Solid returns

30 Nov 2018

With low gilt yields forcing schemes to pile into bricks and mortar, Mark Dunne asks if the reward is worth the risk.

It has long been said that an Englishman’s home is his castle; but these days it could be his pension too. The office where he works, the shop where he buys his groceries or the warehouse that sends him the latest bestseller to read on his early morning commute could also be funding his retirement.

With the yield on 10-year UK government debt hovering around 1% in recent years, several retirement funds have turned to bricks and mortar to help pay their members’ benefits. Yields range from 3.25% on offices in London’s West End to 5.25% on retail warehousing at the side of motorways, according to estate agent Savills. So it is easy to understand why institutions have been lured to these assets in a low return environment.

Another reason is risk. Pension schemes have been forced to stomach more risk to generate much needed cash, but the longer-term returns offered by real estate are, on average, considered to be within reasonable risk parameters compared to equities.

One fund that has built a sizable allocation to property is RPMI Railpen. It has around £2bn tied up in bricks and mortar, or 12% of the £28bn of assets it manages. “We certainly believe in property,” Railpen’s head of property, Anna Rule, says. “We are looking for new, interesting opportunities
that are going to meet our target return.”

She does, however, admit that this approach has been built partly out of necessity. “The strategy also reflects the need to look at alternative asset classes in light of lower bond rates,” Rule adds.


Other funds which have turned to property include Lancashire County Pension Fund (LCPF), which has a £840m real estate portfolio, while London Pensions Fund Authority (LPFA) has £400m at work in the sector. These schemes are part of Local Pensions Partnership (LPP), a local government pension
scheme pool.

Richard Tomlinson, who looks after real estate for LPP, says property is seen as an important part of these retirement schemes’ investment strategies. “Both schemes are maturing and the strategy is towards cash income and property is seen as a good source of that,” he adds.

Adding real estate to a pension fund is not a new innovation. Property, to some degree, was part of many retirement schemes’ investment strategy before the financial crisis forced the risk-free rate down to historic lows. It is a case of increasing their allocations to the asset rather than building a portfolio
from scratch. Indeed, the London Borough of Southwark Pension Fund had a 10% allocation to property in 2005; but today it is close to 20%.

The lack of liquidity in the asset class has not deterred trustees from putting millions, even billions, of pounds to work in the sector. The benefits stretch beyond generating a regular income stream. It also provides diversification, is a hedge against inflation and generally has a low correlation to other
asset classes.

Tomlinson is seeing a lot of pension fund capital flowing into bricks and mortar, which, obviously, is having an impact on pricing. “It is a competitive market,” he adds. “Prices are being bid to levels where sometimes they are hard to justify.”

The rising cost of investing in real estate is not expected to ease anytime soon. Many of the schemes portfolio institutional spoke to about their property strategies are yet to achieve their allocation target.

Lancashire has 11% of its assets invested in property, just short of its 15% target, while Railpen has a 12% weighting to the asset class, below its 15% goal. LPFA has work to do to close the gap between the 7.5% current allocation and its 10% target.

Southwark’s retirement scheme, which is worth more than £1.5bn, has a 20% allocation, or around £300m, which is invested in supermarkets, restaurants, offices and warehouses. “This is not a get in and get out strategy,” says Duncan Whitfield, Southwark’s strategic director of finance and governance. “This is get in, grow the capital and get the revenue returns,” he adds.

Property is core to Southwark Council’s retirement scheme strategy for good reason. “Bricks and mortar in the hands of astute managers has a great record of holding value,” Whitfield says. “It doesn’t necessarily matter if it is in the middle of a city, if it is commercial, retail or housing; there is significant evidence of the certainty of value and return on property.

“Property is a key component of a wider investment strategy,” he adds. “It surprises me that we don’t see the same exposure in other funds.”


All decisions in Southwark’s property portfolio are made by its managers. “They pretty much have a free reign,” Whitfield says. “They are given a target and have the flexibility to invest.”

He appears more than happy to leave it to the managers, which is an attitude that he has developed during the past decade. Southwark’s managers started buying distribution hubs by motorways in 2008.

At the time Whitfield wondered why they were buying big sheds by the M1, but now they “cannot build enough of them”. “That is the manifestation of the value that these low cost, high value acquisitions
have,” he says.

However, another scheme has moved in the other direction when it comes to making investment decisions in this space. He appears more than happy to leave it to the managers, which is an attitude that he has developed during the past decade. Southwark’s managers started buying distribution hubs by motorways in 2008.

At the time Whitfield wondered why they were buying big sheds by the M1, but now they “cannot build enough of them”. “That is the manifestation of the value that these low cost, high value acquisitions
have,” he says.

However, another scheme has moved in the other direction when it comes to making investment decisions in this space.

Anna Rule was hired by Railpen in January 2017 to manage the scheme’s property mandate in-house. She hired a
team of experts and soon set to work building the processes and procedures to end the scheme’s reliance on third-party managers.

