Direct or indirect?
For a pension fund or other institutional investor seeking to build up a real estate portfolio, there are more options today
than ever before. Direct property, unlisted funds, listed stocks and even more esoteric
products such as derivatives are now available.
However, choice can lead to confusion and there is much debate within the real estate industry about the best way to invest in the asset class. An institution’s starting point is of crucial importance. A pension fund with an in-house real estate team and an existing domestic real estate portfolio will have a certain degree of expertise and market contacts which can be exploited to expand that portfolio, either domestically or overseas.
However, many investors are looking at investing in real estate for the first time or getting back into the asset class after a long time under the spell of the ‘cult of equities’. To build up a meaningful weighting from a standing start is difficult, especially when there are vast quantities of competing capital from other investors, often in similar positions.
Direct acquisition of property is the traditional way to add real estate to a portfolio. Inevitably there are a number of advantages and disadvantages to investing in this way. A major advantage of direct ownership of real estate is control. The investor has complete control over the assets it acquires, the way these assets are managed and the timing of disposal. The portfolio is entirely customised to the investor’s preferences – for example the amount of leverage employed is entirely up to the investor. In unlisted funds, the use of debt is the domain of the manager, although subject to the controls embedded in the fund structure.
Investment Property Databank provides indices for most Western European countries, allowing investors to benchmark their performance. Direct property also has a lower correlation with other asset classes than either unlisted funds or real estate securities. It is also not necessary to build up a large real estate team in order to invest directly. For example UK building society Nationwide has retained LaSalle Investment Management to build up a £100m (e145m) direct property portfolio (see box). Investors can give managers as little or as much discretion as they like and can also outsource day-to-day facilities and property management.
However, there are a number of downsides to investing directly. Firstly, building up a portfolio can take a great deal of time – according to a report by the UK Investment Property Forum, it takes an average of six months to complete a major real estate transaction (although due to the recent appetite for real estate, deals are becoming ever speedier).
A certain amount of scale is also required. LaSalle Investment Management’s Robin Goodchild suggests at least 15 properties are required to avoid specific risk and to gain economies of scale with running costs. For an international portfolio, the need for scale is even greater. Aqil Khan, of Adimmo, says: “On an international level we see a major risk for investors making direct investments. In order to achieve solid diversification we believe that you need to invest at least e500m. “Strong expertise and market knowledge are essential,” he says. “You need to have the people on the ground. Also, you must have a strong and persistent network in at least the major countries or certain regions.”
Direct property is also illiquid; it takes as long to sell as to buy. However, due to the immaturity of the market in unlisted funds it can be easier and quicker to dispose of direct property than it is to sell a stake in an unlisted fund as there is almost no secondary market. While property investment markets continue to rise in most locations, few investors are interested in selling stakes in unlisted vehicles, particularly as they might have difficulty re-investing the cash.
Finally, manager selection is important as there is a great deal of variance between the returns gained by the best and worst real estate asset managers, far greater for example than between the best and worst equity or fixed-income managers.
Building a portfolio through unlisted funds is probably the most popular route for new entrants into real estate at present, either those investing for the first time or those investing overseas. The Irish National Pensions Reserve Fund has begun a significant drive into global indirect real estate, with a strategic allocation of 4%. It is targeting unlisted funds in order to build a diversified portfolio quickly and with the minimum of internal staffing.
Danish pension fund ATP is looking to unlisted funds to give it access to international real estate. It started the programme in 2002 and expects to have invested e550m invested by next year, having already invested nearly e400m. The initiative has also allowed ATP access to specialist management in a variety of sectors as well as to a variety of styles: core, value-added and opportunistic.
However, the speed of execution and flexibility comes at a cost. Fees for unlisted funds are higher than for segregated accounts. Recent research by INREV found that many funds have a hurdle rate much lower than the targeted return rate and that many funds, notably opportunistic funds, have a ‘catch-up’ arrangement, which allows the manager to take the lion’s share of returns at certain levels. IPE Real Estate’s Investor Forum (Jan/Feb) found that investors generally consider fees to be fair but several spoke out against low hurdle rates and catch-up arrangements. INREV’s research concluded fee structures tend to be over complicated.
Benchmarking indirect fund performance is not as easy as benchmarking direct real estate. In the UK, the Association of Property Unit Trusts index is well-established, but INREV’s indices for European funds was only launched this year and is still very much a work in progress.
Taking advantage of specialist management in unlisted funds leads to a loss of control. Once the investment criteria for the vehicle are set, investors generally have little or no control of the day-to-day running of the fund and often have few options even if the manager is underperforming. Even the biggest investors tend too take a hands-off role, doing little beyond sitting on the vehicle’s board.
Mike McCook, head of real estate for CalPERS, the US’s largest pension fund, says: “We find it is best to deal with questions of strategy and control in the early days of the fund’s creation – that’s the best point for an investor to have a say. After that, you have to let management take control – that’s what you pay them for after all.”
