In 2009 the strength of the recovery in UK property values took investors by surprise. Long term, UK property should deliver strong returns for pension funds but the risk is now a lack of suitable investment stock. Gail Moss reports

After the headlong fall and recent rebound in UK property values, a huge chunk of pension fund money is poised to hit the property market.

"Funds are generally upping their allocations to property," says Nick Mansley, global director of multi-manager, Aviva Investors, and member of the property committee of the National Association of Pension Funds. "After two very difficult years, there was a resurgence in real estate performance in the second half of 2009, focused on the UK. A lot of significant allocations were made in a short period of time, by pension funds investing direct, through pooled funds and through recovery funds with a short lifespan."
And this inflow is likely to continue, says Mansley.

"The emphasis is on core and core-plus investing - very few are looking at an aggressive strategy. They are looking at geared and non-geared funds with a focus on income-generating property."

Pension funds might well believe that now is the time to start investing again.

Figures from IPD show that UK commercial property markets ended the final quarter of the decade with the largest-ever recorded quarterly capital growth of 8.1%. According to the IPD UK Quarterly Property Index, the return to positive capital growth - a cumulative 9.8% over the second half of 2009 - was sufficient to lift the annual total returns to 3.4%, including a final quarter 10% total return.

Geographically, Mansley says the recent focus for investors has been on the UK. "The UK market fell so fast and so far that UK pension schemes saw this as something they wanted to exploit quickly," he says. "However, the global side has come back again into prominence now that the UK market has bounced back."

"We've called the market overpriced for the last four years, and many Mercer clients were therefore underweight in property," says Kirstin Irvine, senior associate, Mercer. "Then when values started falling, their positions were even more underweight. However, that has reversed over the past year, as clients seek to reach their target allocations. The problem is to find the right properties."

Hewitt also reined back from recommending investment in UK property during the price bubble of 2006-07, instead shepherding clients towards continental Europe, where it saw more value.

"But that has also seen some disappointing returns, although we continue to believe it has diversification benefits," says Nick Duff, head of property, Hewitt. "Overseas markets have gone the same way as UK markets, with a weakening occupier market and rising yields. Furthermore, some clients don't like the impact of currency movements on the pension fund, and there is also the issue of gearing and higher total expense ratios."

Over the long term, and based on current pricing levels, UK property should deliver returns of about 8%, or around 4%-5% above RPI inflation. This is very attractive to UK pension funds, according to Duff.

For the past year or so, Hewitt's strategy for clients has reverted back to the UK market. "By the end of 2008, UK property was starting to look more attractively priced, although we expected further market deterioration over 2009," says Duff. "We have put a lot of clients into UK property over the last five months. We felt that yields had overcompensated, although there is still some fallout expected from the occupier market."

Even so, he agrees with Irvine that there is now too much capital chasing too few properties. "One risk is the lack of stock in the UK market, with prices rising substantially over the fourth quarter of 2009," he says. "That means what you've got is a potential front-end loading of performance - that is, the risk that the performance for 2011 will be largely reflected in the performance for 2010. What we need is short-term holders of property such as banks to gradually release more stock on to the market."

"From mid-2009, UK pricing became relatively attractive compared with government bonds," says Anne Breen, head of property research, Standard Life Investments. "Listed property companies started to rally from March 2009, which is a key indicator. As a result, there has been some improvement in capital values over the past nine months, with a sharp improvement in capital values in the fourth quarter of 2009, and we are seeing investment flows and interest picking up."

The rally at the end of last year was not, however, prompted by British institutions, says Breen. "The key buyers were international investors, many of whom were looking for a trophy building in London, such as the HSBC building," she says.

The HSBC building in Canary Wharf was sold by HSBC to the National Pension Service of Korea last November for £772.5m (€863.9m) in cash. But foreign buyers have also been attracted by the twin factors of the price crash and the depreciation in sterling.

Breen says that after the 9% capital improvement throughout 2009, she expects another 10% over the first half of 2010, as yields move inwards. "At present, there is a lack of quality and of distressed assets," she says. "But by the second half of this year there should be more assets for sale. So growth is likely to be weaker over the second six months." And she says the office sector should outperform retail, since it is offices which have been under more pressure.

In property investment terms, the UK is a country of two halves, according to Andrew Angeli, associate, CB Richard Ellis Investors, Investment Research.

"Within the UK, London is the only region that will perform better this year than in the past, although some other regional centres such as Manchester and Birmingham may also do well," he says.

He points out that London is a wealthy area because of its substantial economic base. It is currently seeing an influx of continental Europeans taking advantage of the cheaper pound to go shopping across the Channel. The 2012 Olympics has also brought London specifically back into the global limelight.

Angeli says the mini-investment boom in the last quarter of 2009 revolved around investment in central London offices. "High net worth individuals and sovereign wealth funds have been viewing London as a safe haven, so prices have been rising in the City and West End," he says. "This has driven down yields, but UK pension funds themselves haven't been very active in making purchases in central London."

