Our panel of experts discusses the practicalities of pension funds investing in property

Chair: Paul Richards, Head of European Real Estate, Mercer

Andrew Allen, Director of Global Property Research, Aberdeen Asset Management

Richard Butcher, Managing Director, Pitmans Trustees Limited

Phil Ellis, Client Portfolio Director – Real Estate, Aviva Investors

Fraser Hughes, Research Director, European Public Real Estate Association

Paul Jayasingha, Head of Real Estate Research, Towers Watson

Richard Kirby, Director, Property Funds, F&C REIT

Chair: The first item on the agenda is the economic climate: has recent economic uncertainty been a positive or a negative factor for property as an asset class? One of the areas which has concerned us and which is affecting the way that we look at property is the eurozone crisis. I‘m not just thinking there about the uncertainty for the economy and for growth, but what’s been happening to government bond yields. It’s important to also highlight that the environment in the UK, where we’ve got incredibly low bond yields, is very different to the environment elsewhere. For example, I was in Italy a couple of weeks ago where government bond yields are at 5 per cent, so that’s very different to the UK where you are getting a zero real yield on index linked gilts.

Ellis: It’s hard to say that in overall terms the economy has had a positive effect on property. If you think about it in two ways, firstly the negative effect it has had on tenants and vacancies and supply and demand, and secondly the negative effect it has had on the availability of debt, or the availability of finance and capital flows. Saying that, though, since 2009 there has actually been a strong bounce-back in UK property led by London and led by core/prime property - well secured, well let property - but that doesn’t represent the whole market obviously.

Butcher: From a trustee perspective, it has been a bad time for any type of investment but at least property is a tangible asset, something solid, made from bricks and mortar that investors can fall back on, if they choose the right properties of course.

Allen: I think there’s a challenge here. Everyone can see where fixed income yields are - they’re at historic lows - and it would be an error to assume that means property is necessarily good value. Just because the yield spread’s enormous doesn’t really tell you about the true value of property. What it does do, though, is it forces capital into our market so that’s very good for us in that we see people come in because fixed income doesn’t do it for them in some way or another. Our question is whether they are doing it for the right reasons and then what they are doing as a consequence of that. My issue though is that everyone seems to be heading for this universal prime high quality kit, and then that really does beg the question of whether those assets are fairly priced or not. We would definitely put our flag up to say that we are concerned about the pricing of some of that perceived high quality prime kit.

Kirby: I think as a manager we would be taking some chips off the table in central London because the pricing has become so high, and especially in relation to anything with a residential angle or a perceived residential angle, it’s an opportune time to take some profits on that type of property. But you’ve got to look at the underlying quality of each individual asset; you have to drill down into the strength of the covenant, the length of lease, and so on. It’s back to fundamentals and if you can support that with an attractive income then I think property has a position in a diversified portfolio.

Jayasingha: Uncertainty is a bigger issue for those clients that are already fully invested in real estate, given the disparity that we have seen in the markets between Northern Europe and Southern Europe, prime and non prime. But for a client that’s looking to put new money to work, I think it’s actually quite an attractive time, certainly in terms of distressed debt opportunities and mezzanine finance opportunities, both in Europe and the US.

Chair: One of the things that I’ve been seeing is money coming into property, as Andrew [Allen] said, not because it’s property but because it’s got other aspects and it’s got a high yield. I’m thinking of long inflation linked leases, or going into debt, and I wonder whether that’s pushing pricing up to unrealistic levels? Investors are moving away from the property fundamentals and looking at it as a financial asset and I wonder whether that’s a risk?

Allen: There are risks in that and I think the challenge lies in what the inflation-linking does to your underlying tenant. There’s a rich history of failures of occupiers who have attached themselves to an inflation-linking fixed uplift type deal and that has been a catalyst for their failure. So we’re very fearful about stepping into index-linking property assets where that rental uplift will take them over-rented, because it will get you in the end! We’re much more positive towards those sorts of assets where we think rents are below economically affordable rents, and that’s absolutely not the case for much of the index-linked type property assets we can see.

Chair: How are you seeing demand for property versus other asset classes?

