Property is thrift

PENSION FUNDS ARE showing renewed interest in property as an asset class as the expectation of stunning equity returns fades. In difficult times these funds have been forced to refocus on asset liability management and have learnt the hard way that a diversified portfolio is a prerequisite of good performance.

Investors are therefore keen to consider alternative investments and property is beginning to receive the attention that is its due. Somewhat belatedly, fund managers have come to realize that property has for years been outperforming other asset classes and matches better with pension liabilities than equities do.

Property’s outperformance of other asset classes on a global basis has helped to draw the attention of institutional investors worldwide. “One thing that has triggered renewed interest is that, as of last December, property has been the best performer over 10 years,” says Cliff Hawkins, head of UK property at UBS Global Asset Management. This holds true for property globally. In the 10-year period to April 2003, global property returned 11.5%, compared with 8.1% for equities and 7.6% for bonds.

Pension funds have had their fingers burnt by the equity markets and have been looking for ways to avoid this happening again. Investors in the US and UK have been particularly hard hit since they allowed equity allocations to drift up towards 70% while allocations to other asset classes languished.

In the renewed search for diversification, a steady income and a better match to liabilities, allocations to property have increased. In the US, institutional investors’ allocations to real estate have risen from 2.3% in 1999 to 3.4% in 2002, according to Greenwich Associates. The diversification drive has also meant an increase in allocations to other alternative asset classes. The share of assets invested in private equity went from 2.1% in 1999 to 3.1% in 2002, and allocation to hedge funds grew from 0% in 1999 to 1% in 2002.

UK consultants and pension funds are also showing more interest in property as an asset class. The allocation of pension funds to property has increased from 4.4% in 1999 to 5.8% in 2001 and 6.9% in 2002, according to the WM All Funds, which measures 70% to 75% of the UK pension funds industry. Eric Lambert, head of client consultancy at The WM Company, says: “Almost every large fund of, say £500 million upward, will hold property.” It is more difficult for smaller pension funds to do this because of the nature of investing in the asset class and the necessary expertise and resources required.

The cult of equities Large UK pension funds typically have higher allocations to property than smaller ones. In 1999 larger pension funds had 6% allocated compared with 8.2% in 2002, according to the WM50. Smaller funds were 2.3% invested in 1999 and 4% in 2002, according to the WM2000. Tim Bell, head of UK property at F&C, says: “Prior to the 1980s [UK] pension funds were very concerned about inflation, so property fitted well. But during the 1980s they became caught up in the cult of equities.” Equities were delivering the highest returns, so relatively immature pension funds put most of their cash into equities.

Although consultants and pension trustees globally show an increased interest in real estate, the extent to which the rise in allocations can be attributed to active investment is difficult to ascertain, particularly in the UK and US. This is because the fall in value of holdings of equities has automatically led to an increase in the proportion of other asset classes held.

Glenn Newson, head of UK property at Credit Suisse Asset Management, says: “Traditionally, 10 years ago you would have seen pressure to reallocate [out of assets such as property] because it was out of kilter with their strategy.” But there is no evidence that pension funds are selling real estate to take down their allocations now. Newson adds: “[The question is] whether pension funds are prepared to pump more money into property to maintain levels reached over the last 18 months.”

Real estate is the most popular alternative asset class for institutional investors in continental Europe, according to a survey published by JPMorgan Fleming Asset Management in July. Seventy per cent of institutional investors there are currently invested in real estate, while only 48% are invested in private equity and 22% in hedge funds.

Continental European pension funds have been typically more highly invested in property than those in the UK and the US, mainly because they didn’t become as heavily caught up in the equity culture during the late 1990s. In fact, allocations to real estate by pension funds in Sweden, the Netherlands and Switzerland have remained consistent at around 8%, 6% and 12% respectively at the end of 2001 compared with 8%, 6% and 13% at the end of 1999, according to UBS.

It is important for investors to be well diversified across asset classes to avoid the impact of poor performance of any one asset class. It is also important to be diversified within each asset class. This is difficult for a pension fund to achieve if there is only a limited amount of capital allocated to property and will inevitably be a more difficult task for smaller investors.

Among the best performing property sub-sectors in Europe have been the industrial and retail property – that is, out-of-town retail warehousing and shopping centres. One of the worst-performing sectors has been urban office space – for example, central London offices that have suffered from the financial markets downturn.

Fonciers sans frontières Cross-border investment is one way to increase diversification and it has been growing in continental Europe. Patrick Bushnell, director of property for Europe at Henderson Global Investors, says, for example: “German investors are increasingly looking at pan-European investment rather than just Germany.” He adds that Dutch pension funds, which in particular have a tradition of investing in domestic property, are also increasingly investing cross-border. Danish and French pension funds are also looking more at non-domestic property investment.

Cross-border investment has yet to attract much interest from UK investors. “Interest in UK property has only just been reawakened and there’s a slim probability they’ll invest overseas,” says UBS GAM’s Hawkins. The UK interest has been mainly confined to larger pension funds. Nick Duff, an associate at pension fund consultants Hewitt Bacon & Woodrow, says: “Pension funds with less than £500 million are able to get enough diversification from investing in the UK market.”

