Game, set and perfect match?
The last few years have revealed the extent of pension deficits across Europe; not only in continental pay-as-you-go schemes, but also in the much- vaunted UK model with its over reliance on equities. Aon Consulting reports that of those FTSE 100 companies still running a defined benefit scheme the majority are now in deficit, with an average shortfall of assets relative to liabilities of 15%. This gloomy picture is typical of many continental markets. A survey by Greenwich Associates recently found that one third of continental pension schemes have sub 100% funding ratios.
What is worse is that we are now told we live in a world of small numbers. In a post inflationary age European bond yields are 3.5-4.5% and long-term expectations for equities are only 8% a year. Current deficits will therefore be harder to offset purely by rising asset values, especially when liabilities are likely to grow by 4% a year over the longer term, driven by rising salaries and dependency ratios.
By the year 2050, the estimated net present value of pension debt will equal 332% of GDP in France, 188% of GDP in Germany and 230% in Italy. Based on these figures, many are concerned that pension funds will soon be bankrupt. Countries across Europe recognise that they can no longer finance current levels of state old age pensions. Consequently, some have begun to cut benefits and may put pressure on employers to take up the slack, while others have begun to raise the age of retirement. There is a clear need to increase long run risk-adjusted returns in pre funded schemes.
This is not news; reports of the “demographic time bomb” have been around for the best part of a decade. What has brought it to a head has been the adoption of FRS17 in the UK and variants of ISA19 in the rest of Europe. These accounting regulations require pension funds to make an annual comparison between the current market value of assets and the value of future liabilities, capitalising them with yields drawn from the institutional bond markets.
As a result pension schemes face a dilemma. They can either seek to fully invest in bonds to closely match assets against yearly fluctuations in the value of their liabilities. Alternatively, they can try to meet their long-term liabilities by investing in higher returning assets that capture future growth and inflation in liabilities.
As Figure 1 shows, neither equities nor real estate returns have matched annual bond returns over the past 20 years. If anything, equities are a better fit than real estate and at first glance the case for real estate in a liability-matching exercise seems weak.
But is this so when real estate is viewed in conjunction with equities and when one looks forward rather than at history?
In the UK, government bonds offer a prospective return of about 4.5% and the consensus of pension fund expectations for long-term equity returns is 8% a year. LaSalle currently expects long-term real estate returns of about 7% annually, largely driven by its 6% income yield. Figure 4 uses these returns in conjunction with past correlation to evaluate the risk/return trade off facing pension funds. The black line shows the efficient frontier between a strictly bond and a purely equity portfolio and the green line the effect of adding real estate. There are clearly some risk-adjusted return gains to be made by adding real estate to the bond/equity mix.
For funds seeking returns much higher than bonds, allocating up to 20% to real estate reduces the risk of an all equity portfolio by nearly 200bps at virtually no cost in terms of expected returns. Similarly adding real estate to an all bond portfolio (the Boots Solution) will reduce portfolio volatility and increase returns (red line in Figure 4). A similar graph can be drawn for the major European economics. However, real estate does not match bonds.
Figure 5 looks at asset allocation in an IAS19/FRS17 world. It charts expected return relative to bonds on the vertical axis and volatility relative to a 100% bond portfolio horizontally. As a result the 100% bond portfolio is at the graphic’s origin, zero FRS17 risk and zero excess return.
In an FRS17 world, the equity/real estate line stays much the same as in Figure 4 but the frontier is stretched down to the origin, and the position of the average fund now looks much closer to the efficient frontier. Note how substituting real estate for bonds still improves “FRS17” risk-adjusted returns where the green line in Figure 5 bulges above the black bond equity line. This should prove an attractive diversification for funds seeking a higher performance over bonds.
While these conclusions look positive for real estate they remain theoretical. Volatility is an imperfect measure of risk, especially in real estate and past asset co-variances are far from stable. So to what extent is there evidence from other sources to support the case for real estate?
Firstly, real estate income is the predominate component of expected return. Income returns in mature European markets vary from 5-6% and expected rental growth only 0-3% over the cycle depending on sector and country. The future predominance of income means that the bond-like quality of real estate is likely to show through with the bulk of value represented by contracted income. Admittedly, lease lengths are shortening in the UK and on the continent are subject to regular tenant only break options. However, evidence shows that over 75% of tenant breaks remain unexercised. European real estate may well perform more like a bond in the future than it has in the past, especially in the slow growth core of Europe. In the UK, we estimate that the discounted value of a property’s contracted income stream equates to around 60% of the asset’s capital value.
Secondly, most European occupational leases give the owner some protection against inflation. This, combined with the ability of market rentals to keep pace with inflation in the long run, suggests that real estate captures at least part of the future growth in liabilities. It also offers a yield higher than most institutional grade alternatives. In passing it is worth noting that the proposed removal of the upwards only rent review (UORR) would increase the bond-like nature of UK real estate. The UORR is a relatively volatile component of value as it is in effect a real call option on the rental market. If it were to be replaced with say annual indexation, it would to all intents and purposes be a corporate index linked bond, with an individual equity component attached to the end of title lease contract. This would reduce the short-term volatility associated with the UORR.
Thirdly, a benefit of real estate’s high yield is the opportunity to enhance returns by leverage without eating into cash flow. In the Euro-zone five-year swaps are less than 5% compared with a mean property yield for good quality space of 6%. Not only does leverage enhance returns but where it is left uncapped the value of the asset becomes more aligned to that of bonds, where capital values are correlated with changing interest rates. So applying variable rate debt could have the perverse result of risk reduction when seen from a liability matching viewpoint.
Finally, there seems to be an inevitability about the spread of the REITs concept, which will resolve a number of investor concerns about real estate’s tax and pricing transparency. REITs will increase liquidity and provide a conduit for bringing new products to market. The spread of REITs renewed interest in real estate synthetics and the introduction of leverage are symptoms of a process by which an essentially private market is being migrated into the public domain. As this happens we can expect continued interest from institutions that seem to have an unquenchable thirst for income. How long this thirst will last is anyone’s guess but with a shortening demographic profile and a growing need to meet current liabilities out of investment income, chances are that the need for income will be with us for some time. From being the oldest alternative, real estate may well find itself first among equals.
Gerry Blundell is director of research and strategy at LaSalle Investment Management