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Property: building the best strategies

Written by European Pensions team
November/December 2011

European Pensions Property Roundtable

McNamara: What impact do you think the recent economic turmoil has had on property as an asset class?

Forbes: Our view at PWC is that the next four to five years are going to be pretty grim for Europe, which means that we are still going to see a period of continuing tenant failures. With property what is really important is that investors can no longer rely on an environment where yield compression would deliver a return, so it’s going to be very asset specific. There’s going to be a greater focus on asset management skills within the fund managers, so it’s difficult to say how real estate will do on average. It’s going to depend on the individual investment, the price at which you buy it, the nature of the tenants and the skills of the asset manager or the fund manager who are delivering your return.

Crawshaw: The way I look at it is in terms of back-to-basics property selection and property asset man-agement. It seems that in the run-up to the problems that we have faced over the last couple of years there may have been a reduction in the general skills or the application of those skills in the fundamental basics of buying and running a building.

McNamara: Is there a geographical divide, north and south, in European markets? Can one generalise like this or is it too granular?

Forbes: It depends hugely on the investment doesn’t it? Real estate covers a huge spectrum so if you are, say, a core investor looking for a low-risk return then those sort of investors are chasing after class A properties in London, Paris and German cities with a good covenant strength tenants and long leases. At the other end of the spectrum, if you are an opportunistic investor and you are looking for the higher returns you are not going to achieve those by chasing after core assets. There is value in distress as well, so it’s very much driven by where the investor is on the risk spectrum and what their target return is.

Richards:
I definitely see a change in the pattern of demand from our pension fund clients, almost the archetypal institutional investor. Going outside core property and looking at value-add and opportunistic activity really relies on having a buoyant economy, which we don’t have. There is very little going in terms of that higher risk activity. We have seen very little interest in distressed investing in Europe. We have seen more interest in the United States, where it is a more accepted part of the institutional investment culture. We are seeing clients looking at property for an absolute return, rather than an IPD benchmark-type of return, and also looking for longer term gilt substitute type income because the yield on gilts is so low.

Tidy: When looking at the real estate market in Europe there is still significant competition for core assets, in the major cities with strong tenants, so there is a real focus on the prime end of the spectrum. Going back to Paul’s point on the value-add side of the equation, in Europe we have noticed that there’s more of a geographical focus so for value-add strategies you might be looking more closely at the southern European countries where yields are at higher levels currently.

McNamara: Is property in a kind of sweet spot in that it is less risky than equities but more remunerative than bonds?

Archer:
I wouldn’t say it’s a sweet spot, there are liquidity issues and macro concerns, it’s not perceived as a compellingly attractive investment at the moment, but it’s part of a balanced portfolio for larger schemes. If you can take a long-term view it’s attractive and it obviously offers a hedge against inflation. Coming back to the comments made earlier, it’s value, it’s timing and it’s all very well wanting to grow a portfolio premium size, but I do have some concern about some of the premium prices. But generally speaking on the buy side we look at it very favourably. I suppose it’s also easy for trustees to understand as opposed to some of these other investments. They get property.

Crawshaw: There has been a move of late to secure long-term cash flows. It’s not only the security of the tenant that’s important but also it comes down to picking the right building and the right location. You might have a superb tenant, for example the UK, but what would happen if that government tenant were to go. Would the building they occupied be attractive to others
or would it be effectively unlettable. This leads me to restate that property investment should be focused on fundamentals – not least location but also including every aspect that makes a property attractive to existing and potential future occupiers. Also, whether those assets are fully valued or possibly over-priced is also a concern. Are properties trading at prices supported by their funda-mentals? One should also look at the next level down – from super prime to prime to good secondary (where fundamentals support the investment case) to see where your capital may well be moving over the short to medium term to take advantage of any mispricing opportunities that may exist.

McNamara: Marc, anything from the legal perspective? Are you seeing any changes in the demand for property versus other asset classes?

Werner: In the last two years, the demand for core real estate has been extremely high all over Europe. Maybe not so much in the southern part of Europe obviously, but if you look at the continental European countries like Germany, like France, and the Nordic countries, they are all competing for the same quality. And I agree with what has been said before, I think that there is a high demand for those investments.

McNamara: Is there a general agreement as to what percentage of pension funds’ assets should be allocated to real estate?

Richards: It really depends on the kind of fund, the maturity of the fund, and their other investments. If we put property to an optimiser the answer is always about 20 per cent, but investors usually have about five per cent. I think the problem is the illiquidity. That’s a risk factor but it also provides an illiquidity yield premium.

Archer: Our largest allocation is 15 per cent across about 200 teams.

McNamara: Acknowledging the maturation issue, are there any generalised patterns across Europe with respect to changing patterns of allocation to property?

Tidy: In our experience, in terms of pension funds in Europe, the big buyers of real estate are institutions in the UK, the Netherlands and Nordics. Dutch pension funds have been investing in real estate for a long time and there has been a trend in the Netherlands where a lot of domestic Dutch pension funds, which held direct real estate, have gone through a process of divesting and are now looking to invest more internationally through the indirect route.

McNamara: Has the crisis changed investor attitudes to European real estate? Are they looking at it more favourably or less favourably now?

Tidy: The Dutch in particular have looked on it less favourably but that is more to do with fund-specific issues through the financial crisis, the use of too much leverage by some funds and governance issues. The countries that are less focused from a pension fund’s perspective are the southern European countries. Additionally French investors remain more domestically focused.

McNamara: David, do you have any perspective on what the gradual evolution from DB to DC spells out for property allocations going forward - either the nature of it or the quantum of it?

Archer: My guess is that as DB schemes go into decline over the next 30 years, the trust-based investment schemes will decline and this will mean less investment into property. On the other hand of course, there will be more appetite for DC funds.

Richards: About 90 per cent of DC members will go for the default option, so the crucial thing is finding a place for property in the default scheme, whether that’s through putting it in a wrap that’s got some other liquid asset such as cash, listed securities or derivatives, or it’s the DC scheme as a whole saying we don’t need absolutely everything to be daily liquid.

Forbes: They don’t seem to make the distinction between daily pricing and daily liquidity and that’s some-thing the real estate industry really has to get across. We have to educate the trustees not to put it all into a diversified growth fund but we will have to do something more imaginative with the default bucket.

Crawshaw: We’ve got time as an industry to resolve this issue but time is marching on and there doesn’t appear to be a great deal of options for these schemes. Now we have a good opportunity to start thinking about the provision of suitable opportunities for DC investors. It may need to start with education, to better understand whether daily liquidity is necessarily needed or whether there is some other form of structure that provides what DC investors need – such as some sort of hybrid type product.

Forbes: I certainly don’t think that they really need daily liquidity. They have to cope with life styling, they have to cope with the flexibility of the people to move in and out, but you aren’t going to have your whole pension fund move out on one day. The actuaries spend their time predicting which way these things move, it’s like steering an ocean liner – they need to be able to work out the portion for which you need liquidity and the proportion you don’t.

Crawshaw: One of the arguments that have been put to me is that individuals get paid on different days of the month. But it must be possible to structure things within the investment management community to have some kind of liquidity fund available to cope with this problem. For example, can cash be deposited for a couple of days before being fed into (or brought out of) a property fund so that actual investment or divestment in those funds can occur on a set day of each month. Funds offering monthly liquidity appear acceptable and running them is well understood.

Forbes: But even within that, even if the money has to come in daily into the pension fund it doesn’t mean it has to come daily into every underlying asset and that’s the point I made about daily pricing and daily liquidity. There’s an argument where you need to come up with some sort of pricing on a daily basis.

McNamara: Why should pension funds invest in European property? What does it offer investors?

Tidy: For UK pension funds going outside the UK for the first time, the case is built on the diversification arguments and spreading risk. Additionally there is an added level of diversification between continental European markets and that’s very evident at the moment particularly between the northern and southern markets.

The Nordic markets are currently very buoyant with positive economic fundamentals compared to those more stressed economies of Spain and Italy. There are other positive aspects of European property from an investment perspective - if you look at the lease structures, which tend to be shorter compared to the UK, the interesting characteristics is that most of them are indexed, which provides stable and growing cash flows. Over the longer term these leases will be more inflation hedged.

Werner: For example when UK investors are going go to Europe; if their advisers know their level of risk and their approach for how they do their investments, as a UK investor you can get the same level of security or even more than you would have in the UK. We advise on following many institutional investments into foreign countries, either from Germany into different European countries, or Asia or south America or north America as well as other institutional investors coming into Germany, and for example some of our institutional investor clients don’t want to take on any kind of risk. Yes, we know there’s no such thing as a watertight lease, although you can terminate every lease for a good cause in Germany and most other continental European countries. However there is a level of legal risk, but if you know what the client is looking for and you know what the client is accepting, then you can relatively easily say whether this transaction or investment is fitting for the investor or not.

