Sharing the pain of many homeowners as property values dropped in 2008 and 2009, pension funds with big exposures to real estate suffered. Yet while property markets are yet to fully recover, noises are being made about funds wanting to increase their real estate holdings, and asset managers are trying novel ways to provide attractive investments in the area

At the end of May, two headline deals highlighted the growing activity in the sector. Devon County Council Pension Fund announced that it was to double its £133m real estate fund-of-funds portfolio, while the Universities Superannuation Scheme (USS) beat off intense competition to purchase the St. John's Shopping Centre in Perth from BAE Systems Pension Fund for £32m (£2m higher than the asking price).

Data held by Pension Funds Online shows that the average allocation to property in the UK remained at the lower end of single figures, with 4.8% of a typical portfolio's assets being allocated to real estate at home and 0.1% going to overseas property.

Marcus Sperber, head of international real estate at BlackRock, says he could foresee typical pension funds increasing their real estate holdings from 2-3% to 3-4% in the next year and is confident some would look to increase this slowly "to 7% and 8% in the next few years."

The bond-like inflation-matching returns of sound real estate investments are well known, but in an uncertain market Sperber warned that an eye for detail is needed. He said: "Following the 45% fall in UK Real Estate Values between 2007 and 2009, investors have retreated to 'safe' high quality assets. We believe prices in this segment of the market are now inflated with a potential bubble emerging."

BlackRock's own strategy centres on identifying assets that have the potential to add value, within the core property market but increasingly away from it, and in non-traditional real estate holdings. Sperber says that "with banks not supporting anything that is not considered to be prime from either a covenant or a location perspective, opportunities exist and I think it is up to us to hunt those out."

BlackRock's real estate holdings (included under the $115bn in BlackRock Alternative Investors) holds, for example, a block in Bedford Street, Covent Garden in order to capture the benefits of added office and retail interest in this particular area of central London, "a global retailing hub". In the non-traditional arena, Premier Marinas is a recent purchase that gives their UK Property Fund a book of over 5,000 prime shipping births on the South Coast of England.

The fund's biggest holding is of General Practice Group, owner of 158 doctors' surgeries in the UK, and therefore a generator of stable government-backed rental income that is said to beat gilt yields by 250 basis points.

Sperber says "non-traditional diversified sectors have less competition due to the specialised nature of the assets" and often offer better value as a result.

Sperber blames investment managers who had an indiscriminate approach to property investment for pension funds losing out in the global downturn. "Investors were encouraged by banks who were investing in properties by leveraging to unsustainable levels and the effects of this are now being felt. Investors, in their hunt for excess return, were giving partners control of their capital at a time when they most needed to control their risks. I would contend we need a back to basics approach" says Sperber.

He now advises that "falling markets unfortunately have compounded illiquidity, which means investors must lever their allocations appropriately".

Notes of caution

John Gellatly, global real-estate multi-manager of Aviva Investments, is more cautious on the demand from UK pension funds for real estate. He says that there "is steady underlying pressure but no rush of immediate money or evidence of significant strategic weightings moving up. There was more at the end of 2009 when there was a sense we had reached a cyclical low."

Gellatly says "there are some institutional investors who have seen what is happening in the global property markets and are now beginning to make allocations for the first time, but there are also others whose real estate portfolios are performing and are wanting to capture more cash".

Aviva's latest offering, a global property fund-of-funds, encourages pension funds to look away from the sluggish domestic property market for value. Gellatly says: "Everybody used to consider property a local asset with opaque overseas markets difficult to get into, but market transparency, systems and infrastructure have improved dramatically. PMBSs [Property Management Budgeting Systems] have imposed a degree of discipline and professionalism in the big mature markets, and you also have more UK investors working in those markets."

He adds "if I were a pension fund I would ask why I shouldn't invest in real estate in broad regional economies where the trend growth rate is arguably double that of the UK?"

Aviva's new global property fund is focused on core overseas markets (US, Canada, Eurozone, Hong Kong, Singapore, Australia and Japan) and attracted a £100m investment immediately on opening, Galletly reveals. Structured as a Jersey Property Unit Trust fund of funds, it allows LGPS schemes to outmanoeuvre caps on their limited-partnership holdings, and offers the pooled structure that tends to be popular amongst small and medium sized pension funds for its ability to "aggregate capital, heighten ability to negotiate with managers and reduce transaction costs."

Gellatly added that pension funds' inflation concerns were informing investment managers real estate offerings, with Aviva having launched a REALM (return-enhancing asset-liability modelling) concept that aims to lock in secure long-term cash flows with indexed rental terms. He adds "real estate generally is a good way to manage inflation risk – when you invest outside of the UK many of the markets have annual CPI-indexation attached to them, so you are picking up the protection you want."  

Gellatly added that Aviva was "holding fire a little bit on the UK market" as it waits for banks to re-price away from the London prime market.

First published: 02.06.2011

dbillingham@wilmington.co.uk