Jayasingha: There’s certainly a lot of appetite for property because, in an uncertain environment, investments that are understandable and tangible gain a lot of credibility, especially when they are income producing as well. A lot of investors have been burnt by the global financial crisis so they’re a lot more cautious about leverage but overall there’s still a lot of appetite for property in general and back to basics type strategies that focus on fundamentals rather than financial engineering.

Ellis: I agree and if you think of property as an asset class that has some equity characteristics in terms of growth potential and rental growth, and bond like characteristics in terms of its fixed income term and lease structure, in the long term we should expect to see returns somewhere between the two. The unfortunate thing is that if we look at the stats over the last 10 years, property has performed between equities and fixed income but actually fixed income has outperformed and equities have underperformed so that’s an unusual thing. But property has possibly been in its right place albeit it has been through some difficulties.

Butcher: As trustees, we are trying to find something that is solid and tangible that will give us a return, and when all of the asset classes are looking dodgy, to have something in bricks and mortar is a useful thing. But things have got to be kept simple. I am a professional trustee, but we are surrounded by lay trustees and those lay trustees have got to be able to understand what they’re buying.

Hughes: We are out seeing investors approximately 30 per cent of our time. We travel throughout Europe, in addition to the US, and the Asia Pacific region. In the past, we’ve been armed with all kinds of statistics and research that show how listed property acts as a proxy for direct property in terms of correlations and long-term performance. Of course, this material is great from an academic standpoint but what really seems to resonate with investors is simply showing what they actually achieve at an asset exposure level when they invest in listed securities. So, in an extremely simple case, we show investors exactly what they get property-wise if they buy the top three listed companies in Europe: Unibail-Rodamco, British Land and Land Securities. It is really quite incredible – when you show them a map of the UK and Europe with the dots representing the diverse range of properties that these companies’ own, and you show them pictures of the properties themselves, it visibly stimulates investors’ interest and questions. We then back that the industry offers very attractive dividend yields - global REITs are around 5-6 per cent on average, which makes it a very strong, and more importantly, simple story that we can take to investors.

Kirby: That’s exactly what we are seeing from our client base - our shareholders and investors - that income dividend yields of 6 per cent are very, very attractive but they need to be aligned with a simple structure, not highly leveraged, because those days are over for the moment. Most of our shareholders’ investor base want conservative gearing in their pension portfolios. They want to be invested in strong properties producing a solid income.

Chair: Do you think there’s a danger in the fact that, because property is a tangible asset that you can go and see if you want to, people just assume it’s a good investment?

Hughes: It probably depends who you go and see. If you go to see a German investor who wants to invest locally, then that type of story rings true – because it is tangible they feel they can really relate to it and it means a lot to them. But if you go and see one of the big Dutch institutions what they want is global diversification, so the tangible nature of property doesn’t rank highly for them - they understand that listed property offers broad diverse property exposure, in a cost effective manner.

Ellis: The tangible nature of property can be overplayed sometimes but, physically, one of the benefits of property is the ability to actively manage an asset manager restructure, change planning consent, redevelop, and that in itself is a way of adding value. But you would expect that would be a relatively small part of an overall portfolio; that wouldn’t be 100 per cent exposure of a portfolio, but it might be 10 or 15 per cent of your portfolio to add some spice to your return. But I think the key thing about property is the income generation side of it and that ability to provide a sustainable net yield of a relatively high level compared to other asset classes, and make that predictable in terms of the cashflows you’re going to get.

Chair: We have discussions every quarter with all the asset class analysts. It’s the income side of things that is the big draw when we talk about property.

Ellis: And I think if you look at the stats over the last 25-35 years, and you look at the income and the capital growth elements on a chart, you’ll see a relatively stable income which only goes down when capital values boom because your denominator has changed, and what you’re seeing is capital value spikes and busts. So I think most investors should expect to see a return somewhere in line with the income return as being sustainable long-term.

Butcher: I don’t think that the tangibility aspect of the asset class is that misleading, otherwise pension funds would be investing 50, 60, 70, 100 per cent of their money in that. We’re still, as an industry, maintaining a fairly small holding.