“We feel [bringing it in-house] is a better alignment with our overall objectives,” Rule says, also pointing to a cost advantage. “It reduces principal agent issues and ultimately there is a lower cost.”

LPFA’s strategy has also changed. It now has a national portfolio of directly acquired properties, which has reduced its reliance on pooled funds. The downside to moving to an almost exclusively direct property portfolio is the expense.

Indeed, Southwark’s property management fees doubled to £694,000 in the 12 months to the end of March 2017. “Direct property is more expensive than pooled investing, but performance is net of fees,” an upbeat Whitfield says.

Tomlinson describes property fund fees as “pretty competitive” when compared to those charged for infrastructure and private equity pooled investments. “Depending on the type of manager, the fees can be competitive,” he says.


In the property market, housing was once seen as something of a final frontier among professional investors. Unlike its commercial counterparts, residential has traditionally not been considered an institutional asset. The issue has been a lack of scale, a barrier that institutions are removing.

RPMI Railpen has around £200m invested in housing built for the rental market. The scheme will not touch a scheme unless it has at least 100 units. It owns five assets in this market and, once they are all open for business, they should have about 1,000 beds.

“Residential is an area where there is a strong income stream,” Rule says. She describes it as a burgeoning asset class that is a good hedge against inflation. LCPF kicked off its debut foray into housing by part-funding a 119-apartment building in Hayes, West London four years ago, while LPFA is building rental units at Pontoon Dock by the Thames Barrier.

“Private rental sector schemes are attractive in the major metropolitan areas,” Tomlinson says. “It is hard to find the scale in provincial towns.”

Southwark Council has some residential exposure through private rented sector (PRS) funds worth £15m and £20m. It also has similar sums in two opportunistic funds, which invest in distressed assets, including real estate. “These are the buy it, do it up and get out schemes, which we are not comfortable with in the other [parts of our] scheme.”

Another institution benefiting from putting a roof over peoples’ heads is the London Borough of Islington Pension Fund. Islington’s now former pensions chief, Richard Greening, told portfolio institutional before his retirement that residential is becoming a popular investment.

“I’m pleased that we have started investing in residential property,” he says. “There is such a huge need for that in London and in the UK.

“It is completely mad for pension funds not to be invested in it,” he adds. “I’m pleased that we have kicked that off, although only in a small way at this point.”

Islington’s retirement fund has joined the London Pension Collective Investment Vehicle (London CIV) and Greening hopes that it will be taking residential investment “more seriously”.

But real estate is not just about housing, offices, warehouses and shops. More alternative properties are emerging as pension scheme’s chase higher yielding assets. Railpen, for example, has student housing in its portfolio.

“We believe in the alternative sector, such as retirement living,” Rule says. “It benefits from strong demographics with the UK ageing at a faster rate than ever before and it also has strong anti-cyclical characteristics. We are looking to increase exposure to alternatives.”

Lancashire also has student housing among its assets. Tomlinson describes the yield on student housing and elderly care homes as a “bit higher” than typical housing. Indeed, Savills puts the yield on student property at between
4.25% in London in the direct let market to 6.5% in secondary markets in the regions.


Despite the clear benefits long-term investors can receive from investing in property, it has been far from a smooth ride. Whitfield describes the scheme’s property strategy as a “journey of ups and downs and peaks and troughs”.

“We have had some downturns in our property experience, but we have stuck with it because we see the long-term benefit of capital growth from our direct property portfolio,” he adds. “So we stuck with it and in the past three or four years property has been on an upturn and as we have had volatile markets, in that period, property has
provided us with that steady platform that supports the rest of the fund,” Whitfield says.

There is also the benefit of the natural caution that valuers tend to have on property fund valuations. “They tend to be extremely prudent, so when you come to sell you are automatically getting a little bit of value over that,” Whitfield says. Value is a big part of the management of these assets.

RPMI Railpen’s core investment themes include affordability, creativity and connectivity. It looks for assets and projects in areas of strong occupational demand, selects the right stock and then creates value. This typically involves lease extensions, extending the assets, refurbishment or a change of use.

“In a relatively low return environment it is key that asset management drives performance,” Rule says, who believes that sustainability is a big part of managing her portfolio.

“It is not just about delivering attractive risk-adjusted returns for our members; I am keen on investing in strong economic assets in the areas where we invest. That is a big point for me, i.e. making things better for the future generations,” Rule says.

“We look to invest in economically, socially and physically-relevant investments. We are all about investing in buildings and locations where people want to live, work and play.”

Whatever purpose it serves and wherever it might be located, property is becoming a mainstream pension fund asset. “From what I have seen in Lancashire and London, property, infrastructure and the like are well established parts of the investment landscape these days,” Tomlinson says.

Whitfield concludes that property has underpinned his scheme’s investment strategy for almost 15 years and that long-term investors with a need to generate regular cash-flows could be missing out if they are not exposed to bricks and mortar.

“I would invite others to have a much closer look at and see if their property exposure is as extensive as it might be,” he adds.

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