The future in the balance

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The consumer society has finally reached the property market. Over the last few years real estate investment has become a place where there is real choice. In the past, when the trustees of a pension fund decided they wanted a property portfolio, they either instructed a firm of chartered surveyors or set up an in-house team and started buying local properties. Today that decision is much more complex. Here are a few of the parameters that have to be defined.
A pension fund can still instruct an external manager or set up an in house team to assemble a direct property portfolio but the indirect route is available too. This comprises both private (unlisted) vehicles and public real estate securities. Regular readers of IPE Real Estate will know that both indirect routes are expanding fast, particularly private vehicles in Europe aided by the very successful European Association for Investors in Non-listed Real Estate Vehicles (INREV) initiative. A derivatives market is also developing although this is largely confined to the UK at present.
In the past, a pension fund would invest domestically. Those trustees that took their funds internationally during the 1970s and 1980s generally regretted the decision and still have the scars to prove it. But things have moved on and thanks to the growth of global real estate investment managers, it is now realistic for a pension fund to access market returns in any developed country in the world.
There is also a choice of investment style. European institutional property investment has generally been ‘low risk’ with as little management as possible. This investment has been equity only, with no debt except where it was required to offset tax, and the properties purchased 100% leased, income-producing assets with as long a contractual term as possible. The arrival of the US opportunity funds in Europe during the late 1990s changed all that and there are now three recognised ‘styles’ of real estate investment as defined in a recent INREV study. ‘Core’ is the traditional approach with well-leased buildings and limited leverage up to standard senior debt levels (60%). ‘Value-Add’ targets low to mid-teen returns with leverage of 30-70%. ‘Opportunistic’ targets returns of 16% + with leverage over 60%. All these target returns are net of fees and taxes.
Although the option of an in-house property team is still available the trend towards outsourcing is strong. Institutions have either outsourced their property fund management team, the most recent example is CIS – the UK insurance company, or made them into a stand alone business that seeks mandates from other pension funds as well as their sponsor, for example, Achmea and MN Services in the Netherlands. The wholly in-house option would be an unusual choice and contrary to current trends however could be appropriate for a property portfolio in excess of €1 billion.

Performance objective
So with all this choice, how should trustees decide how to construct a real estate portfolio? The first decision required is the return objective and risk tolerances. This should be determined by the fund’s overall investment strategy, which will be based on either an Asset Liability Model (ALM) or an absolute return target based on the liabilities alone. If an ALM approach is taken, the return objective should be the assumption in the model for property, usually the long-term average on the relevant IPD Index; in these circumstances, the return objective becomes beating the IPD Index. Otherwise the objective is an absolute return that is best expressed in real terms, i.e. net of inflation, and could be 5% pa real. A performance objective should always be expressed for a rolling period of 3 or 5 years to encourage consistent results. Property is a long-term asset and liquidity constraints make annual returns less relevant. Notwithstanding the best way to achieve a medium term performance objective is to exceed the target return every year rather than expecting one year’s results to make up for under-performance in the intervening period.
Where property data is sparse, the performance objective has to be based on judgment rather than empirical analysis. Investors expect property to deliver returns that are less than those from equities, but higher than bonds. Precisely where in this range is down to individual preferences, for example, Prudential expect property to deliver returns only a little below equities, not at the mid point between the two.

Risk tolerance
Risk tolerances associated with performance objectives need to be clarified. This is a difficult issue but, if appropriate parameters are defined at the outset, it should insure that the strategy adopted does meet the trustees’ expectations. The key considerations here are levels of gearing in the portfolio, both secured on directly held assets and within vehicles, development activity and investment style.
The case for using leverage is strong as long as the income return exceeds the interest cost, i.e. the leverage enhances ‘cash-on-cash’ returns. Leverage also increases the portfolio size, so enabling more assets to be purchased thereby spreading asset specific risk, or increasing the average lot size where large properties deliver higher returns, for example, because of increased embedded active management opportunities.
Trustees need to decide their attitude to development and particularly speculative development. Buying a pre-let development is only a little more risky than buying a completed building as long as the contractor is competent and is supported by an experienced professional team. A speculative development is one we define as ‘committing capital prior to there being a contractual income stream in return’. This type of development is especially risky because circumstances may change between the time when the commitment is made and the building is ready to be let. It is not appropriate for inexperienced property investors, and any manager using clients’ money for speculative development needs to be very certain of a successful outcome.
Attitudes to leverage and development have a significant effect on the choice of investment style. Funds should adopt a blend of styles with some ‘core’, ‘value-add’ and ‘opportunistic’ investments. However, a number of funds in Europe regard ‘opportunistic’ as too risky. This is certainly the case where a fund requires the majority of returns from predictable income flow.
The trustees’ risk tolerance should be expressed in terms of overall gearing and speculative development limits as a percentage of portfolio value, but these limits could be zero. However, it is difficult to invest in vehicles if no gearing is permitted because most funds use some leverage. Trustees who do not want to gear a direct portfolio should set a separate limit for gearing on indirect investments, as well as having target ranges for investment in different styles of fund.

