For the majority of pension funds, diversification from quoted equity investment is the key reason for holding real estate. Real estate is typically seen as sitting somewhere between equities and bonds, albeit closer to bonds than to equities. Historically, real estate has shown low correlations of returns to both of these asset classes.

There are a number of reasons for this, notably the valuation process, which is reliant on a
valuer assessing market value (which tends to smooth out volatility) and other more fundamental characteristics. These include the attractive income return (relative to bonds and equities) which has and will continue to underpin

However, what most pension funds are ignoring is the fact that real estate offers opportunities for active management and can fit different strategies. Based on this, we believe there are two key roles which real estate can perform in a portfolio:

n Diversifier - as mentioned previously, this has traditionally been the main reason for holding real estate in a portfolio.

n Alternative source of equity-like returns - utilising a much more aggressive approach incorporating developments, more speculative investments and leverage has the potential to produce equity-like returns over the long term.

The decision as to which of these roles is the
primary motivation for holding real estate will have a large impact on portfolio strategy, governance and choice of fund manager.

Another important question when investing in property is geographical exposure. Pension
funds have long included non-domestic and
global assets in their equity and fixed income portfolios but in some markets relatively few
have taken steps to invest in property outside
their home market. The natural way to begin such an expansion is investment in other European countries.

In the UK, for example, the size, diversity, transparency and greater maturity of the local real estate market relative to the continental European alternatives have, until now, deterred many potential pension fund investors.

However, real estate markets are evolving rapidly in mainland Europe, and increasingly UK pension funds are recognising the need to consider opportunities beyond a purely domestic focus.

We believe that there are a number of key reasons why pension funds should consider expanding the scope of any real estate mandate to include other European countries. These are:

n The sheer size of the market in terms of investment product.

It is estimated that the investment grade stock in Europe totals €2trn; the UK, for example, one of the largest real estate markets in Europe, accounts for only 20% of this total.

n Opportunity to diversify risk/return profile.

Exposure to other European countries will further improve diversification as investments will be split across the different countries and sectors exhibiting different economic cycles, and individual real estate markets will also behave differently both in terms of the overall returns and volatility.

n For pension funds
considering an investment in UK real estate, the
difference between the performance prospects for UK real estate and those for continental European real estate are also a key consideration.

There is evidence to suggest that the performance prospects for continental Europe over the short to medium term are attractive relative to those for the UK.

Yields for real estate in the UK have fallen over the last two and a half years, resulting in significant rises in capital values. This has been driven by the weight of investor interest in this sector and is known as yield compression. The chart on the opposite page provides an indication of UK yield levels in comparison with the rest of
Europe and illustrates that most continental European markets are lagging the development of yield compression in the UK. This indicates
a greater potential for capital growth for continental European real estate compared with UK
real estate.

A key decision for fulfilling a real estate allocation, whether focused on the pension fund’s home market or incorporating other European countries as well, is the method used to access the sector. The three main options are:

n Direct segregated portfolio, so that the investor would have direct control and ownership of real estate assets;

n Investment in pooled funds (alongside other investors to improve the overall exposure to a well diversified real estate portfolio);

n A manager’s fund of funds product (alongside other investors) or a segregated multi-manager approach (where a manager implements and monitors a client-specific portfolio usually comprising balanced and specialist pooled funds).

For a pension fund wanting to invest €100m in European real estate, we would recommend the indirect route, either via a selection of pooled funds or via the multi-manager approach. This is largely due to the size of allocation. A direct portfolio of €100m with a relatively small number of properties could be overly exposed to single poor performers caused by top-down (eg over-supply) and property-level factors (eg tenant default on rent, building falls vacant).

These risks can be mitigated by indirect investment, through which investors can gain exposure to a much larger range of real estate by country and sector despite the relatively small allocation size. This provides diversification benefits and the increased exposure to a greater number of
tenants and properties means that the income produced can be regarded as more stable. For pension funds which are unable to gear directly, indirect investment also provides exposure to leverage and can have a beneficial impact on returns.

Having explored all of the above questions, let’s have a look at practical
examples based on a property allocation of €100m.

