ERAFP is breaking new ground by expanding its portfolio into real estate and by using an SRI overlay to do it. Olivier Bonnet and Erik Christiansen tell Christine Senior what they are planning
ERAFP, the French pension fund for civil servants, is poised to take a new direction with the widening of its investment activity to include real estate. This is dependent on ministerial agreement. The go-ahead is expected by the end of this year's first quarter. Investment into real estate could then begin at the end of 2010 or the beginning of next.
The decision to invest in real estate was prompted by two considerations: to take advantage of the illiquidity premium, and secondly for inflation hedging.
"Today we have built up very liquid assets, such as sovereign bonds or large cap listed equities," says Erik Christiansen, head of investment strategy. "But we don't need this liquidity. We hope through real estate to get an illiquidity premium. The other aspect is the inflation hedging properties of real estate. Legally, our liabilities are in nominal terms, without inflation taken into account. Nevertheless, the objective of our board is to maintain the purchasing power of the pension which means we need to have assets which protect against the risk of rising inflation. To some extent real estate is linked to inflation since rents are more or less indexed to inflation."
What is remarkable is that this real estate investment will be carried out, as is all ERAFP's investment, on a sustainable basis through the application of an SRI overlay. The fund's portfolio is managed according to a charter which sets out five values that govern its policy: the rule of law and human rights; social progress; democratic labour relations; the environment; and good governance and transparency. Work is currently under way to adapt these principles to a potential real estate portfolio.
The fund is breaking new ground here. The challenge is that the SRI policy should have a dual focus, so apply both to the buildings and their management. Most of the SRI work done so far in the real estate industry has been on the environmental impact of buildings, for example their use of energy and water. ERAFP is developing this first level of assessment, following a lead taken by building ratings systems elsewhere such as the HQE (Haute Qualité Environnementale) in France, the LEED (Leadership in Energy and Environmental Design) in the US, and BREEAM (BRE Environmental Assessment Method) in the UK.
ERAFP's policy will go further than this. "We don't want to limit the process to mitigating the environmental impact of the building," says Olivier Bonnet, ERAFP's head of SRI strategy. "We want to apply it to the whole investment process including the impact of the construction phase, the renovation of existing buildings, property management, the relationship with tenants, and the impact on local geography - for example, the way employees commute to work."
The process will include a rigorous scrutiny of construction companies involved in any building project, their working practices, and the human rights and working conditions of employees. For existing buildings, and for the ongoing management of new buildings, the same process will be used to assess the management company with responsibility for the building on a day-to-day basis.
A hurdle for the pension fund is that there is no database for SRI criteria for buildings. ERAFP must start from scratch to set up its own processes.
"We will do a preliminary audit before buying any building, to see if there are discrepancies between the building or the project and our SRI grid," says Bonnet. "Then if there is no discrepancy we will buy the building and fix SRI targets for the asset managers to ensure the building we buy will be in line, in the medium to long term, with best practices."
"We want to set ambitious targets to asset managers to act in accordance with best practice," he adds. "But we want to compare comparable buildings. You can't compare an old building in the centre of Paris to a new suburban building."
Managers will be chosen through a public tender offer which includes SRI criteria, to ensure the asset managers follow best SRI practice.
The fund is also planning to invest in forestry. As with real estate this has involved in a rethink of its SRI principles to apply to land and forests. It took the Helsinki principles on sustainable forestry management decided by European governments, and added some criteria from the Forestry Stewardship Council relating to treatment of indigenous people, for investments in emerging markets (although its investment will at first concentrate on France or Europe).
Real estate investment is expected to be allocated between 5 and 10% of ERAFP's portfolio, probably at the lower end of that range, says Christiansen. As the fund enjoys strong positive cash flows, because of its relative youth, it will be able to fund investments out of these, investing between €75m and €150m a year.
The fund's first foray into real estate investment is likely to stick to assets that are close to home, probably office buildings in Paris and its environs.
"We will probably start by doing office buildings in Paris or the Paris region, in France and then progressively diversify to other types of buildings, and even other countries," says Christiansen. "We would probably start in the euro-zone and maybe one day we will go out of the euro-zone, but the first step will be France."
Whether it will invest indirectly or directly depends on what regulation will permit, but in any event the in-house management will not act alone.
"In the regulation they will decide whether we have to go through discretionary investment management with external asset managers or whether legally speaking we can invest directly," says Christiansen. "But even if we were investing directly it wouldn't mean that we would go out in the market and look for buildings ourselves. It would just mean the mandate would be more advisory, where we have an asset manager who finds buildings, assesses them, and proposes we should buy them. The final decision would be made by us."
The fund has quite modest expectations for returns on all its assets, and real estate is no exception. Its target return is just 50bps excess return compared with long-term government bonds. But as Christiansen says, at least in the beginning the fund will be concentrating on the less risky type of properties, with an emphasis on offices in Paris.