Tidy: Building on that as well, the size of the European market is three times the size of the UK, so it just gives us as fund managers a much bigger playing field to try and extract value.

McNamara: How do you perceive the relative opportunities of east versus west with respect to property investment returns?

Werner: I don’t think it’s possible to separate continental Europe in west and east anymore. International investors would probably rather would go to Russia or Krakow in Poland or Hungary rather than going to Spain or Portugal, unless if you don’t talk about Madrid and maybe Lisbon. You can’t divide continental Europe into west and east, it is more that you look at the market and its strengths where the market is strong, which gives you the stability you are looking for and the transparency. Some eastern European countries are more trans-parent than Italy and the Nordic countries.

Crawshaw: I tend to think about western Europe and central Europe as opposed to west and east. This includes some countries that may fit into different buckets. Western Europe and CEE countries have different dynamics associated with them and it may be better to separate them and think of them as discrete investment opportunities. The key is in defining ‘core’ in each country or region and it is possible that this differs depending on where you are looking.

Forbes: It’s very different to the period going up to 2007 where the rising market would rescue even bad deals. I remember a speaker at our real estate client conference back in 2007 saying ‘with enough of a wind even a turkey can fly’.

Werner: But look at what happens afterwards. I mean in 2007 everyone thought you can buy all over the place but if you look at 2010 and 2011 where are we now? Investors who didn’t have a clue but invested anyway they now have a problem and the problem came from wrong pricing. They bought in the wrong locations, they don’t have the right asset and property managers and it’s not that you can say “we need an asset manager for the western part of continental Europe and the central part of continental Europe”. Each jurisdiction is different and you need – which maybe one of the down sides maybe of going to continental Europe – you need a person who knows France, you need a person – probably not the same person – who knows Germany, and the Czech Republic is again completely different.

Forbes: That’s both a downside and an opportunity. I don’t have any tacts at a micro level but there is nothing you can directly do about the price of bonds or equities but with real estate you can at a granular level and you can make a difference to the value.

Werner: And obviously when you enter a market for the first time it costs you some money to understand the market and to build up the team, and once you are there, there is a difference between global bonds and equity, but you have to do the due diligence, you have to know the asset.

Archer: Given that you did it properly, you would be incurring quite significant costs because you need good quality managers, you want someone that knows the market. What is the case for saying that you will invest in European real estate rather than simply European equities where you are also getting exposure to the real estate market anyway? The yield on equities could well be better.

McNamara: Do you feel the argument about property as a good inflation hedge has been weakened in recent times?

Richards: Yes, especially when you have clients who assume that inflation hedging means doing what an index-linked gilt does which is lock onto RPI. Property doesn’t do that. Recent research by IPF and others is showing that there is quite a lag in terms of following inflation. It depends on the kind of inflation as well so it wouldn’t be right to look at inflation hedging as one of the main attractions of the property market.

Crawshaw: I would agree with that, obviously there’s been a lot of research into this recently and I think our perceptions have changed over time. It’s just one of the arguments for property, there is an element of inflation linkage, but it’s not the main one any longer. Diversification, whether it is out of your domestic market or on a more global basis as well, that’s one of
the main drivers.

McNamara: What are the relative advantages and disadvantages of European property when compared with taking the capital to Asia or north America? Is there anything in particular we should look at in terms of European property?

Tidy: If you look at the north-western European market, the market is much more stable; we haven’t seen the volatility. If you are looking at it in a global context then the Asian market could be seen as the growth story although there is a danger that investors could be tempted to overpay for that growth given that yields are very low, for example in Hong Kong. Again in a global context to exclude the US which is the largest real estate market in the world would seem counter intuitive.

Richards: If you follow the progress of clients who are trying to go global, many look at Asia and are deterred by the emerging market risk in much of the continent, then look at north America and find that FIRPTA reduces their returns too much, so they are left with Europe, or maybe Brazil.

McNamara: Can you explain FIRPTA?

Richards: FIRPTA means Foreign Investors in Real Property Tax Act, an American law putting in place a withholding tax for foreign investors in American property. The tax loss depends on the status of the investor but for many it can be prohibitive.

Werner: From a western per-spective we are more used to looking at the US market, obviously at Europe or the UK or now maybe even at Brazil for example, rather than at some markets we don’t know. So from a political perspective, from a cultural perspective, from an investor’s perspective, we are more susceptible, not just to people in the UK but at least to continental Europe. We are a little bit afraid of Asia and it’s difficult for us because we don’t have this tradition with Asia. We feel much more comfortable going to the United States or staying in Europe and the UK.

