ERES Conference 2010 External shocks on property markets & implications for asset allocation Anthony De Francesco, IPD AUS/NZ Saturday 26 June 2010

© IPD  Introduction  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocation  Summary remarks Outline

© IPD  Introduction  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocations  Summary remarks Outline

© IPD Some dimensions to the GFC - a brief review of events  External shocks  Need to identify and distinguish between structural and temporary shocks  Transmission of shocks across markets and countries  Non-linearity of shocks – how it impacts behaviour of markets from “normal” state  Capital markets and macroeconomy  Access to capital restricted – the role of financial (banking) sector  Pricing: an upward re-rating of risk across the complete asset space as well as across property sectors  Property markets  Performance impacted by fall-out in capital markets  Performance impacted by spill-over into space markets  Asset allocation  Standard SAA process frustrated with significant departure of asset performance from historical averages  Conventional models not robust to shocks

© IPD Objective of study  Gauge and assess the nature and influence of shocks on property markets  Examine the nature of the shocks  Explore the influence of shocks on the asset markets  Use econometric modelling to explore the interplay between shocks and asset markets  Indentify key drivers on return performance  Quantify relationships  Implications for asset allocation  Consider other dimensions which makes the framework more robust

© IPD  Introduction  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocations  Summary remarks Outline

© IPD The influence of global shocks - understanding the transmission mechanism across markets DIRECT PROPERTY CAPITAL MARKETS FINANCIAL (BANKING) SECTOR MACROECONOMY LABOUR MARKETS EQUITY MARKETS LISTED PROPERTY DEBT MARKETS  Valuation multiplier  B/S impacts  Liquidity run  Leverage  Non-linear effects arise due to shocks between Balance Sheet (B/S) and real economy.

© IPD The influence of global shocks - the interplay between various markets: display high correlations  Binding leverage constraints impacts the financial transmission channels which results in high correlation among macroeconomic aggregates.

© IPD  Softening in property cap rates in 2008/09 reflected deteriorating capital market conditions (CMC) with an upward re-rating of investment risk and weakening space market fundamentals (SMF).  Discount rates saw spreads shift upwards. Property yields & discount rates - adjustments towards new equilibrium

© IPD Comparing downturns - synchronised downturn with variation  A synchronised downturn was experienced in many property markets around the world due to common factor risks.  However, the nature of the downturns vary across country, reflecting country-specific risk.

© IPD Comparing downturns - the nature of downturns varies across countries

© IPD Synchronicity of property cycles - asymmetry between downturns and recovery  A synchronised downturn was experienced in many property markets around the world due to common factor risks.  However, the nature of the downturns vary across country, reflecting country-specific risk. Consider that Australia experienced a relatively sharp rise in capital return and now experiencing a relatively shallow downturn.

© IPD Various “states” of return profile - stable versus unstable periods  Downturns linked to changing macroeconomic conditions.  Occur with significant departure of markets from fundamentals (associated with shocks).

© IPD  Overview  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocations  Summary remarks Outline

© IPD  Simple bivariate regression,  Following Boswijk (1994), a single equation ECM of a time series, conditional upon, can be expressed as follows,  The model can be extended further to capture additional short-run dynamics, such as stationary covariates. The formulation becomes Long-run componentShort-run dynamics Stationary covariates Modelling strategies - a variety of time series models and cross-sectional analysis

© IPD Data set for empirical analysis  Property investment returns  Primary markets: Australia (AUS), New Zealand (NZ)  Other markets: USA, UK and CAN  Economic variables  Output variables: GDP growth – nominal and real  Labour market: employment growth and unemployment rate  Investment markets  Property: direct, unlisted and listed (REITs)  Other assets: bonds, listed shares  Time series  Annual data spanning around  Quarterly data sets

© IPD Macro-property investment - the interplay between labour markets and real economy driving return  There is a strong link between the real economy, labour markets and property markets.  Correlation between nominal GDP growth and property returns:  Correlation between employment growth and real property return: 0.74.

© IPD The influence of macroeconomy - the impact of real economy varies across country property markets  The variable impact on property markets is reflected with varying degree of positive correlation values.  This provides some support for a diversification strategy.

© IPD The influence of macroeconomy - cycles have significant influence on relationship  Moderate correlation values between GDP growth and property returns.  Correlations fall away with the purging form the sample period.

© IPD Property cycles and real economy - the relationship between capital growth and labour markets  Countries with steep declines in capital growth have experienced a rapid deterioration in labour markets.

© IPD  Overview  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocations  Summary remarks Outline

© IPD Competing asset classes - significant divergence between short- run and long-run return performance  Common factor risk saw a downturn in returns in 2008, significantly away from long-term averages.  Direct property allocations rose significantly above their target (or SAA) allocations.  The current overshooting in returns experienced by specific investment classes suggests that markets are still in adjustment phase towards equilibrium.

© IPD State-space and risk-reward - current market dynamics highlight that markets are in transition phase  Different “state” environments reflect significant movements in volatility.  The distinctly different states of the world require different strategies for asset allocation.

© IPD  Introduction  External shocks and property markets  Modelling approach and preliminary results  Implications for asset allocations  Summary remarks Outline

© IPD Summary results  Direct property returns  Influenced by a variety of macroeconomic aggregates, but highly contingent on cycle profile  Importance of labour markets  Property cycle patterns vary across country due to varying influence of financial sector  Asset allocation  Distinction between permanent and transitory shocks  Need to consider different “states” when formulating target asset allocations  Research  Expand research to include more countries  Explore the impact of shocks across both direct and listed property markets

© IPD Intellectual Property Rights and use of IPD statistics as benchmarks Whether in the public domain or otherwise, IPD's statistics are the intellectual property of Investment Property Databank Limited. It is not permissible to use data drawn from this presentation as benchmarks. © Investment Property Databank Limited (IPD) Database Right, Investment Property Databank Limited (IPD) All rights conferred by law of copyright and by virtue of international conventions are reserved by IPD Contact Anthony De Francesco Managing Director Telephone: Mobile: +61 (0) IPD – AUS/NZ Address: Suite 3, Level 3, 275 George Street, Sydney NSW 2000, Australia Web: IPD - UK 1 St. John’s Lane London, EC1M 4BL United Kingdom Tel: +44 (0) Web: