Drive to devise packages for funds

British investment banks and real estate agencies are using all their ingenuity to design property packages that appeal to pension fund tastes.

They are having some success, not least with pension funds from elsewhere in Europe.

Why does real estate need packaging? On the face of it, commercial property should have a big appeal for pension funds. They need to invest in assets that will match their long-term liabilities: liabilities that may be 40 years off. Property is an asset with a very long life.

For many years the UK property industry been searching for ways of securitising” property. Not many funds would want (or be able) to buy a single large property for £50m or £100m. And all property takes a considerable time to market and sell.

But supposing you split the ownership rights to these large properties - or to a portfolio of different properties - among a range of investors? The properties themselves could be managed by professional managers, thus removing this burden from the investors. And the pieces of paper representing ownership rights would probably be far easier to buy and sell than the properties themselves, but still confer much the same benefits as direct ownership.

Securitisation is one line of thought. The other is the development of property “derivatives”. Instead of needing to buy or sell physical properties when you wanted to increase or reduce your exposure to property, you could deal in property derivatives whose value would depend on movements in the value of physical properties. Again, the derivatives should be much easier to buy and sell than properties themselves. Or so the theory goes.

Plans to securitise properties have been around for many years. They have usually foundered on the complexities of English property law, which makes it difficult to divide the ownership of a single building, and on the UK tax system. It proved very difficult to design a vehicle that would own the properties and channel the rental income down to the investors without any prior deduction of tax. If tax was deducted before the investor received the rental income, he was not in the same position as if he owned the property or a chunk of the property direct, and the investment lost much of its attraction.

The difference this time, according to Rupert Clarke of real estate agency Jones Lang Wootton, is that the pressure for new property investment vehicles is coming from Britain’s existing major commercial property investors: the insurance companies and pension funds. The repackaging of property cannot be dismissed merely as a way of attempting to drum up business by City of London advisers and large estate agency firms.

And some progress has been made. In 1994 Barclays Bank launched Property Index Certificates (PICs). In effect, these were a form of bond whose return to investors depended on movements in the UK’s most widely used index of property values: the IPD Index. This was not a securitisation of portfolio of physical properties, but it had something of the same effect. By buying PICs, investors could acquire an exposure to movements in property values and the income from property without needing to buy physical properties.

The sale of PICs, in several different tranches, has raised a total of £275m and pension funds have been the predominant buyers. Though the UK’s own pension funds accounted for more than two-thirds of the total, pension funds from other European countries took up almost 17%. The Dutch, in particular, have always shown an interest in innovative property vehicles.

It was again Barclays - in the shape of its investment banking arm, BZW - that took property derivatives a stage further near the end of last year with the launch of Property Index Forwards. This over-the-counter derivative product provides a way of betting on future movements in the value of commercial properties - represented again by the IPD Index. The bet can, of course, be used in conservative mode as a way of hedging the value of an existing portfolio of properties. You have a large property portfolio, you think property values are going to fall over the next year, and you want to reduce your exposure to property. Rather than trying to sell the physical properties, you can sell a property forward contract. If you are right and values fall, the money you make on your forward position compensates you for the loss in value of your physical property portfolio. Based on Property Index Forwards, BZW has also introduced another “synthetic” product, the Property Index Note, which provides exposure to movements in property values but also allows investors to lock into a known level of income.

BZW may not have the field to itself. A group of heavyweight City of London institutions, led by Australian insurance group AMP, plans a traded market in property futures under the title of REIM (Real Estate Investment Market). This is not the first attempt. The commodity exchange then known as London FOX launched property futures contracts in the early 1990s. The project rapidly collapsed. The backers this time are more impressive and the project appears to be considerably better planned.

For funds wanting a packaged property investment rather than a synthetic product, specialist property investment funds are enjoying considerable popularity. Real estate agent Jones Lang Wootton has been involved in the development of several of these vehicles, including one specialising in leisure property (a growth area in the UK). The agency has made use of its worldwide know-how to structure funds that will appeal to investors outside Britain as well as domestic institutions. Typically, these vehicles will be set up as limited partnerships with a finite design life of five, seven or 10 years.

There is no doubt that further property vehicles and derivatives will be developed to appeal to funds which want the exposure to property without the attendant hassles of direct ownership. The remaining question mark is over the liquidity of the new vehicles and products. Will an active secondary market develop in these products? Will forward or futures products remain truly liquid at a time when, say, a majority of funds decide to reduce their property exposure and appear as sellers at the same time?

Liquidity has its cost. Prices of the packaged property products that are freely traded in a market may prove considerably more volatile than the values of the underlying physical property.

Michael Brett is a freelance journalist and author of “Property and Money”