McNamara: What are the biggest risks facing property investment markets at the moment in the European arena? What big risks could pull the rug from underneath it?

Tidy: I think the fundamental thing is the economic environment, which has deteriorated over 2011. Additionally the potential for the banks to begin diposals of assets could have a dampening effect on the investment market.

Forbes: You need to also distinguish between the macro risk and the micro risk, as we learned in 2008 when all assets are correlated and everything goes down at once so it’s not as if property is going to be particularly badly impacted relative to everything else. If we don’t have strong macro fundamentals I think there’s going to be continual failure at the micro level so the next four to five years of generally poor economic performance and business failures and everything else means that some investments are going to do badly and some are going to potentially do well. It all depends on price.

McNamara: Are there any other things that pension fund trustees should be aware of, where property can help in the risk management process of their overall fund? Paul, I think you were clear that it provides investors with a reasonably high level of running yield which must be a comfort?

Richards: It’s interesting looking at the focus of manager selection activity this year compared with last. 2010 UK activity was dominated by core open-ended funds, at the end of the recovery. This year the majority of activity has been in real estate debt and in long-term inflation linked leases and ground leases. I think that de-risking, particularly by DB schemes, has pushed people to look at doing different kinds of things in property.

Tidy: Like liability matching?

Richards: Yes exactly.

Tidy: Where do you see property debt, what does it fit? Is it in the property bucket or fixed income?

Richards: It depends on the client really. It’s a fixed income investment backed by a property risk. Sometimes the money can come from the fixed income bucket and sometimes it can come from the property bucket.

McNamara: John, I know you have done a lot of work on the potential impact of Solvency II. What do you think its implications are for the institutional investment community and, indeed, for the property market as a whole?

Forbes: Insurers can either use the standard model of Solvency II looking at their asset risks and the capital consequences that those have, or they can seek approval for their own bespoke models in which case they need to prove to their local country regulator. The issue is that we don’t know what they are going to get approval for in terms of those bespoke models and how far it will diverge from the standard model which is why everyone is focusing on the standard model. All that requires you to do – which is hugely important for real estate and real estate funds – is that for property as an asset class you have to assume 25 per cent right down the value of the asset regardless of where it is and what it is and that’s the same test that’s used for collateral for real estate debt, which is why if you are lending less than 75 per cent loans value as an insurer, real estate is quite an attractive asset class because effectively the risk is always assumed to be with the equity holder.

What is really a major issue is that the treatment of real estate funds is not yet clear. There are two possible treatments, one is transparent treatment where you look through to the underlying property and calculate the 25 per cent market shock on the gross and then deduct the debt, the alternative is to treat it as an equity investment which the market shock for listed equity is 45 per cent of the net value of the equity. That means that there is a 50 per cent gearing that’s more or less indifferent as an investor between investing in a fund or investing directly. If the gearing is less than 50 per cent and the equity treatment is what’s adopted then you are much better investing directly than through the fund. If the gearing is more than 50 per cent and the opaque treatment is adopted then you are better off investing in the fund than directly. I put forward that whatever they choose is going to be wrong for someone, so I believe you have to allow for that ability to choose between an opaque and transparent treatment because what’s right for a core fund with 30 per cent gearing earning nice, simple underlying asset is not going to be the right treatment for an opportunity fund going into a hotel company.

McNamara: Do we think that pension funds and pension fund trustees are on top of this issue currently? Do they really understand it?

Forbes: The regulator has been listening to the insurance companies, and to the insurance companies property is not a big issue. It’s very important to us in the real estate industry but to them, Solvency II covers every part of their business and property is just a small part of the investment side and they are also equally concerned about how they work out the liability
side of it.

The effort to make it simple means it is a massively blunt instrument, the idea that all property across Europe has an equal risk and an equal fall is bizarre but no less bizarre than the idea that any equity in the world that carries a risk at 39 per cent falls in value and any other form of fund or equity is at 49 per cent.

McNamara: There is an issue about where European regulators are taking their evidence on property from, which is perhaps from a more volatile UK commercially based database whereas, in truth, European markets have tended to be more stable than the UK. They also have a lot more residential exposure than in the UK.

Forbes: The other thing that we are finding is that fund managers who are not up to speed on that are generally the ones who are not up to speed on the change of demands – investors have got a lot more focused on good governance, investment reporting, risk management, controls environment etc. The people who are struggling with the regulatory side are also the people who are not really there with the whole change of business environment for investment management.

McNamara: What are the prospects for European real estate in the year ahead?