Once clarity on the performance objective and risk tolerance is established, the shape of the portfolio should fall into place reasonably quickly. The next issue to define is ‘geography’.
Pension funds should start a real estate portfolio in their domestic market, where they normally have preferential tax status. They should only look outside that domestic market if it is too small to meet the Fund’s investment needs, and/or if higher net of tax returns can be obtained elsewhere. Trustees normally prefer to invest at home because they have a better understanding of the underlying market, and going outside is always more risky. However, defining a Euro-zone fund’s domestic market is not as straight forward as in the past.
Pension funds domiciled in one EU country are meant to retain their tax exempt status when investing in other member states. So the domestic market for funds within the Euro-zone should be the Euro-zone as a whole, not their national market, because their tax status is maintained and there is no currency risk. In practice, it takes some time before countries accord tax exempt status to ‘foreign’ pension funds, but it can be obtained with patience and perseverance.
The scale of the desired portfolio determines whether or not the pension fund needs to invest outside its domestic market. Most UK pension funds have no need to look beyond their local market because the UK has a deep and liquid real estate market that generally provides attractive returns, even for core investing. The UK IPD index averages 6% p.a real return since 1980, which would enhance most funds’ solvency issues today. Notwithstanding, the largest funds have started to diversify internationally, particularly to continental Europe, as they are starting to find it more difficult to invest all the capital they would like in a very competitive domestic market.
Funds in the Euro-zone are in similar positions although their markets are not as deep and liquid as the UK (over half of all property investment transaction in Europe during 2004 occurred in the UK). Most pension funds should be able to find sufficient investments within the Euro-zone to fulfil allocations. The Dutch, even prior to the Euro-zone, found they needed to invest outside the Netherlands simply because of the weight of capital generated by their well financed pensions system. German funds have also had an incentive to invest outside Germany because returns have been lower than in other markets due to the special demand for real estate assets from retail investors through, for example, the Open Ended Funds. But now both Dutch and German pension funds can invest in, for example, France, where the weight of domestic capital is less heavy, with the same advantages as if they were investing at home.
Young pension schemes and those that are willing to accept a little more risk for higher returns, as well as the large schemes that cannot readily place all their money in domestic real estate, should look to international markets. This becomes a large canvas and lends itself to two basic approaches – either the lower risk diversified global route or actively seeking out higher return opportunities available around the world as real estate is driven by local factors.
The global option is best effected through a portfolio of real estate securities, concentrating on the markets where there is a REIT style vehicle. There will be tracking error against direct market indices but, in the medium term, returns are reasonably similar. This market now has a capitalisation of over $400 billion and is growing fast, with the potential for further growth once the UK and Germany authorise REITs. The benefits of REITs are not just tax exemption; they also distribute a higher dividend yield than tax-paying property companies so their pattern of returns resembles direct real estate more closely. My US colleagues have demonstrated that a portfolio of global real estate securities enhances returns and reduces risk within a multi-asset portfolio.
The cherry picking option of selecting attractive markets around the world is now available to sophisticated investors with the expertise and resource to appraise the opportunities. Investments are most likely to be sourced through funds with niche strategies exploiting a cyclical or other special opportunity. Often they reflect a financial/banking problem in a market, which causes local capital to be sidelined, giving foreigners a special opportunity. LaSalle, for example, has recently offered funds targeting medical offices in the US and warehouses in Japan which each provide higher returns at moderate risk due to special local market circumstances.

The final decision – execution?
So, having defined the funds risk/return objectives and the geography to be targeted, the final decision is how to execute that strategy. The options are, first, whether to employ a real estate professional or to instruct an investment manager to execute on the Fund’s behalf. This decision should reflect the scale of the portfolio required. The National Reserve Bank of Ireland hired an experienced individual last year to devise its real estate investment programme while UK pension fund Total Oil has recently appointed a manager to create a UK portfolio.
The next decision is direct or indirect exposure. Where a Fund wants to invest more than e100m in a single national property market, the fund should consider having a direct portfolio run as a separate account by an external manager. This is a cheaper option in terms of fees than investing in private funds and, with a good manager, can deliver better performance.
The larger the desired portfolio, the more compelling the direct route becomes. However, for Euro-zone investors, the size of portfolio needs to be e250m to produce a diversified portfolio across a number of countries. In fact, if potential investments span a number of jurisdictions, the attraction of using the indirect route increases because of the difficulties in administering a multi-national portfolio, even if the local management is out sourced. So today, the direct or indirect route is a less black-&-white choice than before. Most funds are investing at least some of their real estate allocation in indirect vehicles.
The key choice today is whether any of the portfolio is held directly. Larger UK pension funds wishing to invest £100m in property should certainly have a direct UK portfolio because they have a deep domestic market which provides competitive returns on their door step. French funds are similarly placed but elsewhere in Europe, it is harder to point so compellingly to the direct route. The Nordic countries, especially those outside the Euro-zone can make a case for a direct domestic portfolio, but their strong local funding levels suggest that a significant proportion of their real estate portfolio should be international.
The decision for a pension fund, and any other investor, as to how best achieve property exposure is much more complex than ten years ago, or even 25 years ago when institutions were last looking to upweight on the scale seen today. There are far more options but they are more robust and every type of investor should now be able to find a real estate strategy that suits their needs.
Dr Robin Goodchild is head of European strategy at LaSalle Investment Management

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