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Friday 18 October 2019

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Roundtable: Property

Written by European Pensions team
October 2013

PANEL
Chair: Richard Gwilliam, Head of Research, M&G Real Estate
Alex Greaves, Fund Manager, M&G Real Estate (residential)
Paul Richards, Head of Real Estate Investments, Mercer
Simon Jones, Senior Investment Consultant, Hymans Robertson
Tony Hales, Managing Director, Stadia Trustees
Dermot Kiernan, UK Fund Manager, M&G Real Estate (commercial)


Chair:
We have recently had some relatively promising economic news coming through in the UK, so what impact has this improvement had on property as an asset class?

Richards: It is almost as if you can feel a change in the direction of the wind. Our clients are now much more interested in doing value-add-type investments and taking risks, whereas for the last four or five years it’s been about income and risk reduction. Vacancy rates in many places are declining. Clearly we are not out of the woods yet, but things are picking up.

Kiernan: I would agree with that. There has been quite a significant change in the market as a whole. The last few years have been typified by almost extreme risk aversion, which has been softening, but certainly on the back of the positive economic news we are seeing there is an increasing appetite for risk. A lot of that is on the fundamentals of demand and supply. Economic growth results in improving occupational demand and as we have seen relatively low supply over the last few years, investors feel a lot more optimistic about rents and capital growth.

Jones: Looking at how other asset classes have performed over the recent past, we’ve seen rallies in both bond and equity markets, whereas property has been a relative laggard over the last few years. Investors are now changing their focus in the search for return. You could argue that both credit markets and equity markets have repriced to reflect low levels of interest rates but property hasn’t suffered that repricing to as great an extent. I do see investors’ attention turning to real estate.

Chair:
Is that coming through in asset class allocation levels to real estate?

Jones: Investors have been maintaining their real estate holdings, rather than increasing levels of real estate investment. I think that position is starting to change, at least for reasons of rebalancing. As equities and bonds have both outperformed, property allocations have become underweight relative to target allocations. Investors are facing a need to rebalance towards real estate.

Chair: So what percentage of a portfolio should pension funds be allocating to real estate?

Richards: Asking what proportion should be made up of real estate is suggesting that there is a single thing called real estate. I think a feature of the last few years has been that UK real estate has become a number of things: an inflation-linked bond substitute, fixed-income debt and now a return to private-equity-like value-add. Before the financial crash a model might have said an allocation to core real estate should be 15 or 20 per cent, but you would probably allocate 5 to 10 per cent because of aversion to illiquidity. Now, we are seeing investors with, for example, only real estate debt but in their private debt allocation.

Chair: So pension funds are becoming more disparate in their allocations. Would that differ by countries across Europe?

Richards: Yes I think so. In my experience, the Germans are a lot more open to doing value-add risky investments, whereas in the UK investors have been about de-risking and finding substitutes for gilts and corporate bonds.

Jones: Asset allocation is being driven by the changing nature of the UK pension schemes. Over the last 10 to 15 years, we have seen pension schemes closing first to new entrants and increasingly to future benefit accrual. Pension schemes are maturing and whilst they still need to generate return, they are also facing the need to manage risk. Increasingly, pension schemes are looking for different ways to achieve this. The trend towards investment in annuity-type property funds is just one of the ways that pension funds have found to bridge this gap. Long-term inflation-linked cash flows from real estate, particularly with a real yield of 3 to 4 per cent is more attractive than index-linked gilt investment.

Chair: Relating to inflation, there has been debate historically about how good an inflation hedge property is. What does the panel think about this?

Jones: Property does not behave in the same way as pension scheme liabilities. If you consider, for example, the correlation between returns on property and index-linked gilts, which offer a good match for inflation-linked pension scheme liabilities, this is fairly low. However, looking at the underlying cashflows, particularly in the long-income funds, these can offer a reasonable match to pension scheme liability cashflows.

Chair: How important is income to property investors?

Richards: I think it is very important. There have been times in the last two or three years where property has seemed overpriced but with 5 or 6 per cent income yield it is still attractive relative to other asset classes.

Kiernan:
Income is absolutely key, providing around 70 per cent of the total return from UK commercial real estate over the longer term.

Jones:
The balance between income and outgo in pension schemes has shifted as these schemes have matured. A lot of pension funds find themselves in the position of being perhaps, at best, cash flow neutral or increasingly cash flow negative. As a consequence, these schemes have to meet this gap in their cash flow requirements in their cash flow somehow. Investing in income producing assets is one solution, and in that respect property is a very attractive asset.

