On the way to a single market
The advent of the euro and weakening returns from other asset classes, particularly fixed income, is leading European pension funds to examine their property allocations, with a view to finding a ‘halfway house’ between bonds and equities.
And the impending pension funding question confronting much of the continent certainly seems to have sharpened the focus in recent months.
Hans op’t Veld at Amsterdam-based Global Property Research says he has definitely seen a recent Europe-wide shift towards increased real estate investment. “Pension funds are starting to look for alternatives in which the risks are still modest but the returns more in line with their expectations. In Holland both property allocations and attitudes are changing, despite the property crash during the early 1990s, with book values of real estate getting back to the levels of 10 years ago.
“Funds are becoming flexible again with their exposure and the euro is prompting them to gain exposure to other countries via indirect property shares, which would certainly be too difficult on a research level for smaller funds to do directly.”
He says the Iberian peninsular has been attractive over the last few years. However, he points out that most funds accept that high performance figures from Spain, Italy and Portugal have been linked to large yield shifts in the region, which have now dissipated.
“The funds realise they now must seek out fundamentally sound market zones, and they are waking up to property opportunities in France and Central & Eastern Europe.
“What we are also seeing is an enormous swop occurring between UK and Dutch investors, with switches of domestic property in favour of exposure to the French or Spanish markets, and vice versa for Spanish investors entering the Netherlands.
“It looks like we will soon have a single European market because cross-border activity is increasing and when you look at the continent’s banks and money managers they realise this is happening and are trying to cash in on the concept by offering pan-European real estate products.”
However, the lack of fiscal convergence to date in Europe is undoubtedly hampering the process, and op’t Veld fears political protectionism, which he has already heard mentioned in Germany, could also stall progress. Nonetheless, he believes Europe’s pension funding issue will push the debate on. “Markets such as Sweden are opening up, but the question is how much of this money will be invested in property.
“If it’s a diversification issue then real estate is still a good addition to any bond/equity exposures. And in Holland, ABP and some of the major life insurers have said they are upping property exposure due to low fixed-income returns.”
He adds: “Duration is the key though, and it is essential that two years down the line there is not a problem of real-estate oversupply, because sudden events like an Asian crisis can expose vulnerable markets such as office property, which many feel is overvalued at present but still fetching high prices”.
Gerald Blundell, head of investment at Lasalle Investment Management, concurs on the market’s future promise: “Looking at continental Europe, the pensions underfunding issue is very prominent, so the need is for real assets to come to market. My guess is there will be a flow towards property - mostly sale and lease backs, because Europe’s cautious bond culture will lead to the seeking of a halfway house between bonds and equities, which property provides.
“As long as you have the right sort of income and growth vehicles it is a stepping stone towards equities, offering security, good income streams and a hedge against future inflation.”
However, he adds that should such demand start to drive the market then the characteristics of property investment will undoubtedly change. “In the short term we should experience strong performance, but at some point property yields will fall and become identical to bonds, leading to increased sale and lease back activity.
“Then you get into a situation where there is a property surplus and it be-comes a stock pickers’ game,” he says.
Blundell believes that European property investment in recent times has had an opportunistic outlook with purchases made ’willy nilly’ or debt portfolios being bought and worked out for quick healthy profit.
The next phase though he says will be the search for longer term holdings to be managed and ‘sweated out’.
“There is certainly plenty of opportunity in Europe. Looking at the different property sectors, the emergence of retail and leisure, certainly on out of town sites, is not fully established yet in most countries.”
Blundell sees an evolution in the way property is managed leading to a developed market with deeper liquidity - especially on the indirect side, which he says brings its own benefits because risk premiums are lower.
In terms of the markets themselves, Paris has been buoyant in recent years, Madrid is showing healthy signs and the Dutch market has been consistently strong.
Property opportunities in Germany have been scant, although the reconstruction of Berlin is set to bring opportunities and recovery is likely to be strong according to analysts.
The UK has been getting its second wind with returns of 11-12% last year, despite predictions to the contrary, and the feeling is that returns for 1999 will top this figure.
However, Blundell concedes: “There is always the feeling in the background that this property high will end in tears sometime - the question is when and whether it will be through economic weakness causing tenancy problems.”
Chris Bartram, chairman of the management board of Rodamco UK, says this positive property trend is drawing interest from pension fund managers. “Certainly as far as the UK is concerned we are seeing for the first time in several years a distinct tendency from a broad range of pension funds to increase their allocation.
“The relativity’s of equities and property and fixed-interest investment have changed significantly in the last few years. And those that ‘do’ property believe they are on to a good thing and want to have more.”
Bartram says average property asset allocations currently range from 5-10%, with the trend moving very much towards the 10% level.
“The big thing fuelling this up-weighting is yield. The IPD index yields 7% plus, which is a cracking performance compared with any asset class, and future growth fundamentals are sensible.”
For pan-European investors, Bartram says the removal of currency exchanges and the polarisation of interest rates has been a boon for costs and relative price calculations, although country effects such as the long term savings characteristics of France and Spain still influence the market strongly.