Chair: What is the ideal allocation to property in a pension fund portfolio? Should property allocations have changed given the global financial crisis?

Hughes: We have carried out analysis in the past that looks at the values of the main financial asset classes, property being one of them. So we look at the value of fixed income, debt and equity markets etc. When you work through these numbers, you see that the entire property market makes up around 14 per cent of global financial assets. We believe that is a very good starting point in terms of property allocation when we speak to investors. Global average allocation to property is around 7-8 per cent. But if you go to the Netherlands, it is probably closer to 15 per cent. If you go to Japan it might be nearer to 0 per cent. So, of course it depends on the country and the type of investor – there is no uniform number. All in all, a very good starting point for us is a natural weighting of 14 per cent.

Jayasingha: So what percentage of a pension portfolio should be made up of real estate? There’s no single right answer because it will depend on the pension fund. It entirely depends on the maturity of the pension fund, their cashflow position; who your sponsoring employer is and so on. So it’s entirely scheme and client specific. In terms of whether allocations should change over time, I think yes they should, and clients need to be aware of the initial valuations that they are buying in at to the extent that their governance sets them up to be a little bit more dynamic.

Butcher: I agree with the point that every scheme is different; every DB scheme has got a different liability profile and so the optimum investment structure should reflect that liability. What could be a game-changer in terms of the amount of money that’s allocated to property is the increasing dominance of DC. There you haven’t got a natural benchmark to weigh assets against. So who knows what will happen in
the future.

Allen: It feels to me that we all agree that the numbers should be higher. Fixed income doesn’t really do it right now, and there is so much volatility around equities.

Butcher: I think that’s the instinctive answer, that the numbers should be higher. The problem is that lots of trustees have been burned in the past; properties are a difficult and lumpy asset to get into, and often trustees find themselves tied into it when they don’t want to be tied into it and so, although, it’s got some very good characteristics about it, there are also some very scary things about it.

Jayasingha: So if you ignore liabilities then, I agree, the property allocation could be higher. In reality, pension liabilities act like bonds so in the global financial crisis, pretty much all property strategies went down and bonds went up, liabilities rose and there was a mismatch. Property isn’t a matching asset class, despite all the positive things we like about property, and I think clients just need to be conscious of that. I think there’s a tension though between accepting more of a mismatch when the choice is between negative real yielding index linked bonds and very secure income property on higher yields. Some pension funds can afford to take that illiquidity and mismatch but some just can’t because they’re looking to buy out in the next few years potentially.

Chair: So do you see that 7-8 per cent weighting towards property changing?

Jayasingha: For immature schemes it has gone up. For mature schemes it’s gone in completely the reverse direction for obvious reasons.

Hughes: If you look at the property allocations of the schemes that you deal with, will they add their listed properties in with their overall real estate allocation, or will they put it in with the equities?

Jayasingha: Our starting point is to get clients to think about the full property universe, including listed, so listed would tend to start within property rather than within equities. That said, some clients are happy to regard it as property, but some clearly view it as equities and we work within their constraints.

Ellis: I think when you look at the average UK pension fund weighting towards property, it is around 7 or 8 per cent, but there are still those funds that have zero and others, some of the local government pension funds for example, that have a 10-15 per cent allocation. They have tended to be direct investors with their own large dedicated portfolios, and they tend to have been very, very long-term investors.

Butcher: The maturity of schemes is very important here and three to four years ago we had 7,500 DB schemes, and we’re now down to about 6,000 DB schemes. Everybody is on an exit route, even if they’re in an open DB scheme. The large number of those schemes are at the bottom end of that scale and as they head towards buyouts then they are not going to want to hold property; so the 6 or 7 per cent may still be a representative average, but I wouldn’t mind betting that the split between the top and the bottom is widening.

DB to DC
Chair: I think the move towards DC which seems to be inexorable is probably one of the biggest issues facing the property market. Can we talk about what property’s place should be in a DC portfolio, and how we would actually do it? We’re finding that the execution is a problem because things need to be liquid, not from an investment point of view, but from an administration point of view. How are we going to square that circle?

