Oliver Hamilton, principal for Townsend Group Europe, an Aon company
Historically, most UK pension schemes have focused on domestic core commercial property to gain exposure to real estate as an alternative asset class as part of their wider investment portfolio. This is in contrast to many other asset class allocations, such as equities and fixed income, which have become far more global since the start of the millennium.
Despite this, the same principles of global diversification apply to property as with these other asset classes. The UK property market is only around 5% of the institutionally-investable global property market, meaning that pension schemes with only a domestic UK property allocation are unable to capitalise on attractive investment opportunities, such as the rise of internet shopping across continental Europe, and are exposing themselves to UK specific risks.
Brexit is a topical example of such a risk and although the UK property market has responded resiliently after an initial stumble, a lot of uncertainty still surrounds the conditions of Britain’s exit from the EU. This is having a significant impact on the investment decisions of UK institutional investors. We continue to see pension schemes increasing their allocations to property; however this has been by strategy or sector and in more specialist areas such as long lease, residential, healthcare and real estate debt. Very few of our clients see real estate debt as a property allocation and it sits in other parts of their portfolios which allow for greater allocation to real estate equity opportunities.
Despite increasing investments into property, few UK pension schemes have increased their non- domestic investments; the few tend to be larger schemes committing to funds at the riskier end of the risk/return spectrum. In addition, this allocation is usually a small element of a wider private markets portfolio with a different purpose to an allocation to core property. Notwithstanding this, there are compelling opportunities to invest in global core and core-plus property via pooled funds and these can be accessed by small and large schemes.
The opportunity to invest in global core and core-plus property is set against an outlook of subdued UK core property performance over the short-to-medium term. This is partly related to Brexit uncertainty and also limited capital appreciation of UK property, meaning that returns will be driven by income. Given this outlook, we would expect a global core property allocation to produce superior returns to UK property. In addition, correlations between UK property and other national property markets have been positive, albeit low, in local currency terms since 2000. This shows that investing in global core property adds diversification benefits.
It is important that an individual investor’s unique objectives and constraints are carefully considered when deciding how to invest globally. Broadly, the most appropriate way for a UK pension scheme to access global property is through a fund-of-funds. If the investor is large enough, it would be beneficial to build a bespoke segregated portfolio through which they can invest in multiple funds that are combined to meet their specific needs. The alternative to this approach is investing via listed real estate, which despite being easier and faster to access can be volatile and highly correlated to equities in the short term.
Although we believe that most UK pension schemes considering an allocation to global property should focus on core and core-plus strategies, since these are the bedrock of institutional property allocations providing strong income returns with potential for capital growth, larger pension schemes with higher return requirements and risk tolerances could consider global value-add and opportunistic property funds to sit alongside a core allocation.
There are unique risks associated with investing in global property and important non-investment considerations. For example, currency movements are one of the main investment risks as property cash-flows are notoriously hard to hedge. Currency hedged global pooled solutions are rare and investors will therefore need to accept the risk or appoint another manager to carry out currency hedging, however this will only be an approximate.
Other considerations include tax leakage when investing in other jurisdictions, valuation methodologies (which might be materially different to the UK) and regulatory risks, especially when investing in countries which are far less transparent than the UK.
Given Brexit uncertainty and the subdued outlook for the UK property market relative to higher expected returns of global property and the diversification benefits of investing globally, we believe there is a strong case for UK pension schemes to invest in global property. The attractive stable income element and long-term nature of core property allow investors to diversify globally without materially moving up on the risk spectrum and therefore we feel investors should consider a strategic allocation to global core property in particular.