With pension schemes bullish on bricks and mortar, Catherine Lafferty looks at the trends that are shaping institutional investment in property.
The word on the institutional investment street is that property and pension funds are in the middle of a romance. They seemingly have eyes only for each other’s attractions and like any lovestruck couple are seeing more and more of each other. One example is the Centrica Pension Fund. “Compared with 10 years ago, investment in property was 2.5% of assets, we are now at 5%,” says Chetan Ghosh, Centrica’s chief investment officer.
Partly this romance is due to pension funds’ falling out of love with another long-term partner, bonds. That relationship ran aground amid the rocky turbulence of the financial crash, when central banks, struggling to contain the crisis, slashed interest rates to historically low levels. They are yet to recover to their pre-crash heights.
The drastic move in monetary policy transformed fixed income from being a lush, fertile asset class, to an arid low-yield desert and investors accordingly looked elsewhere. The result has been a shift in the make-up of institutional investment portfolios, which a decade ago were mostly made up of equities and fixed income, says Doug Rowlands, director of client portfolio management at AEW, a real estate investment manager.
The attractions of property make a contrast to the fading appeal of fixed income for institutional investors.
“In respect of real estate, you’re looking at a 400 to 500 basis point premium on the typical risk-free rate or the government bond yield, which is attractive, particularly for long-term holders of capital, which are pension savers, essentially,” Rowlands adds.
Along with attractive yields there has been an improvement, particularly in past 10 years, in the infrastructure of the real estate investment world so the kind of products and routes to investment for investors have dramatically improved and that has also facilitated this growth in the sector as well. Rowlands describes it as “a big trend”.
Shades of grey
Indy Karlekar, senior managing director, global head of research and strategy at Principal Real Estate, notes that while traditional sources of yield, which have historically been fixed income, are “very tight”, there has been a steady uptick in allocations to property across the world, not only the geographic allocations to property but also the types of pension funds investing in the asset class globally.
“Whether a pension fund is in Australia, Europe or the US, there has been a definite shift towards increased allocations within the pension fund industry towards property across the board,” Karlekar says, adding: “We are definitely seeing a shift upwards to broader allocations of property within pension funds.”
In the US, San Francisco, Boston, Austin, New York and Seattle are healthy property markets, Karlekar says. While in Europe, London is a strong market though its shine has been dulled by the shadow of Brexit hanging over the economy. Karlekar estimates that the uncertainty has forced transaction volumes down 30% to 40% in 12 months.
Yet as with any romance there are shades of grey in the relationship, likes and dislikes, ups and downs. Traditional property, for instance, has seen a pausing or even a decrease in asset allocation, according to Matthew Graham, head of UK pensions at Aviva. But the flip side of that has been an increased interest in the matching type of assets, of which real estate also forms a part and to income-generating real estate like long lease property.
Matching or income
The degree of a pension scheme’s relationship with property depends largely on what it is trying to achieve. Factors such as whether the scheme is targeting a buyout, the nature of its covenant and the income profile will direct the role it wants different asset classes to play in various investment strategies.
A scheme can invest in property for growth reasons and enjoy strong returns of up to double digits depending on the market; or it can invest in property for income, Matthew Graham points out. This then leads to questions about how to invest in property, perhaps literally buying a building or lending on it and where that property will be, in the UK or overseas.
The differing uses to which property can be deployed by pension schemes is illustrated by the blend of approaches adopted by the Nationwide Pension Fund.
Mark Hedges, Nationwide Pension Fund’s chief investment officer, explains that the scheme has two portfolios, one for matching assets and one focused on return-seeking assets, between which it splits its property investments.
The scheme has four UK properties in the alternative matching asset portfolios, including residential and commercial ground rents. These are long-dated cash-flows that have a degree of inflation linkage, which match its liabilities.
It also has some 25 year-long lease properties, is invested in two funds and has just backed a mid-market rent fund being operated by Places for People, an affordable housing scheme with low market rents that are linked to inflation, which provides a good match for its liabilities.
“Property does generate higher returns than gilts, for example, but it is very much held for the long term to match the longterm cash-flow needs of our pensioners,” Hedges says.
