Continental European real estate offers a natural second home for UK money scouting for real estate to invest in. But with continental Europe following the same trend, some UK funds are opting to go global. Shayla Walmsley reports

It was liquid, transparent and large - but the UK property market has seen better days.
Instead, UK pension funds are going global. A saturated, yield-compressed domestic market has driven even the more cautious ones at least as far as mainland Europe. Others, already inured to continental European real estate, less cautious, are ignoring consultants and heading for Asia.

Mark Jones, director of investment advisory at Jones Lang LaSalle, which has Hermes and the Universities Superannuation Scheme among its clients, identifies two drivers of UK pension funds' exodus out of domestic real estate: performance expectations and diversification.

On the one hand, UK pension funds expect returns over the next three to four years will be lower than over the past five. On the other, pension funds are in search of diversification. "They have too many eggs in one basket," says Jones. "In the past, they've been more sector-focused; now they're focusing on geographic diversification.

"We anticipate this trend to continue with UK investors looking even further afield to emerging, less transparent markets in an attempt to enhance performance," he adds.
Figures recently released by JLL show that UK investors, including pension funds, were net sellers in their domestic market but collectively invested €11.8bn in continental Europe, compared with €6.8bn recorded in the same period in 2006. Their main targets, accounting for 70% of the investment, were mature markets - France, Germany and the Netherlands, although there was also an increase in central and eastern European markets.

This is as much about broader investment trends as it is about real estate. Firstly, real estate is a global asset in a way it was not a decade ago. Secondly, real estate is following the trend evident in equities over the past 20 to 30 years.

The introduction of UK REITs at the beginning of the year in theory presented pension funds with an alternative to direct investment in European real estate. But even before the recent sub-prime fallout, they were not doing well. Their advisers backed funds or even direct investment.

There were small ripples of enthusiasm. In April, Barclays Capital said it would target investors looking to diversify away from UK property via an index-linked European REIT fund with a focus on large-caps designed to lower the price volatility of the fund.
Around the same time, a report by analysts at Lehman Brothers claimed investors would be better off investing directly in overseas real estate than indirectly in UK REITs.

Lehman analysts Mike Prew and Chet Riley identified sub-prime and industrial yields as at risk of unwinding. They also questioned an article of faith among some investors - that yields capture underlying performance - claiming the industry had a poor grasp of the fact that externally- set yields are inefficient.

UK fund manager Seven Dials likewise urges pension funds to invest in European commercial real estate as a lower-risk alternative to REITs. In a report, director Simon Critchlow says high yields in mainland European markets would continue to attract investors keen on reducing risks against a 30% drop in REITs.

According to Seven Dials, economic growth and strong business confidence underpinned the case for investing in European commercial property. It believes the €1.1trn euro-zone real estate market is radically different from the mature UK market - both in size and because relatively less transparency allows active managers to exploit inefficiencies among a series of relatively immature and not-yet fully interconnected markets.

REITs pension fund investors make up "a small minority" of pension funds, argues Robin Goodchild, European director of research and strategy at Lasalle Investment Management. "If a pension fund goes outside the UK, it tends to go indirect - either in a REIT or a private fund. REITs they'll invest in on a global basis, say in Asian REITs."

That the appetite for REITs among UK pension funds should be limited is hardly surprising. If two of real estate's key attractions are low volatility and the fact that it is non-cyclical (not related to equities), REITs do away with both of them. Even if REITs, as some advocates claim, do not quite behave as equities, they certainly fall like them. In 2007, unlisted funds rose 4-5% in 2007 as REITs fell. The latter also carry an extra layer of volatility.

The same goes for listed securities - including Asian property firms. "On balance, our clients are looking to Europe for their first foray outside the UK," says Greg Wright, principal at Mercer investment consulting. "It isn't a cultural issue. It's more the fact that investing in the US or Asia is more difficult because it means investing in listed securities. In Europe, they can still get exposure through unlisted funds."

Yet in a July report by Deutsche Bank subsidiary RREEF claimed that appreciation would slow over the next five years to 20% in Europe. Meanwhile, the Asian property market will double to more than $1.3trn (€0.95trn) with new developments contributing $460bn.

"It's a trend out there that's gaining momentum," says Tony Horrell, CEO of European capital markets. "It's mostly coming from global funds launched by US investment banks, with money from European pension funds, raised to invest in Asia in search of greater returns.

"Asian markets are not as well developed as European ones but they are the next big thing."

Yet Seven Dials is critical of UK pension funds' moves out of European and into higher-risk global real estate. "The danger is that investors are lured by the more risky, emerging markets too early in their hunt for higher returns," the firm says.