Hughes: The answer is simple – see the listed markets! We see this area as a big opportunity for the listed real estate companies.

Butcher: Our view on DC is that we need to provide robust and proactive default options for members. We also need to provide an environment where they can make informed decisions. We are not going to, with the best will in the world, make all of our members investment experts overnight. So those that choose to make their own investment decisions are going to err towards something they can understand; buildings are something they can understand. They may not understand the complexity underlying it all, but they can see a building, and they can touch a building, and they can walk around a building, thus they will probably gravitate, to some extent, towards property investment. Rightly or wrongly. Within the default environment, the liquidity is the problem. The trick for the trustee invariably when designing a default is to have a well-diversified portfolio. You haven’t got something to benchmark it against as you would do in a DB environment, so you are looking for diversification. So I can’t see the allocation increasing significantly in the default DC portfolio.

Chair: Can you see it falling just because of this administrative liquidity problem?

Butcher: I suppose that depends on whether we can get in and out of it or not. At times when we can get out of it, then probably there’ll be people moving towards property investments. At times when it gets harder then obviously they’ll look to reduce their allocation. I don’t know. I think the jury’s still out on this one. DC investment is still relatively immature, and as we have more and more money available in DC then we’ll see behaviour starting to change.

Jayasingha: Property funds in DC - it’s just a classic case of the tail wagging the dog. Here you’ve got capital being tied up for 40, 50 years potentially, yet there’s a requirement to have daily traded funds. We’ve all, I’m sure, been involved in lobbying some of the very smart people in the DC industry to get around this but it just hasn’t happened. So we’ve worked with a couple of managers to set up hybrid funds which invest a majority in direct property that’s very conservatively managed, potentially with a cash balance, with some real estate securities or REITs to get global diversity and liquidity. The net result is that the cash offsets some of the leverage that the REITs have, so you end up with pretty close to unleveraged property returns but with some equity volatility. That works for certain schemes - a lot of the clients like the fact that it’s got a majority exposure to direct property but it still has volatility from that minority REIT allocation. The key with some of these hybrid property funds is to have clear re-balancing rules because, as we saw in the global financial crisis, when there are redemptions on these hybrid property funds, they’ll sell whatever they can. And in tough times it’s just going to be REITs and that leaves your existing unit holders with a pretty illiquid portfolio. So we’ve worked with the managers to have very clear rules around that. So, property can be done in DC, it’s just that it could be so much better.

Geography
Chair: Is there a case for diversification outside the UK?

Ellis: For performance definitely. If you look at the IPD Global Index over the last 10 years, it has outperformed. Listed property has come second and equities and fixed income-type assets on a global bond index have underperformed, if you just look at that benchmark over 10 years so that track record is there. It’s clearly there from a diversification point of view in terms of different regions, different economies, different markets, working in different cycles. But it’s a question of how you access it, and it’s hard to do it any other way than indirectly, be that unlisted or, increasingly, listed, which I think has a role to play in global portfolios.

Allen: Our take would be very similar. I think the mistake that people made in the mid 2000s, which they are realising now, was chasing returns where they weren’t ultimately available. So the whole idea that you have to go outside the UK to get the highest possible returns has largely proved to be an error. Actually the whole reason for being invested outside of your domestic borders is for the diversification point, and it’s very evident that there are material gains to be made from the risk diversification. Phil [Ellis] makes the point that there are always countries around the world that aren’t synchronised with others, so that must make sense from a diversification point of view to look at these places – the next question though is how do you access these markets and, unless you’re absolutely huge which most pension funds won’t be, you’re going to have to go through some sort of indirect route, one that’s listed or unlisted. Next you need to ask the question of where you want to be right now, and there are clearly regions of the world that are doing much better than here and aren’t quite so synchronised with what is going on in Europe right now. For example, there are lots of things to do in the Asia Pacific region and in the US.

Jayasingha: There are actually stronger diversification arguments for globally diversifying property than there is with equities. Clients globalisation in equities without even thinking about it, yet very few do it in property and I think part of the reason lies in the difficulty in accessing local players, and concerns around structuring and tax, which becomes more complex. This is why sometimes clients will go to a fund of funds or go the listed route, but in reality we can help our clients get global exposure with as few as three core funds.

