When indirect delivers the goods

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Direct investment in European commercial property stood at a record E83.7bn last year and estimates by the property managers Jones Lang LaSalle suggest investors have a further E100bn to spend across Europe. But one of the greatest areas of growth is in indirect investing, either via specialist real estate funds or property companies.
The euro has lifted the currency risk associated with European investment and many funds, encouraged by this, are now looking a more hands off approach. Indirect investment gives access to foreign markets without the need for funds to set up local offices. It also removes the laborious task of trading in real estate, is cheaper and is a means of diversifying into more unusual sectors.
PGGM, the Dutch healthcare and social service pension fund, is one of Europe’s largest investors with E6.5bn of its E48.5bn in property. Earlier this year it completed an eight-year move from direct to indirect investment with the sale of its last building, based in London’s West End.
It chose to switch to indirect investment for a variety of reasons. “The main objective was diversification. It also produces a lower risk profile, greater liquidity and is less management intensive,” says alternative investments director Jan Van der Vlist.
With regards diversification, he gives the US market as an example. When the fund was investing directly, it had eight buildings in North America worth a combined $1bn. Now it has, for example, a considerable holding in the US real estate company EOP. “We used to own the buildings 100%, now we have 6% of six hundred buildings. We have a really diversified portfolio, both regionally and across three sectors- residential, retail and offices,” says Van der Vlist.
Less management is another reason behind the switch- at its peak, the property team exceeded 100, it’s now 12. Like ATP (see below), PGGM concluded that an indirect approach was the more sensible. “On top of this,” says Van der Vlist, “we are a pension fund and we see ourselves as investors as opposed to developers and property managers.”
Direct investment also had its logistical complications. Disposing of buildings normally meant losing the managers responsible for the building in question. Now, if the fund chooses to change its allocation, it is a question of selling holdings in a fund or property company.
After PGGM and ABP, Pensioenfonds Metaal en Techniek, the E18m fund for metal workers and mechanical engineers, is another of the country’s largest real estate investors. It also has very distinct foreign and domestic approaches. Half its E2.4bn is in local offices, shopping malls and apartments and is run by the fund. The remaining E1.2bn is split between the US, the rest of Europe and, to a lesser extent, the Far East.
Head of asset management Theo Jeurissen says they have gradually moved their entire foreign operations to an indirect approach. “We feel you need local knowledge and local partnerships,” he says. “Besides, even for an E18bn pension fund, diversifying into all types of real estate directly would be quite an achievement.”
For its indirect holdings, it takes a relatively conservative approach and focuses on core funds and large real estate companies. “In some cases when we really see an opportunity we will invest in a development fund but that’s pretty rare,” says Jeurissen.
One of the most ambitious projects at present is the international expansion of the portfolio at ATP, the E40bn Danish labour market supplementary fund. Denmark’s property market is second only to the UK’s in terms of growth in recent years and ATP is one of the largest individual investors having built up a E1.5bn portfolio of 130 buildings.
Such scale permits a direct approach. Says head of real estate investment Michael Nielsen: “we’re dealing with the daily management and doing the financial side, the letting and the buying and selling. You need to have the critical mass before you can do it yourself and we believe that we’ve got this.”
Spurred by good returns, the fund decided to increase its overall property holdings. “The problem,” says Nielsen, “is that Denmark is a small and illiquid real estate market so expanding locally wasn’t really possible.”
ATP decided to embark on an international investment programme, concentrating on Europe. Like PGGM, the fund has decided to adopt an indirect approach. “We simply cannot sit in Copenhagen and run a European portfolio, it’s just not an efficient way of doing things. Property investment is all about local knowledge and so we’re buying local expertise,” says Nielsen.
ATP is investing up to E600m in 15-20 funds by the end of 2005 and has already made commitments of E200m to seven funds since the beginning of last year. For example, it has committed to two funds in the UK with a retail focus and to two ‘logistics’ funds- those specialising in warehousing and distribution outlets. Of these two, one covers the whole of Europe, the other Holland, Germany, France and Spain. “It’s a great way of getting diversification,” says Nielsen.
Investing smaller amount makes the investment approach flexible as well. Nielsen says that since Europe’s market for offices is deflated at the moment, the fund will wait another two to three years before making a commitment. Likewise, it is avoiding overexposure to the German market until the financial situation improves. Instead, it is looking further east towards central and eastern Europe where retail property looks attractive.
As for returns, ATP received 9% from its real estate portfolio last year. It has set a more ambitious target of 12% for its indirect investments. “We want to get a premium for the risk of going out into Europe.” To achieve this ATP is combining core with opportunistic (development) funds typically run by US managers and with return targets of up to 20%. One statistic speaks for itself though- ATP has 40 people running the local, direct investments and four working on the indirect investment.
Ireland, where funds invest an average 9% in real estate, has enjoyed some of Europe’s best returns in recent years. The E8.4bn National Pensions Reserve Fund is taking its first step into property investment, due to be completed by the end of the year. Details are vague at present; the scheme is considering direct as well as indirect investment and has met with various property funds.
Killian Buckley, an investment analyst at the NTMA says the fund is likely to invest in international property although a final decision has yet to be reached. The decision is based solely on a means of diversification. “At the moment we’re looking at corporate bonds and small caps and then we’re looking at property and absolute return funds,” says Buckley.