Real estate is covered by Nationwide’s return seeking assets portfolio, in which sit a mixture of different funds, with some directly owned property trying to generate returns of the retail price index plus 5%.
The funds are broadly split 55% to matching assets and 45% to return seeking assets, which include equities and credit with around 20% in private markets, consisting of private equity, infrastructure and real estate.
“Real estate could be 5% to 6% of the fund but we don’t have set allocations,” Hedges says. “We do not have a prescribed limit which says we have to put a certain amount in real estate. If you are a big fund you have to do that, but we are small enough to be more nimble and pick the right opportunities at the right time.”
Winners and losers
Another trend in pension funds’ growing interest in property is towards more focused capital allocations. Principal’s Indy Karlekar says investors have become much more driven by specific strategies with some focusing on opportunistic strategies, while others concentrate on core strategies.
The Centrica Pension Fund has 5% in direct UK property that buys commercial property in a traditional sense. In addition, there is just over 5% in longer dated cashflow generating property options, such as long-lease property and ground rents. In order to access the longer-dated income type of property it is in a variety of pooled funds, one for long-lease property, one for ground rent and one for commercial income strips.
The scheme has found longer-dated cash-flow generating property especially attractive, the types of property include hotels, supermarkets, and key strategic council buildings like libraries or townhalls.
Within the longer dated commercial property income strips the underlying fund manager has invested in council buildings and student accommodation, making agreements with the universities. Ground rents started off with a focus on residential property but over time has been complemented by commercial ground rent deals, which can hail from any type of corporate entity.
Behind the flourishing relationship between property and pensions lies another story: that of the demise of the British high street and institutional investors showing less interest in retail spaces in the era of internet shopping. Principal Investors has seen a clear preference for logistics and industrial properties and forecasts strong occupy demand in the next 12 months.
This is in stark contrast to high street retail. “The traditional centres of high-end stores – Fifth Avenue, Rodeo Drive or Bond Street – have felt a little bit of pressure as retailers have stepped away and as a result we have seen some of the softness in retail rents become quite pronounced,” Indy Karkelar says.
There is also strong demand for private residential rental schemes in the UK. These are buildings that house between 50 and 400 apartments, which are professionally managed and rented out on one-year leases. Multi-family residential property, as it is known in the US, is a massive market across the Atlantic and one that remains a strong favourite for investors, with growing demand by investors for this residential investment in the UK and Europe, Karkelar notes.
Another trend that counts in property’s favour is the ongoing evolution towards an ESG-conscious investment world.
Indeed, The BT Pension Scheme, the UK’s second largest retirement fund, specifically cited the environmental advantages of the asset class in its annual report: “With buildings accounting for almost a third of the world’s energy consumption, greenhouse gas emissions and natural-resource usage, responsible investment is an important factor in property allocation and in many ways property is the asset class in which its application yields the most tangible benefits,” the scheme said in the report. “Investor and tenant demand for well-managed, sustainable assets, as well as clear cost benefits from ensuring buildings are managed in a responsible way, provides a clear value driver.”
It has become a familiar theme for AEW’s Doug Rowlands, who says there has been significant change in the way institutional investors have considered environmental issues in the past decade. Any due diligence conducted with an investor includes an examination of ESG implications, he says. Rowlands expects the subject to increase in importance and notes that the Australian bushfires have sparked further conversations with investors on the topic.
Principal Investors has observed an upswing in interest in property among traditional defined benefit (DB) pension schemes and defined contribution (DC) schemes, especially in the US, which have added property to their allocations.
Historically a lot of pension funds have accessed property through a real estate investment trust (REIT) due to their liquidity and general ease of rebalancing portfolios, but during the past few years there has been heightened interest in more private types of strategies within pension funds that are looking to add a level of diversification to their property portfolio. There has been a noticeable shift towards property by DB and DC funds, large and small, according to Karlekar. “It has been more pronounced in larger pension funds because they have more capital to play with. But it has been a global phenomenon,” he says.
And there is no sign of the romance between the two fizzling out.
“From a broad allocation perspective, we see 2020 as another pretty decent year of capital flows into the asset class, no question,” Karlekar adds.