We differentiate investors in a number of ways, depending on their attitude to investing outside their own market and their risk/return appetite. Broadly speaking, there are three classifications we consider.

n Home market-only exposure:Despite the diversification and return benefits of having non-domestic real estate exposure, some pension funds still prefer domestic real estate investments because of familiarity with the market.

At the low-risk end of the spectrum,
the portfolio will be appropriately diversified and consist of mainly core
(investing in well-let, well-located prime assets) balanced funds with some exposure to specialist funds (concentrating on one particular sector or market theme). At the higher end of the outperformance objective (moving from low risk/return appetite to medium and high), the use of specialist funds may potentially play a significant role (up to 30% of portfolio). There would also be increased focus on ‘added value’ (slightly more letting and refurbishment risk than core funds) to deliver outperformance within the key office, retail and industrial sectors. There may also be material exposure to the ‘other’ sector, eg leisure, garden centres, healthcare and the motor trade.

Gearing levels (debt financing to increase
portfolio size) in the underlying investments
will play a role, especially when investing in value-added and opportunistic vehicles. The aggregate gearing level can range from as low as 20% if core balanced and specialist funds are used, up to 50% if opportunistic funds are also included.

A pension fund with a low risk/return strategy is looking at long-term real returns of approximately 4% pa, whereas investors with a medium to high risk/return profile will be able to target 5-6% pa.

The liquidity for a low risk/return strategy should be good due to the open-ended nature of most balanced funds and an active secondary market in the UK. By adding specialist funds and value-added or opportunistic vehicles the liquidity will decrease because of the closed ended nature of such investments.

n Home market with some exposure to other European countries:Depending on the investor specific risk/return profile, the exposure can range between 10% and 30%.

Investors will mainly invest in core balanced and specialist funds with up to 40% of value-added funds. Value-added investment might still focus on the investor’s home market due to the familiarity with the underlying dynamics. The exposure to non-domestic real estate would be restricted to core funds, although those could include specialist core funds such as French logistics or German retail warehouses.

Opening up to specialist and value-added funds as well as non-domestic exposure would result in higher gearing. We estimate the gearing to average 30-40% on an aggregate portfolio basis for a low to medium risk/return investor, but this could be as high as 60-70% when applying a more opportunistic approach.

The additional risk will, however, be well rewarded by achievable real returns of 5-7% pa for the low to medium risk/return profile and up to 9% for the opportunistic approach.

There will be less liquidity for the investments in continental Europe because of the very limited activity in the secondary market and the closed-ended nature of most investment vehicles. This has to be taken into account when determining the time horizon for the investment strategy.

n Pan-European exposure:Investors with such an investment strategy would want to invest in the countries, markets and sectors which are forecast to outperform the general market over the short to medium term.

The focus again will be on core balanced and specialist funds, but the weighting to value-added funds will be slightly higher (say 50%).

Creating a return-driven portfolio depends on identifying changing market themes in different countries. Some current themes are:

Germany (retail, because of strong cash flows and higher yields);

Central and eastern Europe (higher yields compared with western Europe, but yield compression well under way);

Logistics (lack of quality assets, but location very important); and

Portugal and Greece (lack of quality assets in key urban areas).

A pension fund with a low risk/return profile would start with an overweight to core funds, the majority of which will be specialist funds enabling an investor to explore specific market themes and a satellite investment into value-added funds, say up to 30%. As the pension fund moves up the risk curve the exposure to value-added funds will increase and an investor targeting high returns will also have exposure to some opportunistic funds.

The gearing level for an ‘unconstrained’ approach across the European real estate market will average 30-40% on an aggregate portfolio basis for a low to medium risk/return investor, but could be as high as 80% when applying a more opportunistic approach.

The achievable real return ranges from 5-6% for the lower risk approach and 10%+ pa for the opportunistic approach.

Liquidity has to be managed carefully for such a mandate as the exposure to closed-ended vehicles for which the secondary market is not currently well developed will be high.

From our point of view, real estate can play several roles in a pension funds portfolio, and exposure to real estate in European countries besides the home market should be part of it. However, finding the right indirect investment opportunities or appointing the most experienced multi-
manager is crucial.