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Reducing security-specific risk in Asia REITs

By: Catherine Yoshimoto, Senior Index Product Manager

As I highlighted in a previous post, real estate indexes can provide an important building block for a diversified global investment allocation. But for real estate investors setting their sights solely on real estate investment trusts (REITs) in the Asia ex Japan region, a single security can comprise a significant portion of a traditional market cap weighted index. The FTSE EPRA/NAREIT Asia ex Japan REITs 10% Capped Index (“the Capped Index”) addresses this issue in its methodology, resulting in a more balanced, diversified index.

The popularity of real estate as an asset class has been on the rise in recent years, with several reasons behind this trend. Real estate investments can offer a relatively predictable income stream derived from rents that are also frequently inflation-linked, which can translate to long-term real returns. In addition, low correlations with other equity market sectors makes real estate a natural consideration for investors looking to diversify portfolios with long-term savings goals.

Direct investment in real estate has generally been more accessible to large institutions, as they’re able to transact in large lot sizes and may be relatively indifferent to short-term liquidity risks. However, investing directly in a property can incur high transaction costs and require operational headaches related to property management. And some institutional investors may not even be allowed to invest directly in real estate.[1]

This is why listed real estate securities—most notably REITs—have emerged as a popular vehicle for incorporating real estate into a global asset allocation. Shares of listed real estate are readily converted into cash because they’re traded on the major stock exchanges. And listed real estate companies offer an extra layer of governance to investors: they operate under company law, as well as having to meet accounting standards, stock exchange rules and reporting requirements.

While the potential benefits of REIT investing can be myriad, investors looking for a narrower segment of the global REIT landscape and utilizing indexes to help execute their investment strategies can face challenges. Focusing on a particular region reduces the number of index constituents, and as a result some of the largest securities can have an outsize share of the index.

This is certainly the case with the FTSE EPRA/NAREIT Asia ex Japan REITs Index. This index has just 23 constituents, and if we examine the top five holdings, the perils of not using a capping approach for REITs in this region are evident. Top five holdings represent over 62% of the index, with the most heavily weighted security alone comprising over a third.

Constituent weights for the Capped Index tell a different story. As shown above, weights are more evenly distributed across the top five holdings. Perhaps most notably, the largest security comprises only 9.9% of the index, versus 34.5% for the uncapped index.

Less security concentration in the Capped Index is a result of differing methodology. As the index name suggests, our approach requires constituent weights to be capped at 10%, with the excess weight redistributed across remaining constituents. Further, if individual constituents whose weights exceed 5% are greater than 40% in aggregate, the cap is lowered to 9% for the next largest security. This process is repeated for the subsequent largest constituents until this concentration no longer persists.

In essence, many investors are turning to REITs in search of added diversification, but if REIT allocations introduce security-specific risk this can be counterproductive. The methodology applied to the FTSE EPRA/NAREIT Asia ex Japan REITs 10% Capped Index can effectively mitigate this risk, giving market participants a more balanced index tool to use in connection with their global real estate allocation.

Read more about the FTSE EPRA/NAREIT Global Real Estate Index Series.


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[1] http://realmoney.thestreet.com/articles/07/18/2016/japanese-pension-funds-property-move-first-billions-come 

 

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