Cool, calm, collected
What is the role of real estate in your portfolio?
Real estate provides diversification benefits because of its low correlation both to equites and bonds. Its low volatility of return is also an important factor when optimising the total portfolio.
Our target allocation for real estate is 15%; currently it is 11%. From the risk/return perspective the share could be bigger, but on account of its restricted liquidity, we have chosen this figure.
We have two major goals for real estate portfolio: one is to keep the yearly returns sufficient, meaning a long-term return of 7%, and as steady as possible. Keeping the low correlation to stocks is also quite important.
How do you optimise the portfolio geographically?
We are looking for higher diversification on a European level in order to further decrease the volatility and risk in the portfolio. The target sectors are core type properties in major cities. It is this which will form the main part of the increase in our real estate allocation to 15%.
Local markets tend to perform differently cyclically and by property type. This gives an opportunity to take advantage of the correlation benefit between different markets. That is also why we invest in different types of properties - residential, offices, logistics and shopping centres.
We also look at the correlation between different markets in Europe. For example, Helsinki and Stockholm are on a similar cycle. The correlation between London and Paris is lower.
Because of the modest size of our real estate portfolio we diversify internationally by investing through tax-efficient unlisted funds and listed property companies. We prefer large specialised funds, which invest in core or core-plus properties in major cities.
We are planning to increase the share of investments in Europe, ex-Finland, to 30% of the real estate portfolio. The percentage could be higher but this would not be possible within the next five years. We could reduce the proportion of direct investments in Finland by investing in some Finnish private funds. Through measures such as this we might be able to increase the proportion of foreign investments but because of practical considerations 30% is the target for now.
We also have property investments in Asia for diversification purposes. As these markets are out of our special expertise we have outsourced Asian investments to fund managers. They invest in accordance with our strategy to listed equity markets. There could also be investment in property sector through REITs.
How do you view the individual
Our target allocation is 30% in each of residential, office and shopping centres, with the remaining 10% in logistics or industrial. We had almost half in office but this is now about 35%. One reason is that office market in Finland is more volatile - almost like Stockholm and London. That is why shopping centres and residential - which cater for the needs of private individuals - are calmer and less risky, even though the return might be lower in the long run. We see the European capitals' office markets as more liquid and that is why we are aiming for the non-Finnish portion of our office investments to be 50-60%.
We do not invest in hotels; if we decided to invest in hotels we would invest via listed funds because there is more management required for the property. As for leisure and entertainment - this asset class changes very quickly so every five years you need to offer the market something new.
We might also consider infrastructure but it is just beginning to develop at an institutional level.
What is the strategy regarding
investments in direct property,
listed and unlisted vehicles?
In Finland we have a very balanced portfolio of direct investments which gives a very steady annual return. However, it is very difficult to access portfolios with these characteristics when investing outside Finland if you don't invest through listed companies. However, with these investments the direct returns are not as good because of tax.
The investments in Finland are not all direct - we already invest in two funds and are co-investors in big shopping centres for instance. Some 30% of the Finnish portfolio is indirectly held (co-investments included). In larger investments we prefer co-investments - this also applies to investments in Finland.
Shopping centres and office business centres get bigger and bigger and if you want competitive product you have to build bigger and bigger properties. We are not big enough to invest on our own and for that reason we joined with other investors to get the product which is competititve in the user market.
We invest in unlisted funds. The problem is that European markets are so competitive at the moment that there are not many opportunities available. It seems that because of this the funds which are available are more complicated than we would like them to be. We looked at specialised funds investing in one sector in one country, eg, French residential, Dutch office, German office to provide transparency in terms of what the fund invests in. But these funds are really rare at the moment. It seems that the best properties and core products are in the listed companies.
In an ideal world would you want to have more unlisted property in your portfolio?
ore unlisted property funds would be better but it is increasingly difficult to find a professional company with ready-made long-term investments. The interest of fund managers is not 100%-aligned with the interests of investors. The managers are focused on establishing the fund and getting the investors to commit. It seems that they are acting according to the market in that if the market is overheating they still buy because they have to increase the size of the portfolio. Listed funds already have their porfolio if they see prices not right they will sell and not buy.
