The pandemic is the latest chapter in institutional investors’ evolving relationship with property. Andrew Holt reports.
Property is a good fit for institutional investors. Bricks and mortar in its various forms can be part of two strategies: asset matching or return seeking.
“Matching assets are a combination of long-lease arrangements, commercial and residential ground rents and social housing,” says Mark Hedges, a professional trustee at Capital Cranfield and trustee of the Nationwide Pension Fund. “All of these have long-term contractual cashflows,” he adds.
Citing the example of the Nationwide Pension Fund, the long-lease arrangements are with high quality counterparties – with one fund having more than 50% of its contracts with government – the ground rents are the most senior part of an arrangement and have substantial asset cover, with social housing demand being inherently counter cyclical.
“So, all are relatively low risk and generate matching cashflows, typically inflation linked,” Hedges says. “Return seeking assets are generally spread across a variety of opportunistic and value-add funds to generate capital appreciation returns,” he adds.
How such central ideas of property as an investment are defined depends on the pension scheme. As an insight, property currently represents around 6.5% of the BT Pension Scheme’s assets, says Morten Nilsson, its chief executive.
Nilsson adds there have been two main drivers of change in the scheme’s property portfolio during the past three to five years. “The first relates to our overarching investment strategy, which has been to reduce investment risk given the maturity profile and de-risking glidepath of the scheme,” he says.
This has resulted in a reduction in the allocation to higher risk-return assets, including property.
“The second driver has been the relative attractiveness of property, versus other assets classes as well as within the asset class,” Nilsson says. “Our approach, and that of our principal real estate manager Hermes, is focused on anticipating long-term structural change and assessing underlying fundamental value from an occupier perspective.”
This resulted in the composition of the portfolio evolving significantly in the period leading up to the Covid crisis. “Expo- sure to areas such as retail and central London offices were reduced, not because we foresaw the pandemic, but because there were clear and persistent structural trends for a number of years,” Nilsson says.
Giving an insight into the Centrica Pension Schemes approach, chief investment officer Chetan Ghosh says that the scheme’s allocations to this asset class takes many forms. “We have a target allocation of 5% to traditional UK property,” he adds. “In addition, we have close to 10% in other property – predominantly UK – exposure mostly via various long-dated contractual income mandates. This would include ground rents, shared ownership and long-lease property.”
And recent adjustments in the Centrica portfolio have seen an increase in target weighting for the long-dated contractual income assets, which have resulted in allocations to shared ownership and long-lease property.
Compared to five years ago, the BT Pension Scheme’s portfolio today has a much smaller exposure to retail and central London offices, in favour of more defensive real estate debt, residential and high-quality new offices in a small number of regional cities such as Birmingham, Manchester, Leeds and Glasgow.
In the case of the latter, Nilsson notes there has been strong demand from occupiers due to the lack of quality space in many cities that meets the growing demand for offices with high environmental standards, of which, Nilsson says, “we seek to provide tenants with”.
Property remains an important asset class for the BT Pension Scheme, albeit its role in the portfolio is constantly evolving. The scheme’s current investment strategy is focused on generating cash flows from assets to match members’ pensions. “Within this, property offers significant opportunities due to a number of attractive attributes, namely income, inflation protection and cash ow diversification,” Nilsson says.
As a result, the role of property in the scheme is evolving to become more focused on generating secure, long-dated income that is complementary to other cash flow-generating assets in the scheme. “As an example, through our ownership of the King’s Cross Estate and Milton Park in Oxfordshire we have tenant exposure to large technology and life sciences companies. In many cases these companies are different to the exposures in our public equity and corporate bond allocations which ensures better diversification within the portfolio,” Nilsson says.
Where, though, does property sit in a post-pandemic world? “Clearly the pandemic has accelerated change within certain sectors of the property market: high street retail, office and hospitality. We will see changes to these,” Hedges says. “Both high street retail and office real estate were under threat from technology disruption, though it was perhaps less clear that this was the case for office,” he adds.
Adding to this identified trend, Nilsson says: “Property is a constantly evolving asset class and the pandemic has clearly accelerated a number of trends such as the demise of bricks and mortar retail in favour of online, which is bad for shopping centre assets, but good for logistics.”
Clearly one of the biggest questions at the moment is what the impact on demand for offices is, given the trend for working from home. “It’s still too early to understand the full impact,” Nilsson says. “However, we recognise that overall office demand will likely fall.”
On this issue, Hedges adds: “High street retail and office will change and need re-invention, which means the outlook for asset returns for the foreseeable future is not attractive until these have stabilised. The performance of both will be heavily influenced by location.”
And post pandemic, residential property remains important in the UK, Hedges says, as there is a lack of supply – which, crucially, will persist. Moreover, housing will need to consider how to accommodate working from home practices.
The whole working from home narrative is something that will hang over the property investment world, causing, it seems, long-term implications. “Distribution centres, logistics and industrial will likely remain buoyant and as a new normal around how people work, live and interact is established hospitality, hotels and leisure are likely to return,” Hedges says.