Chair: In the UK, the popularity of long-income inflation-linked property funds has increased, why is that and can that be replicated across Europe?

Richards: It is providing an inflation-linked cash flow at a significant yield premium to the alternatives, gilts and corporate bonds. It seems to me that either the market practice or the legal structures in continental countries do not allow these really long leases.

Kiernan: In continental Europe, lease contracts tend to be shorter when compared to the UK, however, according to our research there is the potential to create longer leases and certainly there would be demand there in terms of the investment market.

Chair: Thinking about geographical diversification, how diversified are European pension funds’ allocations to property? Are they mostly in their own country or across all of Europe?

Richards: I think there is a home country bias but it is very common for continental funds to be diversified across the eurozone.

Chair: What is the argument for pension funds allocating outside of their home country?

Richards: It is usually diversifi-cation as long as you are prepared to take the currency risk.

Chair:
What about diversification into not just commercial real estate but into residential? What impact would this have?

Greaves: This is still very much an emerging sector but there are some new platforms emerging and there will be opportunities to invest in residential property and room for a large impact.

Chair: Thinking about UK and Europe in a global context, how is the performance of UK and European property compared to the rest of the world like North America and Asia?

Richards: It is behind the US. The US came out of the financial crisis much earlier than we did but I think we are catching up now.

Chair:
What about the relative pros and cons of investing in the UK or going outside?

Richards: If you can put aside the currency risk then diversification into North America is sensible because it is a bigger economy, it is more dynamic and it has different risk parameters. Asia and the emerging markets are attractive for entirely different reasons and market transparency and legal risks are different.

Jones: Geopolitical risk is also a factor. To what extent are such risks appreciated and understood when investing in certain countries and to what extent are these risks likely to change?

Kiernan: But didn’t investors in the UK go through the same process many years ago when they were looking at investing in global equity?

Jones: Global equities were an easier sell. An equity in the UK looks pretty much like an equity anywhere else and with greater liquidity, equity strategies can be changed very quickly. Real estate is fundamentally different to equities and consequently the considerations for investing in global real estate are different.

Chair: Has the appetite for leverage seen any change? Are investors more willing to invest in a fund that is highly leveraged?

Richards: It depends what it is being used for. If you are taking some underlying property risk above core (leasing or development, for example) and getting returns above core property, but you could simply gear core property at the same level and get the same returns then clients generally see no point. People do want some kind of underlying property activity that is creating value above core and if gearing is part of that then that’s ok. Taking gearing risk for its own sake just to amplify volatility hopefully on the upside, is not really of interest.

Chair: Property itself is a bond-equity hybrid. Clearly you have more risky types of property and they could be affected by leverage heavily and the more bond-like long-lease aspects. Real estate is multi-faceted. Should pension funds have allocations to all of those different types of real estate within that real estate bucket?

Richards: It depends on the individual pension fund. We are finding that we are dealing with clients who are not coming in saying they want ‘property’. They want real assets and that includes property alongside infrastructure. Or they want some private debt and that includes property debt alongside corporate debt and infrastructure debt. Or they have a liability matching portfolio and one of the elements of that is property. So they are not saying first of all we want property, they are saying we want this kind of investment characteristic, and then a certain kind of property may fit that box.

Jones: I would agree. Clients are thinking more about what problems they are trying to solve and how different asset classes and strategies can meet their particular needs.

Greaves:
When talking about property, does UK residential hit your agenda? Do you consider it as an investable asset class? Residential property has outperformed commercial property on all measures over the last 30 years. It also acts as a diversifier as it has a low correlation to commercial. In time investors will be able to invest in build to rent funds as there is quite a lot of government stimulation going on at the moment to try and create an investable product type. Owner occupation growth has come to a grinding halt in terms of the volume of people occupying that sector. It actually came to a grinding halt in 2000 so even when cheap debt was available you were not seeing increasing numbers of people moving to the owner occupational tenure type. Social housing development has significantly reduced in volume as well so the only thing that is actually growing is the private rental sector itself. The demand is there, the supply clearly isn’t. The requirement is for 250,000 new homes per annum and the best we have done in the last 20 years is 185,000 new homes in 2007. There is a massive shortfall. The American model in the eighties is what we are looking like now.

Chair: Do you think the recent surge of interest in UK residential will continue and gain momentum?