We are also looking at REITs. The correlation of REITs to stocks and bonds is rather the same as property in the long run. Over a period of say five years the correlation meets our requirements because REITs behave more like property. This is not the case over a shorter period of say one month to one year because in the short term they behave more like an equity.
What significant developments have there been over the years?
European unification has made the property market more transparent and easier to access. Currency risk has been eliminated (except outside the Euro-zone). Because several players in the real estate business have expanded as European multinationals, it is easier to make contacts and business. Practices in the sector are gradually becoming rather similar everywhere.
What is your funding position and
how will this influence investment strategy?
Pension fundings have grown enormously and have created the need for a bigger and more diversified investment market in the real estate sector. The investment service sector has grown accordingly to satisfy the demand.
Our fund is still expected to grow over the next 10 years and we have continuous need to invest the surplus.
How do you manage risk?
Our very long-term responsibilities require broad risk management and the systems for this are already in place and are under constant development.
The real estate sector in Europe is still lacking sufficent statistics for long-term risk and liquidity calculations. Markets are changing so rapidly that historical figures and statistics give a poor estimate of future performance.
In the past the portfolio was not so fragmented,
with five main asset classes: stocks, bonds, loans, cash and real estate. We had risk calculations for these major parts of the portfolio. But now risk management is going into more detail and it is necessary to analyse the risk and correlations of each different type of investment. This means that we need more information and statistics about these risks and have to make the risk sensitivity calculations which are becoming more complex.
What is your view of gearing? How big a risk does it represent for you?
In property investments we like to keep gearing at around 50% because the investment becomes too volatile otherwise. Because of low interest rates at the moment people see great benefit in geared investments. But in the UK market this benefit has already vanished because the yields are already lower than the interest rates.
The risk itself is not so big - it is only causing problems with the volatility of the property portfolio. This is a drawback because the intended benefit of the portfolio is low volatility.
What is your view of
taking on more leverage
to enhance returns?
We divide the risk portfolio into portions. Property itself is more illiquid - if interest rates increase it would be much more difficult to dispose of the properties. Of course it could give better returns once in a while, but this would not be the case all the time.
The use of gearing in the property portfolio produces an interest rate risk, and there is enough of that already in the total portfolio - some 40%.
What challenges do you face going forward?
Globalisation has made diversification more difficult, because the investment performance cycles have synchronised. This is one result of the present excess liquidity of the investment markets. Another result of excess liquidity is that the prices for the core products are very high.
We consider private equity-type funds a temporary solution for real estate investments because they are too complicated and expensive to establish and manage as multinationals.
The volatility of real estate in each country and market has been growing because of larger and more rapid movements in investment capital and liquidity. This is particularly evident in smaller countries like Finland. In Europe the Spanish and French markets have been quite healthy. Germany which has been stagnating for years is recovering so it is possible that the property sector there will be recovering as well.
Unfortunately at the moment we consider the markets overheated and we are reluctant to invest at the current yield and price level; risk margins are just too low. Expectations for future rental growth are too optimistic in many markets. At this price level we are more on the sell side.
At the moment yield compression has given high returns for real estate companies and funds, but in the future it is crucial to secure rental return. Only then will we see the difference between those managers who are competent and those who have just been lucky.
What is your view of the prospects for a European REIT?
The European REIT is a dream - but it has to happen if we are to be able to compete with Asian and US markets. It now seems that listed companies are getting bigger and perhaps they might find a way of being listed in the US as a REIT, for example. But Europe is so heterogeneous that it will not be easy to create a European REIT. The whole taxation system differs so much from country to country, so there is much work to do. But governments are not prioritising this.
How do you rate the quality of management supplier services?
There is demand for skillful professional managers. However the local subsidiaries of the major real estate managers are newly established and they have a lot to learn about client needs and service provision. The investment service market in Finland has developed very fast but it is not easy to get ready-schooled professionals locally for this business. Of course these companies have their best practices which they then implement in all local subsidiaries, which includes training programmes. It will still take some time to develop the practices into a smooth-working and high quality service product.
We have also experienced that users and tenants have been dissatisfied with property management services. Sometimes it also seems that fund managers look at properties as documents and figures and forget the real nature of this investment sector.