Hughes: If you look at the listed markets and how the number of global funds has grown in the last 10 years, it has been considerable. We did some research back in the early 00s and there were approximately 10 global listed real estate funds. By 2008, there were over 300. In terms of assets under management, this represented around $60 billion. Those investors were located in North America, Europe and Asia Pacific. In 2006/2007 we introduced with FTSE, our partners in the Global Real Estate Index, an emerging markets section and we experienced a lot of appetite at that point in time for the emerging markets. By 2009, that appetite was less evident, but we’ve now seen the emerging markets come back over the last 18 months or so – there is, again, a lot of interest.

Ellis: I think you’ve just got to think about the correlation of volatility in those markets, and the correlations obviously on the listed side of the real estate market, because clearly you’re going to be, in the short term, much more correlated to general equity markets and in the longer term to the direct property market.

Chair: We’ve talked about property as if it’s a single thing but we haven’t really talked about different sub-sectors. I’m thinking about emerging sectors, such as medical premises or student housing (which has probably emerged by now), but also the different ways of entering property like HLV (High Lease Value), inflation linking, or property debt which I think is very prominent at the moment. What do people see as the attractions of those things? Are some of those things really property or are they fixed interest? How are they viewed by investors and by fund managers?

Allen: I’m a huge fan of the alternative UK property sector - I was behind some of the UK student halls stuff in 2004/5. There were characteristics of that market that were, frankly, just better than the commercial market so the demand side was strong and the supply side was more controlled and, you know, guess what? The rents have pretty much doubled in that period. So that has worked very well. I think you’re right in saying that market has probably emerged now and some of the risks we flagged at the outset of that work are perhaps coming home to roost in that there’s a demographic bulge that is sort of fading away and what’s happening with the fee rates is now starting to present a risk. So the next question is, ‘What do you do next in that sector?’ When we first set out to look at the wider residential areas, we looked at various things, such as senior housing; but that’s problematic in terms of who the occupier is; what the lease structure is, and so on. There is no doubt that there are quasi government residents/primary care trusts, and hospitals and all the rest of it, but to be honest, those sectors are relatively small. Another big question is: what’s going on with social housing? It’s an enormous political problem area – something like 1.8 million households are on housing waiting lists, and no-one seems able to build the right houses in the right place, for the right sorts of people. That is an area that I and the research team have been trying to work out - how it becomes investable. It dwarfs anything we’ve ever seen before, and the government appear to be wanting to list social housing REITs which, whilst I have nothing against REITs per se, just doesn’t seem to make much sense. There are things there that have long secure fixed income characteristics which should appeal to the investors that we are basically referring to today. And it should be very appealing and yet, our community can’t work it out.

Ellis: I think you’re right about the opportunity and we’re in a position where time is now developing that opportunity because quite a lot of the government funding hasn’t yet dried up. In fact, a lot of the government funding into the public social housing sector is going to stop this financial year. The top 10 housing associations can actually raise money from bonds. They’re relatively fundable and I think it brings into play the opportunities that are there in two ways; first in terms of direct investment, like a sale or lease back model; and the other in terms of providing actual debt finance to them as well. I think they’re both relatively attractive and they both have relatively different risk return appetites. There are people trying to do something and it’s important to think about it not necessarily as a property investment, but more of an alternative fixed income investment. Looking at the cashflow, you don’t have to own the freehold and own it in perpetuity, because I don’t think most pension funds would probably want the risk and perhaps some of the public face of owning social housing for 125 years, but they might look at it on a 40, 50, 60 year view where they could actually get out of it and use it as a fixed income instrument as well.

Risks
Chair: Can we talk a bit about what the biggest risks are to the property market at the moment, apart from the general economic doom and gloom? It seems to me that the biggest risk is that we don’t quite know what the risks are apart from the fact that we’re in a very uncomfortable economic environment, nobody quite knows how the Euro is going to work out, or what’s going to happen to the UK economy.

