A lack of available, attractively priced prime assets is forcing UK pension funds to sit tight, writes Shayla Walmsley
UK pension funds planning big moves in real estate are the exception rather than the rule. Few plan to change their real estate allocations significantly over the next few years. And few expect much change in the market.
This is perhaps unsurprising because the allocation levels and investment strategies are determined by triennial reviews. But there are also indications that, when the reviews do take place, property allocations are the least likely to shift significantly. Among corporate pension schemes, any shifts in allocation will likewise be negligible – certainly less than 1%.
For the £5.1bn (€6.2bn) Merseyside Pension Fund, there are two separate issues. The first is a lack of attractively priced potential acquisitions as banks have failed to offload distressed properties in the numbers expected.
“We’ve made a couple of acquisitions – we’re buying selectively – but we haven’t seen the market flooded with distressed properties from banks,” says Peter Wallach, head of the pension fund. “The market has been anticipating the release of distressed properties as the banks wind down their lending, but there have been fewer opportunities than expected.”
The second, more broadly, is a bearish outlook on the property market. The scheme has recently been outbid in its attempts to acquire assets – in two cases by occupiers, and in others by institutional investors willing to pay higher prices. “It’s probably because we’re more conservative in our valuations, which reflects the fact that we’re slightly less bullish on property,” says Wallach.
Instead, the scheme is looking to increase its investment in other asset classes in the short-to-medium term. These include infrastructure, which Wallach believes offers stronger opportunities. “In general, lease lengths have become much shorter, making property less stable as a long-term investment,” he says. “Currently, we favour infrastructure with a link to inflation.”
The ability to hold assets for the long term is one of the reasons why The Church Commissioners’ fund recently won the annual IPD property investment award for highest (12.5%) 10-year absolute total return on its £1.8bn property portfolio, according to head of property funds management Chris West.
The Church Commissioners is relying on traditional diversification to meet its minimum long-term return target of 5% via allocations to six sub-portfolios with distinct functions.
This means it could acquire and hold assets that investors have traditionally shied away from. Having sold assets worth £1bn over the past 10 years, mostly residential, The Church Commissioners now plans to increase its exposure to secondary properties.
“Each portfolio offers something different,” says West. Commercial property, which accounts for 27% of the portfolio, provides general market exposure. Residential, in the form a central London housing estate, represents 17% and gives the fund the opportunity to add value through asset management. The rural portfolio (28%) provides exposure to natural resources and commodity prices, but also a modest income return with reversionary potential and change of use upside “over the very long term”.
The Church Commissioners is working with local authorities to release some of its strategic land portfolio, which makes up 6% of the portfolio, to build residential assets at a significant capital gain. Shared-ownership housing mortgages (7%) provide a link to inflation. Meanwhile, the fund’s indirect property holdings, which make up 14% of the portfolio, including specialist investments in the UK, Europe, Asia and the US, generate what West describes as “superior returns”.
Appetite for niche properties is growing. Over the past five years, the Merseyside Pension Fund has increased its investment in funds so they now represent 30% of the total real estate portfolio. This is partly because indirect investments enable the pension fund to target alternative sectors such as student accommodation and healthcare.
Some pension funds have identified areas for improvement, such as in sustainability.
Wallach says his scheme has been instructing managers to choose the most sustainable asset between two otherwise equally attractive acquisitions. The problem for the pension funds is that its managers rarely face the decision because the portfolio is largely weighted towards retail and industrial, rather than office.
“We haven’t acquired any assets with significant sustainability characteristics because they haven’t really been available to us,” says Wallach. “Sustainable assets tend to be office, rather than industrial estates, retail warehouses or even retail. They are also located in London or major cities and the lot-size is way too big for us.”
Merseyside is not the only pension fund focusing on the environmental impact of its real estate portfolio. The Ealing local authority pension scheme, which channels its entire real estate investment via funds and has a real estate allocation of between 7% and 10%, places sustainability among its top priorities when selecting managers.
Recently, local authority pension funds have begun to use their capital clout to invest in local residential development, despite a potential fiduciary conflict of interest.
Councillor Richard Greening, who represents the Islington local authority pension scheme, admits he is on a mission to persuade other local authority pension funds to fund a nationwide house-building programme after it allocated £20m (€25m) to a residential
vehicle run by Hearthstone.
“Local authority pension funds are in a particular position where councillors have responsibility to improve the communities they serve, and that includes solving housing problems,” he says. “If all local authority pension schemes invested 2.5% of their portfolio in housing, we’d have 20,000 new houses.”
Islington’s followed the earlier example of the Greater Manchester local authority scheme’s decision last year to allocate £25m to local housing via a joint venture.
“The problem is that pension fund advisers are conservative – they tend to want to restrict investments to equities and bonds. It’d be easier to tell everyone to do what they’ve always been doing, but equities haven’t performed over the past 10 years. We’ve had a housing under-supply for a generation, which this investment is helping to address,” says Greening.
“We’re trying to encourage other local authority pension funds to challenge conservative advice.”