Richard McIndoe, principal for pension services at UK Strathclyde pension fund which has 8% (E607m) of the fund in property, explains that the fund’s high property weighting is part of an historical approach by the fund: “We reviewed the fund allocations last year and our conclusion was that the property portion still bore good matching characteristics, inflation protection and gave us a better prospect for higher income than index-linked investments, which were some of the reasons behind our original shift to real-estate.
“However, in reality property as an asset class has been an underperformer now for 10 years to the tune of about 30 basis points, but we are hoping that we’ll get the right performance at some point. It certainly has not been a question of underperformance by Argyle, which manages the portfolio, because they have beaten the IPD index by around 70 basis points over the same 10 years.”
Ian Jones, head of international commercial research in Europe at Savills Fund Management, points out that German funds have been very active in the last five years, particularly in the UK property market, and he believes there is still around E5bn waiting to be spent on real estate from the country’s open-ended and life funds. “The strength of the pound does not seem to be holding them back, they are just hedging the risk,” he says.
Small cities and lack of property availability, Jones adds, is keeping the Scandinavian market in check.
However, on a global basis Europe is definitely being seen as a prospect, he notes. “All the major property consultants are looking for a pan-European presence, and the UK managers are acting to some extent as a conduit for US investors wanting to dip their toes in Europe, but unfamiliar with the property waters.
“Property is being touted as a quasi bond, quasi equity investment and research already shows property acting as a fixed-bond style investment because very few tenants actually fail in property portfolios, so if the appropriate risk premiums are applied then the assets are very stable.”
Stuart Beevor, managing director of Legal & General Property and chairman of the London-based Investment Property Forum, says that from a UK perspective the property market looks extremely good for the years to come: “We have carried out a consensus forecast showing property growth in double figures between 11% and 13% over the next two years, and in a low inflation environment so the risk/ re-turn profile for investment is good.”
“We expect long term that the European market will take on the characteristics of the UK, but it is a drawn-out process which is not helped by the need for real political and fiscal harmonisation.”
Daniel Gloor, head of asset management at the Canton of Zurich pension fund, which has 10% of its fund in direct Swiss property managed in-house, says the high property levels of institutional investors are beginning to creep down towards UK levels. “Swiss funds generally have be-tween 20-30% in real estate due to low equity exposure, although there has been an overall Swiss market shift in the last 10 years to reduce property quotas and boost equity, particularly amongst banks and insurance companies.
“Here at the Canton of Zurich we decided around 10 years ago that we wanted to have a 10% real estate holding and would be content with 5% returns on a net basis, at least for the time being. However, recently it has been difficult to get these kinds of yields on all the properties, and indeed over the last two years we have had problems in actually investing all the property budget, which is our priority at the moment.”
Gloor adds that there are no plans to change the investment strategy by moving to indirect real estate or out of Switzerland though, because of the size of the real-estate department at the Canton.
Bertus Franssens, head of the property group of ABN Amro with offices in Amsterdam, Chicago and Hong Kong, says the property trend over the last two years for Dutch pension funds has been from direct to indirect holdings. “Firstly, many funds no longer want to be involved in property management, particularly the smaller schemes, because of cost and logistics, and the feeling is that the market can run property better.
“Also, with individual pension rights in Holland changing and re-quiring more stringent reporting, there can be calculation difficulties on the property side in a large portfolio, as well as burdening legal aspects over liability, which is becoming an in-creasingly important issue in the US. Furthermore, it is easier to make changes in asset allocation with indirect property, and it offers better chances of overseas investment.” he says.
He adds though that direct property has its relative liquidity merits, because indirect property is not that liquid. “ A number of medium sized pension funds with portfolios in the range of Dfl200m to Dfl700m (E90m - E317m) are currently in the process of selling or merging their direct property holdings, with priority sales of overseas investment.
“The Dutch market is very dynamic at the moment, and although the large funds like ABP and PGGM are still managing most of their own property, I know of one large Dutch scheme which has completely outsourced all its real-estate assets.”
Certainly flexibility is the key at the Dfl90.7bn PGGM pension fund, and Alfred Kool at the scheme says its 12% property holding fits well within the recommended 10-15% real estate benchmark, ascertained through an in-house asset liability study.
“We can shift about a bit between the limits because the property is invested indirectly, mostly in-house but with some outsourced - a strategy switch from direct real estate investment, which we carried out several years ago. I don’t see us making many changes to this set-up in the coming years.”
However, Nic Fox, head of international property investment at international property consultants Healey & Baker, believes that US pension money is the big future theme for European property. “US funds have had all their eggs in one basket for a long time and need diversity into Europe. And if for example US pension fund Calpers allocates just 1-2% of its money to European property, it is a substantial amount of assets. The potential for investment from the state pension funds and insurance companies could be enormous.
“ At the moment this money is being handled by their pension fund advisers, merchant banks or property companies. Sooner or later though this will become serious direct investment.”