REITs or other quoted real estate structures seem to provide a perfect way to access real estate. Investors can invest their money straight away, as real estate stocks are very liquid, they have access to specialist management, there are a number of useful indices at national and global levels and there is a variety of companies available to invest in (although this varies from country to country).
However, opinion varies on whether an investment in a quoted REIT or real estate investment company can be considered as a real estate investment at all. CalPERS and many Netherlands pension funds, including ABP and the Blue Sky Group, invest in real estate stocks as part of their real estate allocation. However in the UK, most pension funds investing in UK quoted real estate companies do so through their equity department.
Research from investment bank UBS shows that, if real estate stocks are held for the long term (at least five years, the sort of length of time an investor might hold a stake in an unlisted fund or a direct real estate asset) then the returns track the underlying real estate that company invests in, rather than the equity markets.
However, in the short term, REITs and other stocks track the equity market and values are far more volatile than any unlisted alternative. Some in the real estate industry question whether, as this is the case, that real estate equities can be considered real estate investments.
If investors invest in real estate securities through third party funds, they have the advantage of getting a good spread of investments, but end up paying fees for both the management of the securities fund as well as the management of the individual companies. Partly for this reason, the ING Group Pension Fund has recently begun moving from a position where all its real estate investments came through securities funds to one where 60% of the investment is through unlisted funds. Head of asset consultancy Frank Bijleveld says: “Unlisted funds also offer more stability and tracking of the underlying real estate markets.”
Double fee-paying is also a problem with the multi-manager or fund of funds approach to real estate. However, this approach is popular with small pension funds who would like diversified access to European real estate but only have e50m or less to spend. By investing in a fund of funds or allocating cash to a multi-manager account, a small investor could get access to funds across the whole of Europe and to assets which it could not buy even a portion of directly.
Many pension funds use a variety of the approaches listed above, depending very much on whether they are a new or existing investor in real estate, whether there is in-house expertise and what the scale of the investment will be. There is no ‘one size fits all’ solution, and as new product lines are developed, this will be even more the case.
ABP, the largest Dutch pension fund, decided in 1994 to ‘distance itself’ from its direct holdings. The assets were moved into new vehicles in order to create quasi-independent, self-sustaining enterprises capable of attracting top quality management teams and to enable the introduction of new shareholders, allowing ABP capital to re-invest cash elsewhere.
The pension fund now has 70% of its real estate investments in listed securities. Barden Gale, executive vice president, real estate, says: “Listed real estate offers a number of advantages, including higher quality assets on average, above average management teams (which can be replaced), lower investment management costs, lower transaction costs to buy and sell the securities than the real estate itself, liquidity and transparency,”
“The cost of internal management is also low: we have 10 investment professionals managing a e11bn portfolio.”
Gale concedes that listed real estate also shows higher measured volatility of returns and that it is difficult to ramp up risk profile if the investor desires as the underlying assets are overwhelmingly “core” in nature. Often development exposure is limited.
Nonetheless he says: “We believe that direct investing will become less desirable, if only because fewer institutional assets will be actively traded. The classic example of this are shopping centres throughout the world, and especially in the US and UK. Access to assets will come increasingly through the securitised equity and debt markets and indirect investment vehicles.
“Also, more defined contribution plans and schemes will require higher degrees of liquidity and transparency which will also militate toward public securities as an investment option.”
Nationwide Building Society Pension Fund
UK building society Nationwide has taken a somewhat contrary view to many pension fund investors, choosing to build up a largely direct portfolio from scratch for its pension fund.
Advised by Hewitt, the pension fund has mandated LaSalle Investment Management to build and manage a £100m (e145m )property portfolio. At least 80% of the portfolio will consist of direct property and LaSalle will have full discretion.
One of the contributing factors to Nationwide’s choice was its decision to have an absolute return benchmark, rather than benchmarking against IPD. LaSalle’s Dermot Kiernan, who will act as fund manager for Nationwide, said: “Nationwide is keen to be a long-term investor in the sector and appreciates that, especially when building up a portfolio from scratch, it will not achieve performance matching recent IPD results.
“The fund chose real estate to provide solid returns, lying somewhere between gilts and equities, to meet its liabilities. This is very much the way a lot of funds are starting to look at
“It is our intention to fully commit monies to the UK commercial property sector over the 18-24 months.” says Kiernan, but admits that this will be tough, especially in the current climate.
In order to avoid asset-specific risk, no single property will form more than 10% of the portfolio and Kiernan says the intention is to build a portfolio of 15-20 assets with lot sizes ranging from £3-10m.
A sign of the way that the market is moving is that, despite being essentially a direct mandate, up to 20% of the portfolio will be invested in indirect funds. “We are very keen to get some exposure to retail warehouses, which have very good performance prospects, and perhaps shopping centres in the portfolio,” says Kiernan. “However, due to the lot sizes involved, it would be impossible to get that exposure in a direct portfolio of this size.”