Commercial real estate is the flavour of the month. It has become the best-performing asset class over one, three, five and 10 years and pension funds have been increasing their real estate allocations for the first time in two decades.
The asset class has benefited from an increased focus on alternative investments, prompting some (most notably real estate investment managers) to suggest it should be considered a mainstream asset class like equities and bonds.
So should real estate be considered one of the building blocks of an institutional portfolio and what does it bring to a portfolio?
Commercial real estate exhibits both income and equity characteristics: rents contracted under leases are rather like the coupons from a corporate bond while rental values can rise either through inflationary pressures or real economic growth.
Historically, most of the total return delivered to investors has been through income rather than capital growth, further demonstrating the asset class’ bond-like qualities. An investor in direct real estate can build a portfolio biased towards the equity or bond characteristics.
Nick Duff, head of property at investment consultant Hewitt, Bacon & Woodrow, says: “Real estate is still an alternative. Pension funds primarily focus on bonds and equities.
“The reason why real estate comes into the equation is that it is a very good diversifier. The long-term correlation between real estate and equites and bonds is very low.”
Research from real estate specialist LaSalle Investment Management shows a correlation between real estate and bonds of only 0.06 and between real estate and equities of 0.19 in the period 1971-2003. In the same period the correlation between equities and bonds was 0.62. Real estate is also less volatile (based on standard deviation of returns) than equities and bonds.
“The low correlation between real estate and the main asset classes means that it smooths out overall performance,” says Duff. “It’s also popular with pension fund trustees because it’s easy to understand. They feel they can identify more closely with real estate than other alternatives.
“The Myners report recommended that pension funds give more consideration to alternatives. They should be looking at other asset classes which help meet their liabilities. So for the past two-to-three years pension funds have put more money into alternatives.”
Meeting the threat of unexpected shocks - such as the recent telecoms and high-tech crash - requires portfolios that are better balanced than those that have historically been held by pension funds. Most analysts argue that these have been overexposed to equities given their maturity.
Past or expected returns alone are now an insufficient basis for asset allocation decisions: portfolio balance is a function of blending asset returns so as to best meet current and future liabilities, that is, asset diversification.
“At investment strategy reviews, real estate is very much on the agenda,” says Duff. “Our house view is somewhere between 5% and 15% and most pension funds have between 5% and 10%.
“Some pension funds which have a whizzier attitude might find real estate dull and boring and prefer to put their money into private equity. On the other hand, there are funds putting money into real estate for the first time and others which are increasing their allocation. But we are not seeing blanket, across-the-board rises.”
Greg Wright, senior investment consultant at Watson Wyatt, says: “It depends very much on the profile of the pension fund.” A mature pension fund is likely to be 100% in bonds; a less mature one, with few pensioners and fairly young contributors, has more scope to invest in equities and alternatives.
“Some large and well-established pension funds have held real estate for decades, so you could argue that it is a core holding for them. On the other hand, as it is being held as a diversifier, it seems odd to call it ‘core’,” says Wright.
The average institutional weighting is still barely over 5%, but this is brought down by the large numbers of funds with no real estate at all. For those UK life funds with real estate, weightings of 14-15% are not exceptional and pension funds tend to have 5-10%.
Duncan Owen, head of property at Insight Investment Management, says some UK life funds
have about 20% in real estate.
The Insight-managed Clerical Medical with-profits fund now has just over 20%.
“We find that the asset allocators are quite comfortable with this level of property,” he says. “But this is at the top end of the scale. For our in-house clients, the lack of volatility in real estate returns is a major bonus.
“Our house view is that the UK is at the start of a long but gentle bear market in equities. Real estate will, of course, track that performance to a certain degree, but there is a time lag – which gives diversification – and the lack of volatility.”
For funds investing in direct real estate, one of the major advantages is that it offers asset management opportunities. Unlike equities and bonds, ownership of real estate conveys full control of the asset. The disadvantage of this is that the owner is fully liable for the asset and, if vacant, its local taxes and upkeep. The costs of trading are also substantially higher than in equity and bond markets: taxes on property transfer are a major cost in most European countries.
“Research has indicated that stock selection and management are the key factors driving out- or underperformance against market benchmarks, usually based on indices provided by Investment Property Databank," says Gerald Blundell, head of research at LIM.
“The more properties are operated as active business situations by their owners rather than passive ‘paper’ holdings, the better their chances of superior returns.”
However, the lumpy nature of real estate (a big shopping centre could cost £200m) means it is hard for a smaller pension fund to build up a balanced portfolio. Even those with the cash to spend might be deterred by the costs of maintaining a real estate team and the management services needed to run the portfolio.
Nonetheless, a recent UK phenomenon has been the entry or re-entry to the market of smaller pension funds. Many have taken the indirect route. Over the past three or four years, investors have been able to choose from an increased range of pooled property funds, both specialist and balanced. There are also multi-manager mandates and funds of funds that enable pension funds to spread both property and manager risk.
Duff says: “These are good for funds with between £20m and £50m to invest. Indirect vehicles can also offer much better liquidity that direct property, although this varies from fund to fund.”
For example the Hercules Property Unit Trust, which invests in UK retail parks, has an active secondary market, with over £200m of units traded last year.
One of the key attractions for real estate investors, especially in the UK, has been the asset class’ recent outperformance. The latest IPD figures show UK real estate posting annual total returns of 16.1% at the end of July, compared with 10.7% for equities and 0.9% for bonds. However, over 20 years annual equity returns were 17.5%, real estate 12.6% and gilts 12%.
Duff says: “Some funds have seen recent performance and think they can reap the rewards but you have to look at real estate as a long-term asset. The long-term position of real estate is where it always was – between equities and bonds. It’s a good alternative but it’s still an alternative.”