Greaves:
It is very early days but government intervention and local authorities are keen to get building. Politically there is a huge motivation to build significant numbers of units.

Chair:
If we are at the stage the US was at 30 to 40 years ago, what has held back institutional investment into UK residential?

Greaves: From my point of view, reputation has been a potential issue for people, being worried about what the risks might be. Rent regulations and a lack of investment grade product is also an issue.

Chair:
If you look at where the US and other parts of Europe are in terms of how mainstream professional institutional investment into residential is, could the UK become like that?

Greaves:
I think it could and I think there is scope for it, subject to not having government intervention and regulation hindering it. In the UK institutions currently own less than one per cent of the UK residential market.

Jones: There has been a surge of investor interest but my experience of late is that this has tailed off slightly. Interest is coming primarily from the public sector as local authorities who face a general need for housing within their respective regions may perhaps look to their pension funds as potential providers of capital. In my view one thing that residential investment does need is a sufficiently long-term investment horizon. Given this, the most likely source will probably be public sector pension funds which still have this long-term outlook. The challenge is to ensure that decision makers fulfil their fiduciary duty which remains to pay pensions, not solve the housing crisis. As to whether residential property can become more common, well the universe of asset classes open to pension fund investors has grown significantly over the last 20 years. I think it is sensible that residential property gets added to this list. Given the current interest in this sector, I
would suggest that if institutional investment doesn’t happen in the next five years, it is likely not to happen.

Chair: Tony, from your point of view what is property’s place in a portfolio from your clients’ perspective and what about the split between commercial and residential?

Hales:
We have been able to see what has been happening to the SIPP market in particular and the retail market in general. Certainly since the fall of Lehman Brothers there has been an appetite away from equities to property-type investments. I think the main search has been either for those funds where there are good covenants and that is probably more what an investor is looking for when they consider property funds. The strength of the covenants within the fund is what they are looking for as opposed to the fund manager’s approach to primary or secondary or tertiary property. For those who are approaching retirement and want to secure an income with the level of annuity rates at the moment, obviously if there is a good level of income underpinned by a good covenant then commercial property is a very attractive investment to make. I think there has been an equal amount of activity between funds and those investing direct either as individuals or we are seeing a lot more of syndicated property purchases. So instead of the one or two man band buying their own commercial premises we are finding many more syndicates coming together and buying small office blocks or shops. There is greater appetite now for property funds than in 2008 certainly. That is growing and property will become much more important in the allocation of pension funds.

Richards:
Picking up on that annuity point I have seen an interesting trend in the last three months which is insurance companies wanting to go into property debt to match their annuity liabilities because gilt rates are so low. Property has historically been a growth asset and when you get annuity time you go away from property but now I think property is actually becoming more attractive as an alternative annuity asset.

Hales: The other side of the coin, and it is probably more relevant to SIPPs than to institutional pension funds, is that I think property certainly accounts for a large amount of the investment in SIPPs across the board. But unfortunately the trend has been more towards the esoteric end of the market and that has caused the regulators a lot of concern and certainly the FCA at the present time in their proposed capital adequacy requirements for SIPP operators have classified property as a non-standard asset. The FCA report into this may mean that it will reconsider property as not being a total non-standard asset but somewhere in between and make the capital adequacy rules
on pension schemes a little easier.
A lot of the schemes which the FCA do not like have involved property or land, whether it is in the UK or overseas, so investors have to be very careful. I think that is why we are seeing this trend of people looking for good covenants in funds and in syndicated property purchases.

Chair: Where are the opportunities for property in Europe? Does the UK stand out?

Kiernan: I think the UK does stand out and on a global basis the UK is looking good value. Our house forecast is around 8 to 10 per cent per annum over the next few years, assuming an ungeared, core/coreplus strategy. We have talked about income, and there is currently an income yield of around 6 per cent plus now the opportunity for rental growth and adding value through active management. Over the last few years, post Lehmans, investment strategies have been defensive, it has been about keeping tenants in place but now I think we will see landlords increasingly going more on the front foot with a backdrop of improving demand and a lack of supply. Taking offices in the South East of the country as an example, whilst this year we will be ahead in terms of new supply against the low points of 2011 and 2012, 2013 will still be around 25 per cent below the ten-year average. The corporates have been holding back in terms of making occupational decisions and I think that the euro crisis was a large part of that. With positive economic growth and improving confidence, we expect occupier demand to strengthen, especially for commercial space. We are seeing good opportunities in other regional cities in the UK, it’s not just about London and the South East. There has been a huge influx of overseas capital to Central London over the last few years but the more sophisticated foreign investors are now looking outside these markets for greater yield and value.