Tidy: I think there will be a widening between the prime end of the market versus secondary. It follows that secondary and the tertiary assets are going to be more challenging and in countries where the economic fundamentals are always positive, you are going to see that gap widen considerably.

Richards: Do you think prime has become over-priced?

Tidy: I think in some areas prime is looking very expensive. Certainly if you look at some of the transactions in the shopping centre sector that have been agreed over ther ecent months there have been some very aggressive prices paid. I still think that generally the prime end of the market and the north-western European markets are probably where we will see better performance.

Forbes: You don’t buy the average property and in the environment we are going to be in over the next four to five years there are going to be natural winners and natural losers out of all this so it is really understanding the capability of the people you are investing in. Digging down the granularity of their ability to generate asset management victories out of something where pricing is going to be fluctuating and there will be all sorts of things going horribly wrong. But that is where the opportunities come from too, the bad ones are going to drag the averages down, but the good performers are going to outperform the average.

Crawshaw: I think it’s really down to skill, whether it’s development, active asset management or stock picking, it comes down to having the people finding those opportunities and if they can’t be created – creating them. Prime may be fully-priced or even over-priced (based on the underlying fundamentals) but that doesn’t mean there are not good opportunities to be found either in prime property or in those buildings just falling short of the definition but in all other respects are fundamentally sound investments.

Werner: But one issue we did not touch upon, and it applies definitely to German regions, is the demographic issue. I mean, are you going to buy some a huge shopping mall in a city in the north east of Germany? Probably not, because you know that people are moving away. I would rather buy a shopping centre in Stuttgart and Munich or Istanbul. It goes back to knowing where you’re investing.


PANEL
Chairman: Paul McNamara, Director, Head of Research for PRUPIM, the real estate fund management arm of M&G Investments
Paul joined PRUPIM in 1987 after several years lecturing at Oxford Polytechnic. He is a Director of the company and has been Head of Research since 1990. He has a BSc Honours (First Class) and a PhD from the Universities of St. Andrews and Edinburgh respectively. He is an Honorary Fellow and past Chairman of both the Investment Property Forum and Society of Property Researchers, and a Visiting Professor at Oxford Brookes University. He has been co-chair of the UNEP FI Property Working Group and Chair of the IIGCC Property Workstream. He was awarded an OBE for services to the property industry in 2003.

David Archer, Director, Pitmans Trustees
David is a Director of Pitmans Trustees Limited and also a specialist in commercial litigation and business recovery. He founded PTL in 1994 when at the time he was Head of Insolvency at Pitmans and began taking appointments as Statutory Independent Trustee throughout the 1990s. David specialises in taking trustee appointments to problematic or distressed schemes; where the employer is insolvent or where there are complex re-financing or clearance issues.

Douglas Crawshaw, Senior Investment Consultant, Towers Watson
Douglas joined Towers Watson in August 2007, after six years at Aviva Investors (previously Morley Fund Management). Prior to joining Aviva Investors, Douglas was a Senior Manager in King Sturge Financial Services (King Sturge) the corporate finance advisory division of King Sturge, a firm of international real estate consultants. He is head of UK and European Real Estate.

John Forbes, Real Estate Funds Partner, PwC
John is a partner in the London office of PwC. He has been with the firm for nearly twenty-five years, six of them in Russia where he led the real estate practice in the mid 1990s. From 2008 to 2010 John led the Real Estate Industry Practice in Europe, the Middle-East and Africa across all PwC’s services to the real estate industry, before last year again turning his attention again fully to client work for real estate fund managers and major institutional investors.

Paul Richards, Head of the European Real Estate Boutique, Mercer
Paul is Head of the European Real Estate Boutique within its investment consulting business. He was previously Head of Indirect Real Estate Investment and Global Managed Accounts at LaSalle Investment Management, where he was responsible for managing global portfolios of unlisted real estate funds.

Rob Tidy, Co-Fund Manager of the M&G European Property Fund
Rob Tidy is Co-Fund Manager of the M&G European Property Fund, a diversified core fund investing directly in European commercial real estate. Rob joined PRUPIM, the real estate fund management arm of M&G Investments in 1994. Since 2001 he has been responsible for property investment and asset management across continental Europe.

Marc P. Werner, Partner, Hogan Lovells
Marc P. Werner is the former Head of Real Estate Germany and is now the Office Managing Partner of the Frankfurt office. He specialises in real estate M&A transactions and real estate financing and advises German and international investors on their investment projects in the real estate sector, in particular in connection with speciality properties.



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