Pension Funds Online

Property’s Ongoing Attraction

Property has, perhaps more than at any other time in recent history, now established itself as the third asset class amongst pension fund investors, offering diversity to complement both equities and bonds.

Providing both bond and equity-like characteristics without the volatility in performance returns, well secured leases can often provide an income stream, like bonds, of over 15 years. Whilst corporate tenants represent more risk than Government income this is reflected in the higher yields available from property in relation to gilts.

With property lease payments reviewed, commonly every five years, there is a growth element not mirrored by gilts. Lease reviews are invariably upward only, so the income during the term of lease is unlikely to fall with the resultant cash flow growth boosting total returns.

Yield Comparison

Source: IPD UK Monthly Digest, Dec 06 (FT & Datastream)

Over the last 10 years, rents have risen by 3.6% per year on average against the Retail Price Index of 2.5% a year. The hybrid nature of the asset class has been reflected in its performance track record with property, to the end of 2006, now the best performing asset class over the last ten years.

Similarly the sector’s risk profile lies somewhere between the two extremes, with values rarely falling as much as equities in a recession but rising less in a boom creating more consistent and therefore more manageable performance track record.

The bond and equity characteristics of property can suit different investors. In balancing risk and return, investors with higher risk tolerance and return targets may prefer a portfolio of shorter leases with a percentage of voids and/or development that create the potential to enhance total returns through active management.

A more risk-adverse investor, like a pension fund, may well favour a greater degree of securely let assets where the yield and growth prospects may be lower but where the risk of tenant default is minimised.

The last few years have also seen some significant changes to the asset class. There has been a considerable increase in the number of unlisted property vehicles, the arrival of the listed REITS and the synthetic investments such as derivatives. All of these are now available to pension funds in order to both manage risk and return - through a spread across many property types and regions - offering a level of diversification not previously possible through direct property investment.

Portfolio weighting

Analysis of risk (volatility) and return across asset classes over the past 25 years shows that adding property to an existing equity and bond portfolio reduces overall portfolio risk. Risk reduction increases as the property weighting increases, but only up to the point where the portfolio becomes less diversified and dominated by property, at which point risk begins to increase again (this occurs beyond a 70% property weighting).

Property returns have a low correlation with equity and bond returns, which combined with property’s relatively low volatility, is the reason increasing the property component in a mixed portfolio reduces risk.

Of course by reducing risk and volatility an increased weighting to property may also reduce overall portfolio return; however this needs to be set against the much more dramatic effect on the risk-adjusted return and the overall portfolio risk.

There is no single ideal property weighting for all mixed portfolios, as fund maturity, duration of liabilities, risk preferences and current weightings all need to be taken into account. That said, a property weighting in the region of 15% to 20% in a mixed portfolio would allow a fund to take advantage of the diversification benefits (lower risk and higher risk adjusted return), without significantly lowering the portfolio’s return prospects.

Allocations to Property by Pension Funds

Source: WM

Outlook

Commercial property has seen a strong run over the last three years with total returns averaging 18.6% p.a. This has prompted some to make gloomy pronouncements about future returns. However, the strong rise in property values must be viewed against a benign economic climate that has seen a sustained period of low inflation and interest rates. In such a climate we would argue that what has actually occurred is a shift in the relative pricing of property creating fair value rather than unsustainable value in most sub sectors.

Total Returns Annualised (% p.a.)

Source: IPD

Looking forward ING Real Estate anticipate the economic backdrop will remain favourable to property during 2007. Even though property yields are at a record low we have already established the belief that these yields still, in the main, represent fair value. In fact in certain sub sectors where continued domestic and overseas investor demand is combined with strong rental growth further yield hardening could be seen.

We forecast central London offices to continue its recent good performance and deliver the best returns. The central London office market is already leading the sector performance with strong rental growth prospects resulting from a restricted supply line and sustained growth of demand on the back of increased employment and a buoyant financial services sector. Rental value growth in central London has further upside potential and will attract keen investor interest particularly in the West End where supply is limited. This strong interest is likely to drive yields even lower. In time, supply response with increased development is inevitable which will impact on rental value growth and overall performance returns, but probably not for several years yet.

Central London Offices: Development Completions (m sq ft)

Source: DTZ, ING REIM

Whilst the outlook for 2007 continues to be strong, investors will inevitably need to adjust to lower return expectations as underlying capital growth becomes more dependent upon sustained rental growth rather than the yield compression that has driven returns over the last three years. However ING Real Estate still forecast property to deliver very respectable returns over the next 3 years.

The ING Real Estate survey of pension fund investors found that the total return requirement that the majority of investors are seeking is in the region of 7 - 8% p.a. We anticipate that property will meet this hurdle rate over the next 3 years.

Hurdle rate of return

Source: ING REIM Investment Survey, 2006

What we do envisage as the markets moves into a more defensive stage is a growing demand on the part of investors towards absolute return strategies. Whilst we believe the time is still right for aggressive relative strategies an early move towards a more defensive income led strategy supported by strong covenants and perhaps fixed of RPI linked increases may well pay dividends in the medium term.

Growth of Alternative Investments

What our research also shows is a growing interest in alternative assets as a result of increasing demand for portfolio diversification. The infrastructure asset class offers characteristic long-term income streams, monopolistic or quasi-monopolistic positions and strong predictable cash flows - quite different qualities to traditional real estate investments. Such an investment could provide much sought after asset liability matching as could institution Healthcare which shares many of the same qualities.

Over the next 2 to 3 years we anticipate value added strategies will increasingly be deployed to achieve out-performance. What is clear is that as the market continues to mature so there is an increasing need to become conversant in both the property and financial markets, so as to fully understand how the use of alternative investments, both real and synthetic, can match portfolio strategies with highly individual investor requirements.

This article has been approved by ING Real Estate Investment Management (UK Funds) Limited which is authorised and regulated by the Financial Services Authority.