It will be different this time
UK investors have invested in continental Europe before. It wasn't a happy experience. Many rushed in during the 1980s but got their fingers badly burned and retreated back to their home market. Many of those have kept their real estate investments within the UK ever since. But any cases of ‘once bitten, twice shy' might do well to study carefully the potential consequences of remaining UK-only invested as pressure on the home market increases.
In general, UK institutional investor allocations to real estate have been increasing on the back of hitherto solid performance in the home market relative to other asset classes. "Allocations vary from a relatively small amount (eg 3%) to more significant amounts (eg 20%)," notes Greg Wright, principal at Mercer. "The smaller allocations are sometimes residual amounts while some investors take time to review their holdings."
He adds: "Those with an allocation cite the diversification benefits, the income component - stable and helpful for pension funds - and its relative simplicity when compared to other so-called alternatives to equities and bonds. Furthermore, those that want 10-20% in alternatives but don't like hedge funds or private equity find property a more comfortable solution."
Gabi Stein, director of institutional business at Henderson, believes that "the trend of increasing allocations to real estate is coming from a push from the consultants."
But there are concerns. Wright points out that more recently investors have been looking at the level of the market and wondering whether now is the "right" time to invest. But he sees the concern as being misplaced. "We do not believe the lack of liquidity should be a barrier to investment as most pension funds rarely need to realise assets at very short notice. They can usually afford to be a very long term investor and harvest any illiquidity premium."
ne major issue is supply and demand. The decision by UK pension funds to increase their allocations to real estate from 5% to 10% over the last eight to 10 years came as overseas investors and private investors tried to access the market, as Rupert Clarke, head of real estate at Hermes, explains. "The issue for most UK pension funds, most of whom are invested only in UK real estate, will be to decide if they still want to achieve their higher target weighting given where the market is and the uncertainty of it going forward: are we at the top or is there further growth to come? Against this background, some of the UK pension funds that have been trying to double their weightings over the last three to four years are now considering overseas real estate, although the majority have yet to invest."
Wright goes further: "We have been suggesting to clients that the double-digit growth can't continue and that they should extend their exposure outside the UK."
So what are the likely benefits of a move into foreign real estate? "Diversification is definitely one argument," says Stein. "Another point influencing this move is that while returns in the UK are likely to be very good this year the prognosis going forward is fairly pedestrian. So people are searching for added return in Europe. Having said that, there has been quite a bit of convergence in returns in western Europe and the UK."
Hermes is similarly cautious about the supply and whether it will enable funds to achieve the 10% target. "Our view is that many overseas markets are becoming as competitive as the UK market fuelled by increased international interest," says Clarke. "Certainly in many countries the majority of investment is cross-border at the moment."
ome believe that investors should not confine themselves to Europe. "Having made the decision to invest outside the UK you need to think a bit more widely," says Robin Goodchild, head of European strategy at LaSalle Investment Management. "I expect that the way the economies of Asia and the US are going they will grow faster than Europe, so it does not make sense to restrict your choice purely because of proximity."
But Kathleen Jung, head of European property at Hewitt is more cautious. "Most of our clients shy away from emerging markets for now. It is our impression that they would like to see further stable developments in those markets."
But Goodchild has clear views about where the problem lies: "There is a huge need for education among pension funds and consultants as well. With the exception of a handful of markets you're not going to find IPD direct property series with 20 years of history, which is what the consultants would like. So if that is what they require it is going to take a long time or it is not going to happen at all."
But some pension funds have stuck with the traditional approach, holding domestic property only; they also prefer to invest directly. "Larger pension funds like to be hands-on with one segregated manager," says Jung. "The challenge of buying assets at a reasonable price in the UK and the broadening of the IPD universe has led some segregated managers to advise clients to think about alternative asset classes such as student accommodation, garden centres and motorway service stations. Such investments, however, would mainly be done via specialist pooled funds."
"Because of these challenges quite a few pension funds are also invested indirectly in the UK market; it is quite difficult if you have a £100-120m (€148-178m) allocation to property to then buy all different kinds of asset types. In our experience, fund managers would usually end up with a mandate to do 75-80% direct and a satellite approach to pooled products in the UK for the remainder."
So what are the most typical ways for UK investors to invest in real estate? "Our clients invest in property in a wide variety of ways," says Wright. "Least common these days is the traditional direct/segregated account. The minimum mandate size needed to invest directly has been growing over recent years as average lot sizes have been increasing. Few clients can afford to invest in this way when a single office block may cost upwards of £50m."
