Property: which way now?

Should pension funds look to re-allocate their property holdings to reflect current markets conditions or leave well alone? Christine Senior finds out

Property markets have been in for a rough ride recently with commercial property – the mainstay of institutional investors’ property portfolio – suffering a downturn. Retail funds have been particularly badly hit, with investors clamouring for the exits, but institutional investors with their long time frame and more measured approach should be able to weather the ups and downs to enjoy the long term benefits.

David Hutchings, head of research EMEA, Cushman & Wakefield, says activity among institutional investors varies across Europe. In the UK, for example, pension funds are characterised by a “wait and see” approach at the moment.
“Some pension funds are not particularly active at the moment, particularly those in the UK, because of the recent performance and fall in value in the UK market, but also because in some cases their relative allocations to property may be at the top of the range because equities have also fallen, so property automatically gets boosted. Some funds are waiting to see what happens in the market, where pricing is going to settle.”

But he says this is not necessarily the case elsewhere in Europe. Investors are actively seeking greater geographical diversification, both within Europe itself and also beyond to Asia or North America.

“Pension funds from a broad range of countries, Nordic pension funds, the Dutch, German, some Irish funds are investing in a broad range of markets,” he says. “In southern Europe it started with Spanish bigger investors and developers starting to look in 2006, gathered pace in 2007, and we now see pension money from Spain and Italy looking to diversify.”

The drive to invest outside domestic markets is being driven mainly by a need for greater diversification. Alongside this, accessing overseas markets is now much easier than it was just a few years ago. Once, the only way to buy foreign real estate would be for an investor to establish a presence on the ground in the targeted location, to get first hand experience of the local market. Now the emergenceof a large number of investment funds focusing on particular markets or investment sectors provides gateways to previously inaccessible investment opportunities.

Figures from INREV, the umbrella organisation for investors in non listed real estate funds in Europe, demonstrate just how much the number of investment funds has increased in recent years. In October last year 476 funds were listed in its database; this compares with just 196 in August 2003.

Investors are also benefiting from greater access to data on foreign markets, for instance in the provision of indices. Investment Property Databank (IPD) now offers 19 official national indices tracking property performance worldwide, compared with six 10 years ago. Property has become more international compared with even just five years ago.
“It’s easier for somebody to sit in Madrid and have an idea of what’s happening in a different country’s property markets,” says Hutchings. “If you went back a number of years it was difficult to gauge performance. It was an added barrier to crossing borders.”

The move into overseas markets is also being driven by lack of supply in domestic markets. This is particularly the case for some of the smaller markets.

Peter de Haas, managing director at Protego Real Estate, com-ments: “In small countries like the Nordics and the Netherlands where you have a mature pension industry with a lot of capital in their pension funds, our countries are
a bit too small. It’s also driven by increasing allocations. As a rough estimate from my research and my experience, I see allocations on average rising from 8 per cent to 15 per cent”. De Haas has first hand experience of managing a pension fund real estate portfolio, after working 15 years with Dutch fund PGGM.

Property is considered a valuable element to any pension investment portfolio because of its stable, inflation linked cash flows that are a good match for paying pensions. Traditionally, rental income might have amounted to 60 or 70 per
cent of returns from property, but in recent years capital growth has played a more important role
in returns, and capital growth inevitably means more volatility.

De Haas is a firm believer in the value of the more fringe types of real estate as a way of mitigating this. “Capital growth has meant more volatility,” he says. “That wasn’t agreed in a pension fund’s ALM study. What was agreed was high cash income and stable capital growth. If you go to the alternative sectors – nursing homes, student accommodation, sales and leaseback arrangements with government offices – you get long term leases, a high cash element indexed to CPI and not too much capital growth. That risk return profile meets the liability structure of pension funds. I strongly believe that pension funds are going to invest more and more in these kinds of alternative sectors.”

The trend to more fringe areas is also highlighted by Hutchings at Cushman & Wakefield but for different reasons.
“We have seen more interest in more niche or fringe areas, partly driven by lack of stock. People wanting to buy offices and shopping centres haven’t been able to buy them so have been forced to look to new areas, more particularly seeking out higher yields and higher returns than are available in the mainstream markets.”

These forays into the more risky and exotic segments are not a substitute for the core investments of prime office and shopping centre but more of an additional allocation.

“They are not switching out of CBD offices into nursing homes; it’s more that they are changing their allocation to be more opportunistic and in that opportunistic segment they may be looking for either more emerging sectors or emerging geographies,” says Hutchings.

Morley’s Igloo fund is an example of one type of fund firmly based in a fringe area. As an urban regeneration fund with good socially responsible credentials, its investment targets are projects located in depressed areas of the UK. Currently it is involved in 20 regeneration projects both in direct developments and in partnerships to create 8,500 homes, and 10,000 jobs on around 250 acres of brownfield sites in British cities. It invests in both development and existing properties, targeting an internal rate of return of 15 per cent for the development projects and 8 to 10 per cent for standing property. Both the South Yorkshire and the West Midland pension funds are prominent among pension fund investors in the fund.

“The IPD Regeneration Index highlights that regeneration tends to outperform the wider property market at lower volatility,” says Hoong Wey Woon, manager of the fund. “This is in periods of upturn and downturn in the wider property market.

“Also, most of our projects are mixed use – a combination of retail, offices, leisure and residential. We are more diversified in exposure to different sectors, so our risk and reward are spread over a more diverse sectoral basis.”
But a note of caution on the more fringe areas of real estate is sounded by Alistair Seaton, national director, European research and strategy at LaSalle Investment Management: “In the last two to three years when property pricing was pushing yields down, these semi-emerging sectors often had attractive yields and were able to throw up high rates of income. People now look at them more closely to ascertain whether the covenant strength is sufficiently strong and that they are comfortable the business is a sustainable one. I think this may well be something that was neglected in the rush to high yield over the last few years.”

Written by Christine Senior, a freelance journalist