Building on strong foundations

 

The events of the past 24 months have prompted investors around the world to reassess their portfolios and take stock of holdings across all asset classes. Global real estate markets – in many cases buoyed by unsustainable levels of leverage – have experienced significant dislocation during that period and are likely to continue to suffer in the coming months; property investors have seen capital values drop, equity in leveraged vehicles wiped out and now face an increasingly weak occupier market.

Yet, these experiences look unlikely to provoke a move away from the asset class on the part of pension funds. If anything, commercial property is likely to look fairly attractive versus other asset classes as a secure, income-producing source of absolute return at a time of ongoing global recession.

The latest European Institutional Asset Management Survey (EIAMS) shows that real estate is going to be the main beneficiary – alongside fixed income and commodities – of a major shift in European institutional asset allocations, while other alternative assets like private equity and hedge funds look to lose out in the future. Although average target allocations to real estate remain at a steady level (5%), the survey reveals that investors are looking to increase this going forward.

 

The UK perspective

However, experiences have differed across the globe. UK pension funds, for example, with real estate portfolios weighted towards their domestic market will have felt the effect of a 44% drop in capital values, as measured by International Property Databank (IPD), an index that itself lags the real market. This correction has been quicker and more severe than in any other global property market. US pension funds, on the other hand, have not seen such precipitous declines in their domestic property valuations, but have experienced pain in other forms: many have overshot their allocation limits as a result of the denominator effect (more on this later) and have been unable to liquidate positions.

Such was the speed and severity of the correction in the UK property market that pension funds with large domestic holdings will have seen a correspondingly significant reduction in the market value of their portfolios (although it will still have generated rental income). Consultants, such as Watson Wyatt’s Douglas Crawshaw, believe this experience will highlight to UK pension funds the wisdom of diversifying internationally.

ING Real Estate chief investment officer Damien Smith, agreed. “There are a number of investors who only have UK portfolios and as a result will probably have underperformed quite significantly to what they would have preferred. Therefore, I think some of those will start to ask the question about diversification,” he said.

That said, Smith admitted that a large proportion of the UK pension fund community will be happy to focus on what is the deepest, most transparent and most liquid property market in Europe.

The UK also arguably offers the best investment opportunities today due to its point in the cycle. Yields on commercial property today are at historic highs, although admittedly in part due to a poor economic outlook and expected future rental declines; international investors are now competing on the best quality assets in the UK, causing prime yields to actually stabilise, according to CB Richard Ellis. These are signs that the UK market is near the bottom, although secondary assets (i.e. poorer locations, build quality, tenants, lease lengths) are expected to continue to decline in market value.

Some of the larger UK pension funds have already been active. BP Pension Fund, West Midlands Pension Fund and the Teesside Pension Fund are just three to have bought assets in recent months. Another is the Universities Superannuation Scheme (USS), which during 2006 and 2007 sold approximately one-third of its UK portfolio in anticipation of the market correction and is now actively rebuilding its domestic exposure. In recent months it has bought a mixture of UK retail and industrial assets, including two retail parks, and took full ownership of the Grand Arcade shopping centre in Cambridge after buying the remaining 20% stake in the newly completed development from co-developer Grosvenor.

“It was felt that the UK market was looking attractive on a relative basis and we were comfortable about beginning to invest again. Having said that, we are mindful the economic background is weak; in particular, the occupational markets are suffering,” said USS head of property Graham Burnett. “The acquisitions we have made to date have been defensive, in terms of being prime, well-let and having long leases and reasonably sustainable rents. We’ve invested in the UK to date this year circa £150m, across sectors, at yields averaging in excess of 8%.”

 

A global player

The UK is also attracting the attention of large pension funds in North America and continental Europe. Earlier this year, for instance, the Canada Pension Plan Investment Board (CPPIB) provided a £100m capital injection to the Hercules Unit Trust, a UK retail warehouse fund run by British Land and Schroders. The move will help pay down Hercules’ £300m of debt, while CPPIB will receive convertible bonds due in 2020 and carrying a fixed coupon of 10%.

CPPIB’s senior vice president for real estate Graeme Eadie said the UK, alongside the US, is seen as being home to the best opportunities potentially. “It is an interesting time to look for new investments. Obviously, the market has changed a lot and prices have come down. So we think this is a good time to be looking,” he said.

“One of the challenges is always the general economy and where it is going, but overall we see this as a good opportunity. Our focus at this stage is on core assets designed for a long-term, and the markets where they seem to be coming available would include the UK and the US, which is really where the greatest distress in the capital markets seems to be taking place.”

APG Asset Management, the investment arm of the largest pension fund in the Netherlands, ABP, also sees the UK as offering the best investment opportunities, since it has corrected the most. However, the institution is actually seeing more of an opportunity in the near term listed property companies, which are now trading at more favourable discounts to their net asset values and have now successfully recapitalised. APG’s approach is somewhat unique among pension funds in that it invests across both listed and non-listed real estate with both sectors essentially competing against each other. “In effect, we try to select the best funds and companies, not having any preference for being listed or non-listed,” explained APG’s managing director of global real estate Patrick Kanters.

“The listed real estate market has corrected very strongly, whereas non-listed or direct real estate market is still in the correction phase. We think on the listed side, it is becoming interesting right now to increase exposure in the shorter-term, whereas in non-listed real estate, generally speaking, globally we will see another half-year of further downward correction, and that is typically due to the lagging effect we always see between listed and non-listed real estate.”

US pension funds are targeting the US and the UK for investment opportunities, but many are only just beginning to recover from the denominator effect, as mentioned earlier, which saw weightings to real estate inadvertently rise, as global equity markets plummeted but property valuations in most markets moved very little due to the lack of transactional activity. This led many, including the giant California State Teachers Retirement System (CalSTRS) to temporarily expand real estate allocation limits as target levels were breached and to prevent the need to sell assets into a falling market. US pension funds also sought to redeem capital from real estate funds to generate liquidity and reduce property weightings.

 

The denominator effect

Many today are still in so-called redemption queues, said Ennis Knupp + Associates Heather Christopher – although the denominator effect has eased in recent months as US property markets have begun to correct. Christopher says a number of pension fund clients who have yet to invest in real estate are considering entering the asset class, due to the fact that markets are likely to reach their troughs in coming months.

Pension funds in continental Europe, where market corrections are also lagging the UK, have also experienced the denominator effect, but not to such a widespread extent – US pension funds are, generally speaking, somewhat ahead of their European counterparts in terms of building up their target levels of exposure.

“The Australians, Canadians, Americans, Asians and continental Europeans are now through much of the correction period and the markets will begin to stabilise,” said Smith. “From an allocation perspective, following valuation falls in their portfolios, they are coming back into line with what they expected.”

Smith believes that pension funds today are falling into two camps: those who have experienced capital value losses and/or their equity wiped out in highly leveraged strategies, and are looking to batten down the hatches during the current downturn; others with the available capital and inclination to take advantage of what could be an unprecedented investment opportunity over the next two or three years.

“There will be a number of pension funds who, because of the volatility and falling valuations, will sit on the fence, won’t be in a position, or too nervous, to make a decision. Those pension funds will ride the market and then will probably ride it back up again, as the market corrects over the next five years,” he said.

“But those pension funds today who are willing to make the decision and the allocation to invest in property, will actually make great value investments at a low cost base. We are coming into a very unique time where you get to see prices that we haven’t seen for a very long time.”