A major surprise for property experts has been the speed of the bounce-back in take-up figures, especially in prime properties and for the right floor plate. "City rents picked up during the last quarter of 2009, rocketing by £5 a square foot over the year before, and we are expecting rental growth of 30% during 2010," says Angeli, highlighting last July's announcement of Nomura's planned move back to the City.

The Japanese Bank is to vacate the former Lehman Brothers offices in Canary Wharf, in order to establish its European headquarters in an 11-storey building on Lower Thames Street. "While the first quarter of 2009 experienced the lowest demand on record for office space in the City, the final quarter showed the third tightest on record," Angeli says. "Large floor plates in good locations are getting quite scarce."

He expects this mini-investment boom to continue throughout the first half of 2010. "It is partly a reflection of the coming general election - there is still a lack of clarity as to what the new government will actually do, and until that is clarified, investors will stay active in the market," he says.

However, he believes the second half of 2010 will not continue the trend. "It is not a bright picture," he says. "The UK emerged from recession in the final quarter of last year but growth was only 0.1%, so enthusiasm is relatively muted. And when the government's financial support starts to unwind, occupier markets will be under stress again throughout 2010."

Teesside Pension Fund is one fund which has for the moment avoided adding to its office portfolio. Last year, it bought a Tesco supermarket in Stow-on-the-Wold and a small retail park outside Birmingham - its first direct purchases for 18 months - and it is about to complete a third transaction, making the cost of the three transactions £28m in total.

Real estate makes up 8% of the fund's £2.2bn portfolio, split between direct holdings exclusively in the UK, and indirect holdings in the UK and Europe. The fund is also looking to expand its indirect holdings into the Far East and US, which it sees as offering exciting opportunities. "We invest in growth rather than protection assets," says Fred Green, head of investments, Teesside Pension Fund. "We took the view several months ago that there was some value in the UK, provided properties had strong covenants, decent yields and good valuations. But the office market is very difficult."

"We still believe that the tight level of supply in the West End office markets means if you can ride through the short-term volatility, it's a good long-term investment," says Paul Clark, director of investment and asset management, the Crown Estate, one of the UK's biggest property investors. "But what underpins this is the occupation rates. And in our view, over the course of this year, the real economy will have to pay the price of the cost of stabilising the world financial system through taxes, significant levels of unemployment and an increase in the savings ratio. So while we believe there will be a gradual improvement in occupation rates across much of the market, we expect it to be slow."

Overall, the Crown Estate's strategy at present is to lighten its weighting in the central London office market, disinvesting out of its non-core central London holdings, while looking to bring in third party partners in its core holdings, including Regent Street and St James's.

Outside London, it is focusing on key areas of specialisation, such as dominant retail schemes including a half-share in the Princesshay shopping centre in Exeter.

"When UK prime values fell by 40%, we felt that was an over-reaction," says Clark. "By the spring of 2009, we were optimistic, and it was a good opportunity for us to make some long-term investments. But what we have seen over the past three months is a much sharper correction in the UK market than we had anticipated. The danger for the UK is how much of the upside during 2009 will suck some performance out of 2010."
Nevertheless, Clark believes that 2010 will hold value in terms of income, and stable capital returns.

But while pension funds are starting to rebuild their property portfolios, the recession has changed the way in which they invest.

"There has been an aversion to risk in the market as a whole, so pension funds investing direct are looking at longer, low-risk leases and high tenant quality," says Irvine. "Meanwhile, some clients investing through pooled funds have had their fingers burned by complicated fund structures, so they are starting to look at different ways of pricing risk appropriately. Even so, clients are increasingly looking at the pooled route, driven by the desire for liquidity."

"There has been no trend away from indirect to direct investing," agrees Mansley. "People do have issues about pooled funds, but they recognise that the amount of management time spent running direct mandates is a strong reason not to go down that route."

At the time the recession hit, UK pension funds were looking to diversify internationally, partly because the UK market was clearly overheating. This, however, ground to a halt along with the slump in buying UK property. Now, with some global recovery, trustees are once more looking abroad, if for no other reason than diversification.

But they are still weighing carefully the pros and cons of investing overseas versus sticking to the UK.

"There is more of a short-term opportunity to invest in the UK, given the market falls of 45% were worse than in other countries - so the potential upside is greater," says Irvine. "And because UK property markets are local to the pension funds, they offer more access. In addition, UK property leases are linked to the same inflation index as UK pension fund liabilities."

Duff agrees: "When you go abroad, you have to understand what you're investing in, in terms of transparency, likely income flows, asset types and costs generally. You need to understand what the risks are, the different fund structures, and the governance of those funds."

It is possible that Hewitt will start to consider overseas property again in the future, although most markets are behind the UK in terms of price correction, Duff says. But he adds: "If you move away from the UK, you're investing in markets which are less familiar and you have to be satisfied that the likely returns are adequately compensating you for this. For instance, a pension fund investing in developing markets would need to see returns of 15% plus, compared with returns of 7-8% for investing in the UK."

On the other hand, he says, there is a direct link between property returns and economic outlook, and some economies are in better shape than that of the UK. But Hewitt continues to like UK property: "The UK is a large, developed market with high levels of transparency. Over the long term we continue to believe strongly that it will deliver attractive risk-adjusted returns."