Stein points out that an institution would need to have a portfolio of at least €500m to have a diversified direct European portfolio. "There are really very few institutions who can manage those sorts of numbers," she says.
Wright notes that the most common form of investment "is the pooled, balanced property fund, giving investments across a variety of sectors and geographic regions. Some of these investments are residual holdings of old balanced mandates, and many clients have chosen to supplement the level of investment that was part of this approach."
Another common route is the multi-manager or fund of funds approach. "It brings the extra benefits of manager diversification and access to more specialist vehicles," Wright continues. "It also opens up the possibility of investing outside the UK. However, some clients need to be convinced that the extra layer of fees involved justifies the benefits."
here has been a rise of closed-end and open-ended funds across Europe both on a pan-European basis and a country and sector specialist basis, as Anne Lucking, European director, client services at LaSalle Investment Management, explains. "This gives pension funds more opportunities and more choice about the way in which they are going to invest in property, in addition to the prospects offered by the introduction of REITs in the UK & Germany as well as their rise globally."
REITs may also become significant. "They could play a tactical role because of the liquidity and because you can invest smaller amounts of money, enabling you to access markets which you would not be able to do otherwise," says Jung. "But at the moment we do not see REITs as a substitute for direct property or non-listed real estate. In addition, the final REIT legislation and how property companies will adapt to the framework is still work in progress."
In the past, often due to resource issues, investment behavior would differ according to size of fund. But Wright notes that "because of the move away from direct accounts, there is now much less difference between funds of different sizes."
He points out that "the smallest funds cannot get access to a segregated multi-manager account but with the advent of funds of funds, even they can access the multi-manager concept. The very largest funds will still have mainly direct accounts but they are peppering these with more and more specialist pooled fund vehicles - for example for shopping centres which are, in isolation, beyond even the largest accounts. The largest funds are more likely to engage in development opportunities and access closed-ended vehicles."
Good news for small pension funds is the fact that some fund managers have been trying to have as many unit holders as possible in a vehicle, which means bringing the minimum investment down to a level sometimes as low as €100,000. "This allows the fund of fund managers to gain access for their smaller clients," says Stein. "There has been quite an uptake. However, European vehicles are further behind - in general they will need at least €10m to access those."
In the longer-established asset classes the argument about relative versus absolute has been continuing since the most recent collapse of the stock market. Is it the same picture where real estate is concerned? "We suspect for the next five years UK-invested pension funds which are benchmarked against IPD will have a similar structure to that of their benchmark," says Carl Bennett, head of strategy at Hermes.
"As they become more sophisticated they will take a core, added value and opportunistic approach. On their opportunistic and added value portfolios they will also have to look at their alternative property asset classes to fill those gaps. But it would be very surprising if those alternative plugs will form a very large percentage of portfolio as they are still duty-bound to deliver returns against the benchmark and thus consideration of the benchmark construction is key."
On the European continent things look different. "I think for the time being investors in continental European real estate will stick to absolute return," says Stein. "In time there should be a more robust European benchmark that investors can use if they wish but it does take time to develop that. Continental Europe doesn't have the history of data that the UK has."
s pension funds look overseas there are a number of issues which they need to come to terms with. One is debt. "UK pension funds have in the main been equity-only investors in real estate," says Goodchild. "Their challenge when going outside the domestic market is that real estate comes with leverage; it's not optional. In most cases the level of gearing will be 50% plus. It can be quite tricky for clients and their advisers to appreciate this difference."
The learning process is quite intense. "The whole issue if LDI which is mostly implemented through the use of derivatives has meant that pension funds have had to make derivative transactions in other non-real estate markets," says Lucking.
How well is the supply side catering for their needs? "The best property managers are often closed so investors wanting to get into the market may have to accept less than the best quality to get in," says Wright.
For Jung the picture is more mixed. "The UK has a very good selection of core and specialist managers now. The traditional sectors (office, industrial and retail) are very mature which adds positively to transparency and liquidity. However, some of the emerging asset classes have only a few active managers and still need some time to mature and people just need some more comfort.
"In the case of non-UK property things are improving, but some markets still lack the transparency and liquidity of the UK property market: there is still a need for fund managers in other countries to open up and cater for international investors. In some cases the documentation is still in the local language."