Hales: I think the euro crisis is a good place to start when looking at Europe. I think there surely are some very good property opportunities as a result of the crisis and looking at those who are looking to come out of it strongly rather than those where the economy is shot to bits. I would make a comparison and suggest that perhaps property opportunities in the Republic of Ireland are probably far better than property investment opportunities in Greece or Spain. Certainly Ireland is still attracting a lot of large American corporate investment and it is seen as a relatively safe haven where the government and the people are working hard to get out of the recession as opposed to perhaps some of the Mediterranean countries which just don’t appear to be doing anything.

Richards: Things are changing within countries as well, you cannot just ride the national cycle. I think outside the South East there are probably places that are in decline and there are parts of many high streets which are also in decline, so as a property investor you have got to pick the right asset in the right location - back to property fundamentals. Picking up on the euro point, if you look across Europe, Germany is attractive and so are the Nordics on a global basis. There are probably attractive assets in places like Spain and Italy but I think it would probably be quite difficult to convince a pension fund to go there. They’d rather carry out high risk activity in the UK than buy something in Spain.

Chair: What about other parts of Europe, like central and eastern Europe? Given the improvement in maturity and transparency, is that now part of the core universe of Europe?

Hales: I wouldn’t say the core but it possibly has a satellite place.

Richards:
I think it would come behind the Nordics but above the southern European countries.

Kiernan: Although there is demand for some of the southern European countries. Picking up on the point about the UK and picking the right stock, if they are the right types of assets and suitably defensive, some investors are increasingly willing to make a bet on recovery.

Jones: What sort of investors are actually investing in these locations at this time in your experience?

Kiernan:
Some of the institutions are looking at these areas but it is probably more the opportunistic investors at the current time.

Hales: Should London and possibly parts of the South East, be a separate entity than the UK? Are there two markets?

Greaves:
There is in my world. Central London is not just a different market it is a different planet and is operating in a completely different way.

Richards: I think in terms of the investment market as well, the pricing in central London has been driven by international capital not by domestic capital flows and not by the underlying occupier market particularly.

Chair: So, where do you see value in the UK for real estate? If it is not in Central London then where is it?

Hales:
Many of the syndicated property purchases that SIPP providers do, are not in Central London or the South East, they are in places such as Manchester, Birmingham, those sorts of areas. Manchester is a very popular choice, more than anywhere else I would say.

Kiernan:
In terms of the types of property, I would say good secondary looks good value, that is, fundamentally a prime asset in terms of location and functionality but slightly be impaired in terms of lease length, covenant strength or its state of repair.

Richards: I think one thing that has led into that is the lack of capital expenditure over the last few years. There are some nice buildings in some great locations which have depreciated because they haven’t been taken care of. The pricing has got to the point now where it is worth doing. In terms of what is attractive in property, I think debt is still really attractive in risk-return terms compared with property equity and compared with other sorts of debt.

Chair:
How do you see the availability of debt likely to evolve going forward?

Richards: I don’t think it will ever be enough either for the borrowers or for the people who want to invest in it. Looking at the third party funds which have been launched, there were credible managers in place two years ago when the first wave happened and since then there have only been a few people credible offers. You have got to be able not only to structure debt but also underwrite property as if you own it. The number of managers that can do that is quite limited.

Chair:
In recent months the comments coming out of the US federal reserve about tapering have led to a lot of worries and concerns about the prospect of future rises of interest rates. Bond yields have already increased, how is it likely to affect property?

Richards: I think the spread will narrow. A lot of what has been driving flows from pension funds into property has been low gilt yields and if that does change then I think it will change the landscape.

Chair: So if that is one of the risks what are the other main risks around property at the moment?

Kiernan: The main obvious risk is a slip back into recession and all the knock-on effects from that. Things do look positive at the current time but we live in a fast-moving world so there is the potential for volatility.

Hales:
Yes, that would have a big impact on any diversified property portfolio not just the offices and the industrial units but also on distribution where there has been good growth and logistics. I think it would have a big impact on the leisure sector and also on the retail parks. Whilst the government is trying to limit the number of retail parks that can now be developed and out of town developments perhaps we may see more M&A activity from pension funds taking that type of property over. But if we do go back towards recession it will have a serious impact on the covenants in that type of property.

