by Norman Bowie
One of the reasons for the current desire to improve liquidity in the property market has undoubtedly been the emergence of “short-termism” in the performance measurement of all markets, with the inevitable corollary that managers’ performances are equally subject to short-term judgments.
The abandonment of quarterly valuations by a large securities house — which obviously felt vulnerable to unfair criticism by its clients — is an interesting reaction to the recent volatility in the world’s securities markets. Even valuations at 12-month intervals only present camera shots which could give totally different pictures if taken three months earlier or later.
Should securitisation become a new additional feature of the property investment market it remains to be seen whether or not there will be an increase in price level volatility. Perhaps the underlying asset values will still follow longer-drawn trend lines, while the unit prices will reflect short-term changes in the premium or discount margins, partly reflecting analysts’ views on rental value expectations prior to actual reviews and other events which affect property income, such as the impact of the new non-domestic rates in 1990 and VAT next year.
Short-term judgments and the introduction of indices in all markets have reinforced the herd instinct among managers: it is very lonely out in front, and even more so if you bring up the tail. A small deviation from the median brings little criticism or thanks, but the deviationist from the popular line runs the risk of either the sack or, at best, minimal gratitude coupled with “we expect you to keep this up”.
It is somewhat surprising that the MacDonald moving average system has not been more greatly used. Chartists in the securities market use this extensively, often running two lines on the charts, the 100-day and 30-day lines. To introduce the system into the property market but over longer intervals would require more frequent valuations, at least quarterly, but with the arrival of the desk-top computer and an increasing literacy among valuers, the system could well be beneficial to investors and advisers at little cost.
The original MacDonald system was over a six-month period, and for property probably an overall timespan of a year would be right to throw up useful changes in underlying trends. There would be considerable merit in applying the system not only to indices but also to individual portfolios, property categories and locations, apart from looking at movements in capital and rental values as well as yields.
Even so the property market will still be an imperfect one because each property is unique, with its own special characteristics: every property has a possible extra potential value to someone, who likes to remain anonymous and thus pick it up cheaply. This means that to be of help, the moving average system must reflect the movement in values of a reasonably sized pool of not too dissimilar properties, otherwise it could become a useless exercise.
Performance measurement of all markets has tended to become dominated by total return, ie combined capital and income growth. Undoubtedly for the short-term investor, and perhaps trader, this concept is an unacceptable judgment. The longer-term investor must put much more weight on future increases in income which not only will eventually underpin future capital growth but also cut through any short-term volatility in capital values. To this longer investor sudden ups and downs in the market mean little because he can ride through them. It is also impossible to liquidate a portfolio and rebuild it in a year or two’s time. While dividends can change each year, rent is normally adjusted only once every five years. There is much merit in the old adage “Look after the income and the capital will look after itself”.
The adviser and investor in property for pension fund purposes has another aspect to face. The actuarial valuation of a pension fund is essentially a comparison, both by term and by amount, of its liabilities and its assets. The liabilities are the benefits payable under the scheme and those to which the members are prospectively entitled. The assets are the income from the investments, its eventual sale proceeds and future contributions.
It is essential that the streams of income (assets) and expenditure (benefit payments) are valued consistently. The benefit payments are discounted at a long-term rate of interest (allowing for future salary and pension increases) as are the assets, making provision in suitable cases for increases in dividends and rents and their effect on the ultimate redemption/sale proceeds.
The value placed by the actuary on a property portfolio therefore may well differ from the market value at the valuation date, owing to a different perception of the appropriate discount and expected growth rate. This would be of little consequence unless it were planned to sell the properties. The relative importance of the expected income stream and likely sale price would depend on the profile of the scheme and whether it were necessary to realise assets in order to pay benefits.
It can be argued that a high-yield property portfolio with low growth-rate expectations may be a better bet than the low-yielders of the so-called prime sectors. Short leaseholds producing a high cash flow would appear to fit in well with the picture, particularly for some schemes.
An important factor not often discussed with advisers is the age profile of the scheme’s members and also whether the scheme is showing signs of maturity, with declining membership and pension payments exceeding investment income. The relative importance of the actuarial valuations, and perhaps the validity of that approach, are to property advisers and investors not dissimilar to Sir Winston Churchill’s description of Russia — a riddle wrapped in a mystery inside an enigma — that, of course, was long before glasnost and perestroika.
It is time, in the interests of all concerned, that a study of this subject in depth should be undertaken. Meantime, advisers and managers can hardly be blamed if they adopt a policy to match best the performance tests to which they are subject without the trustees being able to give them a clear lead as to the targets they need to meet in order to attain the best requirements of the scheme and to give the best benefits to employees at the lowest cost to them and employers.
This clarity would then enable investors to decide the role which property securitisation, when it comes, will play in their investment activities and underline the importance or otherwise of greater liquidity in the property market. If it does come about, the turnover in the market would increase considerably, as market-makers will no doubt quickly arrive on the scene. The other great advantages will be, it is to be hoped, much reduced costs of sale and purchase (unless the margins are far too wide) and earlier settlement dates.
The actuarial valuation of life assurance companies performs a similar but not identical function to the valuation of pension funds. Both valuations are concerned with solvency, but whereas the secondary purpose of a pension fund valuation is to determine the rate of contribution which should be paid for the future, the corresponding purpose of the life assurance valuation is to determine the level of reversionary and terminal bonuses to policyholders and transfer to shareholders in non-mutual companies. The time horizon for life assurance may be shorter than that of pension schemes.
Insurance companies’ funds are also subject to tax, so different factors can affect their investment philosophy from that of the tax-immune pension funds and charities. The Government has recently issued a consultative paper as it does not think insurance companies, and thus policyholders, are paying enough tax. So the issue has become a little murky.
It would seem that the investor and adviser to insurance companies may well have a different performance target to meet from that of pension schemes, because its emphasis is partly on growth in income and partly on capital growth.
One cannot but help having the feeling that these actuarial valuations may well be on a very conservative basis.
If so, to be one of the last few policyholders in a closed life fund or one of the long-surviving members of a closed pension scheme could be highly attractive and beneficial.
The smaller investor may well be able to profit from the shorter cycle movements in the markets by buying, selling or holding cash at the right time. Large investors do not have this ability so, inevitably, they have to ride out the troughs and cannot take advantage of the peaks.
Property managers and their professional advisers could enhance the performance of funds under their control by having clearly explained to them more precisely the targets to be achieved in terms of time, income and capital growth.
Additionally, a better understanding by the property world of the approach by the actuarial world to investment performance, both actual and anticipated, is undoubtedly needed. No doubt the actuaries could also learn something from property experts.
At least the property company world does not have to worry about the investment philosophy discussed above. The market looks for the best overall total return from capital and income. Income and capital gains are taxed at comparable rates, and although the shareholder suffers double capital gains tax it is at least relieved by indexation against inflation so that only real gains are taxed.
So the investor needs the best advice to make the right choice of investment. It is a challenge to the landed profession to sort out investment target needs, never overlooking the effects of tax — both capital and income — and tax allowances over the investor’s time-scale.