Andrew Sheen examines whether pension funds are increasing their investments in property

Property has long been a mainstay of scheme investments, offering attractive, real returns over the kinds of long term time horizons that fit well with DB liabilities. However, the financial crisis shook investor confidence, with property emblematic of the cheap credit fuelled scramble for returns.

According to the IPD UK property index, the sector fell by over 40 per cent between summer 2007 and 2009. Although values have recovered somewhat, they are still around 20 per cent lower than at the height of the market. For schemes looking to make allocations to the sector, there is an increasing sentiment among investors that the current market is attractive, with many assets trading at or below fair value.

For pension schemes, there is another reason to reassess property. With gilt yields at all-time lows – standard 10 year gilts are currently yielding around 2 per cent, while the yields on inflation-linked gilts are actually negative – trustees are increasingly looking for alternative sources of inflation-linked income.

Many see property, with its explicit, inflation-linked rental increases, as a prime candidate for this.

M&G Secured Property Income fund manager Ben Jones says: “The sector has been viewed by pension funds as an alternative to inflation-linked gilts – there’s a similar cash-flow profile and indexation, plus an attractive premium over gilts.”

Schemes should however note that while rental agreements do provide for inflation-linked increases, many include a collar to limit rises in high inflationary environments, while residual capital values at the end of a tenancy are more closely linked to wider market conditions, so may not necessarily track inflation. There are other risks to consider, as Mayfair Capital chief investment officer James Thornton notes: “The creditworthiness of the tenant is one of the biggest issues.”

However, there is a question about the absolute value represented by the real estate sector. Hermes Real Estate chief executive officer Chris Taylor asks: “The question is, does property look like good value because of low bond yields, or because the fundamentals are compelling?”

Aon Hewitt principal Nick Duff agrees that while the property market is attractive compared to gilts “it doesn’t look so attractive on an absolute basis against historical values. The market is a bit weak compared to the IPD index”.

Regardless of the historical comparisons, there are sectors of the property market that are booming. The growth in interest in so-called ‘annuity funds’ – vehicles that invest in inflation-linked assets with leases stretching out over decades – shows investor appetite.

Thornton points to the investors wishing to enter such funds and their holdings in supermarkets that offer a long duration, high quality income of 4-5 per cent over 20-30 years. “Compared to returns on index-linked gilts, it’s a very attractive place to be in.”

The post-crisis environment is also seeing a return of interest in REITS, real estate investment trusts, which have often been talked up by the industry as being the next big thing in property investment. As Aviva Investors client portfolio director, real estate, Phil Ellis notes, they offer “a good way of getting global exposure quickly and cheaply”, yet have so far failed to make much headway among schemes. Partly this is because of the relatively immature market in the UK and Europe, which has only been in existence for a few decades, versus 100 years plus in the US.

But many investors have so far been sceptical about their performance, citing the closer correlation between REITs and listed markets than the underlying property indices. Over the short term – up to three to five years – this correlation can be as high as 70 per cent.

J.P. Morgan Asset Management managing director, head of research and strategy for the European real estate group Joe Valente believes that structural problems with REIT markets across Europe may be holding back investment. “There’s something like 20 different REIT markets across Europe – one for each country. There’s no ‘European REITs market.’”

This means any investor looking to invest in a broad portfolio of REITs across Europe must navigate a variety of different regulatory and legislative environments, as well as contend with the fact that as a result of their relative immaturity, domestic REIT markets
tend to be quite small. In Germany, for example, Valente notes that there are only a handful of major REITs available to investors.

With property investing, the mantra of ‘location, location, location’ is key. Ellis notes that to a large extent London has been a “safe haven” for property values during the crisis. This is in part due to its position as both the centre of the UK economy and the European financial services industry, but also due to strong demand from foreign investors. London and the South East tend to overweight in most diversified portfolios as a result.

Valente says that the core market – typified by low risk, high quality stock – has proven resilient, meaning “there are no bargains to be had”. However, risk appetite among investors seems to be increasing. In 2012, investment in opportunistic, higher risk properties made up 12 per cent of the market, up from just 4 per cent in 2010.

Despite this “significant increase”, he says “most activity is still at the lowrisk
end”.

To some extent, this increase in risk appetite is a result of the high level of interest in core and prime properties, the relative lack of which is pushing some investors into secondary and more opportunistic assets. “There’s a significant weight of capital wanting to get into the market,” says Jones.

However, the relatively constrained supply of high quality assets is widely believed to be set to change in the near future as banks seek to deleverage and strengthen balance sheets.

Taylor calls the requirement that banks find £250 billion of refinancing over the next few years “the elephant in the room” for the property market.

This is manifesting itself as both assets coming on the market and a drying-up of bank financing. With property debt in short supply, investors with capital they are prepared to lend can benefit from attractive terms.

Valente says that there is less than about a tenth of the required capital for refinancing available – some £23 billion or so. “It will remain undercapitalized for the next few years, so opportunistic equity is incredibly valuable,” he notes.

Yet Jones is less sure: “The market has been talking about this for many years and so far, there’s not really been a great sign of a flood of real estate coming to the market.” He adds that “if there is a large amount of supply coming, that will hold back growth”.

However, the idea of what constitutes a prime asset is a key consideration too for the more opportunistic and nonoffice ends of the market. For Jones, there are fundamentally different criteria for prime assets between a retail and office investment. “You need to consider what’s prime in a sectorial sense. In retail, prime is about the catchment area, competitors and so on. That’s different to what’s prime in an office sense,” he says.

One of the key long term themes Hermes has identified is harnessing likely growth in ‘up and coming’ areas – those places benefiting from intensive investment and economic development, particularly in London. Hermes is investing in sites close to the Crossrail project – such as around Tottenham Court Road, the site of a major Crossrail station under construction, which is scheduled to open by 2018. It was also part of the high profile deal behind Google’s new offices in the regenerated Kings Cross area.

“We’re looking at locations that will be improved and enhanced by infrastructure improvements,” says Taylor.

In the rest of the world, Taylor adds that Hermes is looking to invest in property to access markets with strong economic fundamentals. For example, it is looking to access what Taylor calls “vicarious exposure” to wider Asian growth in Australia, which is closely correlated as a result of its commodity producing relationship with many Asian countries.

Andrew Sheen is a freelance journalist

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