"Investors are actively looking further afield - some towards global diversification, others towards specific markets in central and eastern Europe," says Critchlow. USS, for instance, in May mandated First Property to invest €100m on its behalf in central and eastern Europe.

Despite Critchlow's scepticism, the reasons for moving beyond European real estate markets are sound enough. Just as stagnating returns are driving investors out of domestic markets, yield contraction in much of continental Europe will do the same in those markets. Already, according to UK property firm Knight Frank, declining yields in prime continental real estate has driven investors towards secondary and niche assets.

The alternative is not to get out, but to go further and smaller - and it is not a trend confined to UK pension funds. Even continental investors - notably German funds - "are getting a bit more adventurous, finding value in smaller markets and in unusual asset classes", says Matthew Colbourne, a research analyst at Knight Frank.
"Despite the rising cost of borrowing and lower yields, people are still interested in markets across Europe," he says. "We might be reaching the top of the market but the data are still positive."

But they may not be for that much longer. Goodchild points out that European markets tend to be much like the UK in several key respects, such as low population growth (or population decline) and well-regulated markets that limit supply.

"It makes more sense to go to Asia," says Goodchild, though he notes regretfully that those pension funds investing outside Europe in Asia "are still a minority".

"Consultants are behind the times," he says. "They're focusing on Europe, which is a pity. We regard Asia as one of the most attractive real estate markets - certainly compared with the US and Europe.

How much of a different proposition investing in overseas real estate constitutes is a moot point. It takes more than a shifting of funds from one real estate market to another. Arguably, it takes a culture shift - and the greater the geographic distance, the greater the shift necessary.

Even for investors in European private funds, there is the issue of debt. "The main issue is getting comfortable with funds that can be up to 65% leveraged," says Goodchild.
A second issue is the style of investment. According to Mercer's Greg Wright, the sheer volume of European funds is an advantage because it means pension funds don't need to find new managers to handle the investment.

"Where pension funds have invested in Asia, it's been via global mandates and where they already have - for example - global equities. But they do it in a different way," he says.

Similarly, Mark Jones points out that "if most fund managers were being asked to place investments directly, most wouldn't have the knowledge". Rather, "pension funds are not picking properties, they're picking a specialist manager. It's a different discipline".

Chances are investors in Asian real estate will be looking further up the risk profile than they are currently. There are simply more higher-risk than core products available, though Goodchild says he expects to see more core Asian funds as well. "It used to be the same with European funds," he says. "But European money tends to be more interested in core than US money, which tends to go for higher-risk funds in search of returns."

So which pension funds will be looking?

Goodchild says there is no profile for pension funds that invest in Asian real estate, although they have features in common. The first is a greater appetite for risk. They are also more likely to have a global orientation because of the nature of their business.

Take as an example the £3.6bn (€2.6bn) London Pension Funds Authority (LPFA) pension fund, which in July appointed ING Real Estate to manage a £150m property mandate. The fund plans to increase its property allocation from 12% to 15%.

"We'd be trying for some time to internationalise it," says LPFA investment manager Philip Jones.

He points out that it was easier to go global than into mainland Europe because a global portfolio also gave it access to mainland European and UK real estate.

"The rest of the portfolio is global and we saw no reason to have anything else," he says. Early in 2006, for instance, the scheme issued new mandates for global equities and bonds.

Global investors are not necessarily bigger, says Wright. "It isn't a size thing. Some trustees have more appetite, knowledge or interest. If you've got 5% of your portfolio in real estate, is it material enough to invest globally? You don't have to be a big fund but you have to have a large allocation to real estate."

They may be approaching it gradually, but Mark Jones sees a shift even in the most cautious investors' perspective on global real estate investment. He cites a charity client with £5m advised to invest it in a pan-European fund. "Five years ago, we'd have got rejected," he says. "Now, it is prepared to listen."

The same will happen with Asia. The globalisation of pension funds' real estate allocations will take place, says Jones. "In 10-15 years - not even that long: in five years - pension funds will have global exposure."

The road to Europe

Shropshire County Council pension fund, which moved out of UK real estate in favour of a €63.7m pan-European real estate portfolio. The allocation represents 5% of the fund.

Graham Chidlow, head of finance at the pension fund, cited diversification as a driver of the open-ended mandate at the time. He sees no reason to change his mind now, claiming there is "still scope for good returns" in Europe.

"We still have some of our allocation in the UK but I can't imagine we'd move all of it back to the UK again," he says. "Europe's just more appropriate for our needs in terms of returns."

He said the decision was not the result of a formal review of the real estate allocation; rather, it was based on advice from consultants.

"We would consider investing in global real estate but we don't have any plans to. Right now we're focusing on Europe," says Chidlow.

"We didn't have a specific market in mind. We appointed Goodman to look for the best ones."