Chair:
What about risks emanating from the regulatory side? What issues are there to be aware of?

Hales:
They are relentless at the moment. Certainly at the SIPP end of the market and for the investors investing direct, property has been seen as a non-standard asset and is put in the same class at the moment as esoteric assets such as Jatropha in Togo. I think the regulators have got to look at property as a separate entity and try and come through with a sensible alternative and accept that it is a good investment. Whilst possibly the vast majority of pension investors will not be affected by what happens in the SIPP market, all press and reporting about the detriments of property being a non-standard asset, illiquid with lots of risks it will put people off investing in mainstream property funds. If you don’t get the mainstream investment from the ordinary investor it will dry up. You need the new money coming in. The regulators are playing a very important role in this. Let’s hope that they come out with a not so harsh opinion of straight forward commercial property investments than their stance is at the moment.

Richards: Solvency II has been a factor and there has been a fear that the effects of that will be brought across to pension funds and property might be regarded as much riskier than we all probably think it is. We all know about AIFMD as well but I don’t think we know what the implications of that will be quite yet. These regulatory issues are all looming in the background.

Chair:
How prepared is the property investment industry for sustainability? Is it investors and developers being pro active or are we just reacting to the legislation that is coming through?

Kiernan: I think sustainability has increased enormously in significance over the last few years. Certainly in terms of what we are doing at M&G, it is very much part and parcel of our investment process, whether that be buying, selling or ongoing asset management. We are seeing it come through in practical ways in terms of occupier demand. An increasing number of corporates (and it has been the case for government departments for some time) won’t take certain buildings unless they meet a certain EPC standard. It’s definitely starting to influence property investment decisions and we expect that trend to accelerate over the next couple of years as the date for implementation of new legislation and affecting the lettability and saleability of buildings with poor EPCs becomes more widely understood. Sustainability is part of the overall consideration of real estate obsolescence which has always been there but it does definitely put this factor higher up the investment agenda.

Chair: What impact is sustainability having on residential property?

Greaves: It’s a little bit further away and is starting to get priced in to how developers and house-builders are looking at land values because we currently build to code level 3 from a building regulation point of view. However, some councils have the powers to enforce buildings with slightly higher code levels so when people are bidding for land they are actually beginning to bid in a dual aspect way.
With regards to EPC ratings, the Victorians were incredibly successful in the speed and delivery of their housing to what we are now and as a result there is a lot of very historic stock out there which has got poor energy ratings which will need to be changed.

Chair:
Thinking about new building just generally across the board what recent trends have we been seeing? Is there under supply generally across the board?

Greaves: There is in the areas that needs it is the issue and where you can build it in volume terms. The NPPF is being looked at in detail and the various different councils are very keen to stimulate new building.

Richards: Going back to the environmental point, we rate all our managers on ESG factors and real estate has recently been the top performing sector in those terms mainly for good economic reasons – efficient buildings generally perform better.

Jones:
How much interest have you seen from investors in the environmental aspects of property?

Richards: It depends. Some pension funds, particularly local authority pension funds, have got really strong policies and some don’t. So the interest does vary and the extent to which a manager will be questioned about their ESG performance will vary from investor to investor.

Kiernan: I find the same thing with individual investors. They are generally returns focused so if there is a good economic case for being greener (which there is) they are very supportive. They are really relying on us to explain how the market dynamic is playing out in terms of stock we are looking at which could be more obsolete as a result of some of the forthcoming legislation.

Jones: In my experience, the public sector has certainly been more focused on this than the private sector.

Hales:
Student accommodation is a good example. Investors do want to see environmentally-friendly actions being taken.

Chair: What are the prospects for property in the UK and Europe for the year ahead?

Hales: From an investor’s point of view, it is a difficult time and there will be much due diligence on good covenants in schemes. If these are there it will attract more people into property funds and it is all about the quality of the stock.

Chair:
How best will investors find value and deliver performance? Is it all about covenants or other things?

Kiernan:
It is about going back to basics and how well the individual managers can add value and exploit favourable conditions for growth picking the right stock and actively managing their portfolios.

Richards:
The interest in property debt and inflation-linked income is still there, it is still very strong but now there is also interest in traditional value adding property skills - finding a good asset that other people haven’t spotted and adding value to it.

Jones:
The attraction of property to pension scheme investors will be driven by underlying dynamics and requirements of individual pension schemes.



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