Investing cross-border has been more popular for investors in continental Europe because the single currency means they no longer have to take on currency risk when investing in other eurozone countries. Kiran Patel, head of research strategy at Axa Real Estate Investment Managers, says: “Five years ago European institutional investors had less than e10 billion invested outside their domestic countries.” In 2002 such investments amounted to e30 billion.

Although property has been outperforming other types of asset classes, consultants warn that there is no guarantee that this will continue. Andrew Walker, senior investment consultant at Watson Wyatt, says: “Performance figures help people feel more comfortable [about investing in property] but what’s more important is that it’s been a good diversifier.” He cautions: “People looking at property because it has performed well have the wrong end of the stick. If it’s had good performance it could mean that it won’t perform as well in future.”

Pension funds are being encouraged to invest in property primarily because it offers diversification and is a better match to asset liabilities than equities. Although pension funds in the US and UK have traditionally had particularly high allocations to equities, investors globally have been feeling the pressure to further diversify their portfolios and look to investments that better match their long-term liabilities. A survey by Invesco in July found that the primary reason why European pension funds employed consultants in 2002 was to carry out asset liability studies, whereas in 2001 they were used mainly to assist in the selection of external managers.

A good liability match The investment characteristics of real estate do seem to be highly favourable for pension funds. The asset class provides real returns above inflation and is bond-like in having a secure income stream from rent paid by tenants. “The income from property is not as guaranteed as government bonds but there are often 25-year leases with five-year rental reviews which are usually only upward,” says WM’s Lambert. And there’s an element of safety that does not apply to corporate bonds: if tenants default on the rent the investor still owns the underlying asset.

There is also an equity-style component to investing in real estate since the value of the property may rise. The fact that there is a low correlation between the performance of property and other assets as well as a high correlation with pension fund liabilities adds to the case for investment. For example, between 1947 and 2000 UK property was 36% correlated with UK pension fund liabilities while UK equities were -5% correlated and UK fixed income was -34% correlated, according to The Pensions Institute.

There are, of course, certain aspects to investing in property that investors should be aware of, such as the high exit and entry costs. In the UK, for example, stamp duty on property transfer is 4%. The investor must also pay management and legal fees on top of that. However, as CSAM’s Newson points out: “Stamp duty is high but most people are looking at holding property for three to five years.” Hewitt Bacon & Woodrow’s Duff adds: “A round trip costs about four basis points more than equities or bonds so you can’t have an active trading policy as you can with equities and bonds.”

Real estate is also an illiquid asset class and the fact that it’s more expensive to buy and sell is balanced by the fact that it’s not traded daily. Although it is illiquid it is no more so than private equity. And pension funds are long-term investors so this should not be a major concern. Axa REIM’s Patel says: “If you’re a long-term investor, liquidity is not a big deal.”

Another issue to be aware of is that property is a management intensive investment. “[It] requires specialist management,” says Axa REIM’s Patel. It also requires continuous maintenance. “If it isn’t kept up to date it depreciates.”

Traditionally, investment in property was direct. However, this is not a viable option for small to medium-size investors. “There are only 30 to 40 pension funds in the UK able to allocate £300 million to real estate,” says Patel. Therefore, pooled vehicles such as pooled unit trusts (PUTs) and funds of funds – where a mandate is given to a fund manager to invest across different property sectors – have gained in popularity.

Real estate investment trusts (REITs) are another way investors can access the market. These vehicles are not subject to double taxation. The investment isn’t taxed at the corporate level as well as at the individual level so end investors only pay individual income tax on their investments. “The primary reason for exposure to REITs is income,” says Duff at Hewitt Bacon & Woodrow. Investors receive a bigger distribution of income because REITs are required to distribute the majority of their income directly to shareholders.

The rise of REITs REITs have been available in the US since 1960 and other countries have since introduced the structure. In Europe they are available in Belgium and the Netherlands and have recently been introduced in France. The UK government has resisted the move but did show signs of softening its attitude in April this year.

Fund managers and consultants believe the introduction of REITs in the UK could increase pension fund investment in real estate. “It could lead to more investment in property but it depends on the pension fund,” says Duff. He explains that if diversification is the main reason a pension fund is investing in the asset class it might not want to invest in REITs. Patel agrees: “They will be another structure for pension funds but because they will be listed instruments they may be correlated to equity markets.” However, the performance of REITs in Europe has been stronger than that of orthodox equities.

Fund managers expect property to continue to perform well. In a Watson Wyatt survey published in May, UK fund managers gave their one-year and 10-year return expectations for property per annum. Expectations for one year were spread between 5% and 8.2% with a mean of 7%. Ten-year UK expectations were between 6.9% and 9%, with a mean expectation of 7.8%. F&C figures show that the manager expects UK property returns to rise from 7.8% in 2003 to hit 9.3% in 2005.