“I would imagine offices will, to some extent, be downsized but not entirely redundant – there will always be a need for face-to-face meetings and collaborative activities. However, the pandemic has demonstrated that significant parts of the workforce can operate as efficiently – if not more so – by being flexible and agile and have the capability of working from anywhere,” he adds.
Ghosh also explains that the picture is changing dramatically. “Thinking has seemingly moved on from the immediate aftermath of the 2020 Covid manifestation,” he says, adding: “It does not appear that offices are going to wholescale disappear overnight.”
And searching for value trends, Ghosh says: “Capital values for UK property have not capitulated in a way that nearly everyone predicted, albeit the decline of traditional retail clearly accelerated during this period, something that would have likely happened anyway at some point without Covid.”
Looking ahead, there is an upside. “Going forward, property does not look especially cheap in absolute terms, but it does pay well versus gilts, and that will matter to many UK pensions schemes,” Ghosh says.
“The evolution of the marketplace in the coming years will be interesting,” he adds. “There is clear demand for long-lease property where a large part of the return is from contractual income.
“However, traditional property is likely to see dis-investments from UK pension schemes as they run off leaving a shortage of natural buyers unless de ned contribution plans can start to make greater use of the asset class,” Ghosh says.
Hedges builds on the theme that many of the changes brought about by the pandemic have just speeded up a process already taking place. “Video conferencing was already in use: Facetime and Skype were already ubiquitous in home life, mobile technology already made people contactable 24 hours a day so the need to be based in an office was unnecessary. It was just that people were not yet ready to recognise it yet,” he says.
“Offices will transform into meeting, networking and collaborative workspaces with a much-reduced need for individual desk and offices,” Hedges adds. “The transitioning involves cost in the interim but there will remain a demand for high- quality property that delivers these requirements.”
However, demand for high quality, environmentally robust property which is well situated should remain strong, and there are clear sub-trends within and across regions. “Valuations have changed significantly in some sectors, notably retail, so while structural trends remain a challenge, we are certainly closer to the point where asset prices reflect this,” Nilsson says.
And like much else, property also offers significant opportunities in relation to ESG, especially climate change. “Ongoing emissions from buildings account for close to 30% of overall emissions, or closer to 40% if we account for the construction phase,” Nilsson says. “There is huge scope to reduce the climatic impact of property in a number of ways from better insulation to construction efficiency. In our portfolio we have set a range of targets.
“This naturally includes achieving net zero emissions from our portfolio by 2035 as well as a number of other targets such as reduced water usage, lower waste and better heat efficiency,” Nilsson adds. “We feel strongly that investors should recognise the risks and opportunities offered by property in relation to the transition to a lower carbon economy.”
The illiquid debate
A big clash in the institutional property market has been caused by The Pensions Regulator’s proposed move to limit pension scheme ownership of bricks and mortar. “Our concern is around restricting investments in illiquid assets to 20%,” Nilsson says. “We fully agree with the regulator that pension schemes need to appropriately and rigorously manage their liquidity to pay their members pensions.
“However, we don’t agree that the best way of doing this is limiting investments in illiquid assets to 20%,” he adds. “For example, a key driver of why we invest in property is for its income generating attributes which help us pay our members pensions. Whilst property is inherently an illiquid private asset class, its income provides natural liquidity that is hugely beneficial – an arbitrary limit on our potential exposure is detrimental to us achieving the best outcomes for our members.”
The same is true, Nilsson says, of other illiquid assets such as infrastructure where the scheme invests in largely because of its long-term secure income which provides it with ongoing liquidity to pay out to its members.
Nilsson’s argument is the regulator is right to impose rules to ensure schemes appropriately manage their liquidity, but a 20% limit on exposure to illiquid assets is not in the best long- term interests of pensioners.
“It’s arguably not in the best interests of the country as it will restrict the ow of pension savings into much needed infrastructure and property investment required for the country to achieve its decarbonisation goals,” Nilsson says. “Again, something we feel strongly about as we believe pension schemes have an important role to play in helping nance the transition to a low carbon future.”
Yet property has always been illiquid, Hedges says. “Yes, funds can be established to provide investors with an ability to sell units in the fund but as we know liquidity can dry up.
“It is usually the case that when you need liquidity it’s difficult to find,” he adds. “Property is held for capital appreciation and running yield or a combination of both. It should never be considered a liquid asset.”
Property’s lack of liquidity has seen it fall out of fashion lately in the UK pension scheme space, Ghosh says, as schemes have entered the run-o phase. “Many, if not most, schemes face an 80-year run-o problem and arguably there is space for property in portfolios given this time horizon.”
But importantly, he adds: “Property can bring important diversification to portfolios as well a high degree of return linked to inflation and contractual income, all with relatively acceptable levels of absolute price volatility. We are happy to continue the allocation for the time being.”