms of investment.
Such low allocations to real estate are somewhat surprising, given the diversification effects that real estate can bring. Tables 1 reflects data that Deutsche Asset Management's RREEF real estate investment operation has generated on correlations among real estate and other primary investment indicators.Table 2 sets out the longer term performance for direct investments in real estate (NPI), investments in real estate investment trusts (NAREIT), and investments in equities (S&P 500). The correlations, when considered in view of the associated returns, suggest taking a closer look at real estate.
A reasonable concern is with the liquidity of real estate investments. Mortgages are amenable to securitisation, and there can be active markets for REIT stocks. Monetising direct ownership in real estate can, however, entail liquidity issues and transactional costs significantly beyond those characteristic of paper assets. Selling a property can take a year or more. This suggests that real estate occupies a balance sheet position analogous to that of funds of hedge funds. They should fall within the stratum of investments attributable to capital and which bears at most a remote likelihood of having to be monetised unexpectedly.
Charges under capitalisation models tend to reflect such reservations on liquidity. Standard & Poor's assigns a 4% capital charge for mortgages and an 18% charge on real estate, the latter to reflect risks perceived as slightly greater than that on common stocks.
Real estate has advantages relative to other alternatives to fixed income securities, such as private and public equities. That is, much total return on leased properties takes the form of income, not capital appreciation. This increases their utility in funding the cash outflows that insurance liabilities entail. Further, by relying less on capital appreciation for total returns, real estate provides the higher quality stream of investment earnings that both securities and rating analysts value. Real estate earnings derive from written rental contracts with, in the case of institutional holdings, highly creditworthy parties.
Further, returns tend to be serially correlated. Knowing the return from a property in one year is relevant to anticipating what it will be in the ensuing year. Income producing physical assets carry a predictability and transparency unlike corporate earnings and valuations that underlie the prices of typical corporate stocks. This supports a more active ability to manage portfolio earnings and performance, compared to the vagaries of the general stock markets. Real estate is not immune from economic cycles that affect stock investments, although a combination of performance characteristics unique to income-producing real estate have helped to support reasonable performance. This suggests institutional investors should base investment decisions on the performance characteristics and underwriting of individual assets, not on sector allocations. Real estate investing is a long-term strategy.
- Richard Major is director of Insurance Investment Strategy at Global Insurance Asset Management, Deutsche Bank.
These opinions are those of the author and do not necessarily reflect the opinions of Deutsche Asset Management.