At the E1.8bn Eircom fund, the real estate strategy has broadened and recently changed to include an indirect approach. Prior to the launch of a new fund in 1999, Eircom invested E300m solely in Ireland and in retail and offices.
Its new fund now invests indirectly and outside Ireland as well. It has holdings of E21m in a European fund run by Pricoa and invests E14m in the Irish Pension Fund Property unit trust, which has holdings in commercial, industrial, retail and offices.
“We only recently started looking outside Ireland. The Irish market has done very well but we now want to diversify,” says pensions administrator Gerry Ryan. As for the decision to invest indirectly, the reason is the same as that expressed by ATP. “We don’t have the scale or expertise to do direct investment in Europe,” says Ryan.
The introduction of the euro also had a bearing on the decision to broaden the horizon. Ryan says the Euro has cancelled the previous currency risk associated with investing in European property. Consequently Eircom has overlooked those EU countries shunning Euro membership. “We made a conscious decision to stay in euro denominated funds,” he says.
In Switzerland, funds hold an average 15% of their portfolio in the asset class. Like the UK’s local authority funds, Switzerland’s cantonal schemes typically have significant holdings in property and many also consider them as being socially beneficial. Take the E1.1bn public authority fund for Fribourg, for example. A third of its assets, or E350m, are tied up in real estate in the western city of Fribourg and the fund itself acts as a developer.
Administrator Claude Schafer says the fund builds rather than buys properties. “We don’t have a precise programme of construction but we have plots of more than 50,000 square metres and we build as we go along.” He says that most other Swiss funds keep investment within the country but venture out of their own departments. “This is the policy of our committee though. If you keep construction within the department, you create jobs in the department as well.”
Real estate holdings at the Basellandschaftliche Pensionskasse are almost as high- 26% of the funds E2.7bn. Of the CHF900m (E142m), CHF820m is invested directly, the rest in funds. Chief investment officer Roland Weiss says the fund is reassessing its holding, cutting it to 20% of the portfolio and switching to a direct:indirect ratio of 2:1.
“The reason we’re moving into indirect investment is that most of our direct investment is in Basel and that’s not ideal.” As for the indirect investment, the fund already invests in two European funds and is considering increasing its investment outside of Switzerland. “The problem we face at the moment is not that the market is bad but that it is illiquid,” says Weiss.
Novartis is another fund broadening its horizons and switching its CHF1.5bn fund from property held in and around Basel to a countrywide fund run by Credit Suisse. “We thought that we lacked diversification because all our property was held in and around Basel,” says chief investment officer Andre Ludin. Prior to making the switch last year, Novartis had 20 people running the real estate portfolio, a job that is now done entirely by Credit Suisse.
Investing further afield was out of the question as the fund was slightly bound by rules stipulating it has to invest 50% in Swiss franc-denominated assets (as a mature fund it only holds 10% in equities.) The move appears to have paid dividends already. Ludin puts returns from the old direct portfolio at around 4%, the funds are thought to return nearer 5%. “The costs are also sinking as we’re in a larger fund so it has been a sensible move. We also don’t have to pay for the staff to run the old portfolio,” he says.
In the UK, funds have more modest holdings – the average scheme holds 4% in the sector. Since average portfolios are small, most UK pension schemes choose to keep their investments domestic and directly managed. Unlike most of the rest of Europe, currency risk in the UK remains a consideration.
Diageo has one of the highest holdings in property as a percentage of overall assets. Pensions director Graeme Robertson says 15% of the E4.9bn fund is invested in property although this figure is above the strategic allocation of 12%-13% due to a fall in the value of the equity portfolio.
Diageo has nothing to do with managing the portfolio having employed FPD Savills to do so. “They’re our long standing property managers and have served us well so there’s no need to change it.” As to why Diageo has such a high holding in property, Robertson points out that, unusually, the funds holds no fixed income instruments. “In many respects, we use property in place of fixed income,” he says.
The E49bn British Telecom fund has increased its strategic allocation by 2% to E4.5bn over the past two years yet has done so within the confines of the UK. Head of property investment Richard Harrold says they considered extending into Europe but chose not to due to sufficient local opportunities. It had in place a property team of 30 managers that has simply taken on the additional investments.
Some funds, although the exception, are pulling back from foreign investment. In the Netherlands, PME, the E11.8bn fund produced from the merger of the PMI and SVM funds earlier this year, 13% of the portfolio is in direct real estate investment. Chief investment officer Roland Van Den Brink says that, unlike many Dutch funds, PME has reined-in its foreign investment completely.
This decision was taken two years ago after it was agreed the foreign investment was failing to earn its keep. “Even if you get additional returns, you’re too fragmented and too small in the various markets,” says Van den Brink who maintains that diversification within real estate makes sense but less so at the fund level.
Others have deserted real estate altogether. Only last year, the Shell pension fund chose to offload its E400m commercial real estate portfolio to MN Services. Shell describes the event as a ‘closed book’ but says the holdings, which were direct, required a disproportionate effort given their relatively modest size.
For those funds choosing to diversify, evidence suggests that, whatever the size of investment, an indirect approach is the most sensible. The same refrain is heard from fund to fund-successful investing requires local knowledge and local contacts. Investing in specialist funds or directly in property companies is a means of acquiring both. In addition, it’s also cheaper, makes trading real estate more liquid and requires less management.

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