Kirby: Also risk can be the difficulty of sustaining a long income stream due to shorter leases and cost conscious occupiers. In addition we need to be aware of structural changes in the market such as digital solutions challenging the historic retail model and lower public sector demand for offices.

Butcher: From a trustee perspective risk, to us, is liquidity diversification and this is a large and lumpy asset class.

Hughes: Is there a risk of not having all of your eggs in one basket at this point in time? If you have a broadly diversified portfolio, across asset types, regions and countries, then at least you probably stand a bit of a chance.

Ellis: Another risk is actually around regulation. For example, Solvency II is on the horizon and everybody’s talking about what position that will leave real estate in; whether it will be more or less attractive. Unlisted funds, highly leveraged funds are clearly not going to be more attractive because of the capital adequacy requirement but perhaps that’s a reason to talk about real estate debt because, potentially, that could be more attractive.

Prospects for the future
Chair: The last topic on the agenda is ‘prospects for the future’. What’s going to perform best in the next five years?

Ellis: Anything that generates a solid, secure, sustainable income return. With regards of sectors, I think UK pension funds are, in terms of their average exposure, very heavily biased towards retail which I think is a risk, so I would recommend looking at the increasing area of alternative newly emerging sectors, be that high lease to value or secure income funds or be that sectors like social housing or ground rents. Things that effectively are inflation proof but provide secure income streams with good covenants, so they’re almost alternative fixed income. They’re not going to give you very exciting returns but if they’re giving you 6 per cent or even 7 per cent that might be considered a good, un-geared return, because we’re not in an environment of great yield share or great rental growth.

Kirby: I think over the short to medium term, prime we believe will be out-performing the rest of the market because there’s nothing really there to be driving those secondary values just at the moment. I also agree with Phil [Ellis] - it’s property with income attached. When you’re looking at returns over the next three to five years of 6-6½ per cent, i.e. if you can buy a good quality product with that sort of income yield already attached, there’s a place for it in the portfolio. Again, we’re also looking at the alternative sectors and, in a market where there’s not going to be much rental growth moving forwards outside of central London and the South East, then if you buy something of the right sort of rents, with sound fundamentals, which has some partial inflationary hedging, that sort of 6-7 per cent might be dull, but I think it’s looking quite attractive in this environment.

Allen: I might just flip the question on its head and say what would I be most concerned about? The pricing of some of those high quality prime assets that, such as central London offices, builds in an expectation of rental growth that just won’t be achieved compared to normal long-term pricing of such assets. So we would be very concerned about the pricing of high quality prime. The price might not collapse over night, but the risks attached to it are certainly very substantial.

Chair: Any recommendations from the REIT world?

Hughes: Going back to what I said before, I think investors should hold a globally diversified portfolio. Touching on some of the comments made on sub-sectors, logistics, storage and healthcare, have grown, at a global level, over the past five years, and sit alongside the more traditional sectors like office, retail and industrial. As I said earlier, we are also seeing interest in emerging markets from a whole range of investors based in Europe, North America and Asia Pacific who are focused on holding a broad range basket of investments.

Butcher: A few thoughts from me. I would have thought there must be huge growth to come from residential, as there’s such significant demand in and around London, and I can just see that demand increasing. It’s up to you chaps to work out a sensible way of accessing it for the institutional investors. Sustainable, i.e. ‘green’ buildings, again I would have thought that there must be an increasing amount of demand there. Finally, I expect increasing demand for emerging markets - just from a diversification point of view.

Jayasingha: The four things that I find currently interesting include near term opportunities for distressed debt funds both in Europe and in the US; opportunistic funds in Europe to take advantage of the current and likely weakness in coming years. Asian Real Estate Securities would be another - we’ve been working with managers to invest in Asia Pacific Ex-Japan real estate securities because, firstly, many of our clients are underweight Asia and in our view there’s not very many well diversified, core open-ended funds. Finally various inflation linked opportunities in the secure income space given current low bond yields. Ground rents are perhaps one of the most attractive risk adjusted opportunities. And then certain long-lease strategies e.g. supermarkets - which can offer some protection in an inflationary and deflationary environment means that this strategy could be quite attractive.

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