Diversification benefits in the Finnish commercial property market/Diversifikacijos nauda suomijos komercinio nekilnojamojo turt

1. INTRODUCTION

Internationalisation of the European real estate market has been a growing trend of the millennium, the cross boarder investments accounting for 63% in 2007 (Jones Lang Lasalle, 2007). This trend reached the Finnish property market in 1998, when the first international real estate investments were conducted by an opportunistic U.S. investor. The internationalisation took off, however, only in 2002, when 7 international investors entered the Finnish market (Catella, 2005). Today, cross border investments represent about a half of the yearly transactions volume in the Finnish commercial real estate markets, and more than 70 international investors have entered the market. (KTI, 2008; Catella, 2008a).

Modern portfolio theory (Markowitz, 1952) suggests that investors base their asset allocation decisions on the risk-return characteristics of the asset returns, as well as on the co-movement of the asset returns, and thereby provided diversification benefits. The objective of gaining diversification benefits has been shown as the main motivating factor driving also international real estate investments. The early questionnaire surveys by Worzala (1994) and Newell and Worzala (1995) confirm that the primary reasons for investors to invest in international real estate are diversification benefits and possibilities to achieve higher returns. As other important rationales the respondents had chosen e.g. the lack of domestic investment opportunities, currency strength, diversification benefits due to different economic and political environments, the ability to invest in property-specific feature that are different from domestic opportunities, matching investments to liabilities and the low correlation between the asset returns in the countries (Worzala and Newell, 1997). Similarily, McAllister (1999) showed that the potential benefits U.K. investors saw in international property investments were diversification, high returns, liability matching and support to core business. The aim of this paper is to determine, if the Finnish commercial real estate market provided diversification benefits in its early years of internationalisation. As international real estate investors in the Finnish property markets include investors with both real estate only, as well as mixed-asset portfolios, the diversification benefits are studied both in terms of a Finnish mixed-asset portfolio, as well as an international real estate portfolio.

The international investors in the Finnish property markets represent a broad range in terms of their origin, type and investment strategies. Figure 1 shows the international investors by their country of origin. More then 80% of the international investors in the Finnish property markets were of European origin, most commonly from other Nordic countries (32%), Germany (22%) and U.K. (15%). The investors from outside Europe were either from the U.S. or Israel, and the group "other" includes investors with more than one country of origin.

A possible explanation for the strong representation of European, and especially Nordic, investors in the group of international investors in the Finnish markets are the challenges related to international investment. In the questionnaire surveys of Worzala (1994), and Newell and Worzala (1995) the respondents identified as most important problems of international property investment the lack of local expertise, inability to identify acquisitions in a foreign market, taxation differences, potential for misunderstandings due to language and cultural differences as well as the management and operation once investment is made. Again, the survey of McAllister (1999) confirms that investors regard the information costs and high costs of diversification as the main problems associated with foreign real estate investments. Thus, European investors might feel that the information-related risks are lower when investing within the same continent. The Nordic countries, on the other hand, share similar legal structures, and the cultural differences between the countries are low.

The following chapter presents the research conducted in the field of diversification benefits in international property portfolios. Thereafter the data and methods used in the analysis, and possible limitations related to them are discussed. The results of the analysis of diversification benefits provided by the Finnish market are discussed separately for Finnish mixed asset portfolio and international real estate portfolio. The last section draws the conclusions and gives suggestions for further research.

2. LITERATURE REVIEW

The benefits of including real estate in a mixed-asset portfolio including financial assets, most commonly stocks, bonds, and real estate, has been extensively studied during the past two decades. Seder et al. (1999) provide a review of the early studies summarising that property has a low correlation with other asset classes, and thus should have a place in a mixed asset portfolio. Due to the data availability issues most of the early studies analysing mixed asset portfolio are performed on U.S. and U.K. data, the amount of research being more limited in the continental Europe. For more recent studies in Europe, Hoesli et al. (2004) provide an analysis of benefits of including real estate in mixed-asset portfolio using the perspectives of seven countries: Australia, France, the Netherlands, Sweden, Switzerland, U.K. and U.S. According to their analysis, property investments provided diversification benefits in all of the studied markets, the optimal allocation to real estate varying depending on the risk level and country, being on the 5 to 15% range for unhedged returns and in the rage of 15 and 25% for hedged returns.

A large part of the investors investing in international real estate, however, have a real estate only portfolio. Among the early studies on international diversification benefits in real estate portfolios is that of Wurtzebach (1991). He evaluated the diversification benefits of a property portfolio consisting of equal allocations of office investments in London, Frankfurt, New York, Paris and Sydney markets. All returns were measured in local currency. The diversification benefits were measured through reduced volatility of vacancy rate, rental values, capitalisation rate and projected rates of return. The international diversification reduced the volatility of each component compared to the portfolio consisting of only U.S. real estate. In comparison to each of the individual markets, the results were more varied, but in many of the cases international diversification reduced the volatility of the portfolios.

Gordon (1991) analysed the diversification benefits for an investor holding U.S. and U.K. real estate, concluding that the investor would benefit from the international exposure. The analysis was conducted based on local currencies. Also Worzala (1992) studied the diversification benefits of U.K. and U.S. real estate, finding gains from international diversification benefits. She performs the analysis with and without taking the currency fluctuations into account, and notes that the level of diversification benefits is higher if local returns are used. A similar, pair-wise country analysis is provided by Hudson-Wilson and Stimpson (1996), who analyse the diversification benefits of including U.S. real estate in a Canadian investors' portfolio. The diversification benefits were analysed by comparing a portfolio of only Canadian real estate to a portfolio holding up to 20% U.S. real estate. The analysis is conducted in returns denominated in Canadian dollars, i.e. assuming unhedged returns. The analysis of incorporating U.S. assets into the portfolio in conducted in three stages: first, analysing the benefits of incorporating aggregate U.S. real estate; second, analysing the benefits of incorporating various U.S. property types; and third, analysing the benefits of incorporating property from individual U.S. cities into the portfolio. The authors conclude that international diversification was beneficial, in all of the three studied levels. The authors conduct the analysis also based on returns in local currencies and due to the differences in results, suggest, that currency risk might have a substantial effect on the investment.

Addae-Dapaah and Yong (1998) study the international diversification benefits of international office investments in Asia-Pacific from Singaporean investor's perspective. The authors find substantial diversification benefits in international property investments. The authors also study the significance of currency risk on the returns and correlation coefficients, concluding that the impact of exchange rate volatility is marginal.

Case et al. (1999) analyse the property returns in 22 markets from 21 countries. They use returns converted to U.S. dollars, to reflect the U.S. investor's point of view. The authors find diversification benefits in international property investments, but note that the level of diversification gains depends from the property type included in the portfolio. They also find that property returns are dependent of the global GDP changes, which limits the benefits obtainable through international diversification of property investments.

Addae-Dapaah and Yong (2000) study the effectiveness of international diversification in the context of Asia-Pacific real estate from a Singaporean investor's perspective. Their analysis, which is conducted both for local returns and on returns denominated in one currency, shows that diversification benefits existed over the reference period from 1984 to 1996, and were the highest for retail property. A more recent analysis of the international diversification benefits in Asia-Pacific market is provided by Jin et al. (2007). They create efficient portfolios of both individual asset classes (incl. real estate) and a mixed-asset portfolio of 11 countries in the area, using U.S. dollar denominated returns. The analysis shows diversification benefits for the international property portfolio.