Large pension funds were the worst performers in UK real estate in 2008. But why? Malcolm Hunt uses a series of performance metrics to explain. The results are surprising and informative

There has been little to cheer about for some time in the UK commercial property market. Two years ago the UK was at the very top of the market, which had been rising relentlessly for three consecutive years, with trophy assets selling at inflated prices to boot. The purchase of HSBC's Canary Wharf tower by Spanish property giant Metrovecasa in May 2007 for £1.09bn (€1.24bn), and its subsequent sale back to the banking group just 18 months later for £250m less, is a classic example of the scale, speed and depth at which capital values have plummeted.

Naturally, in these volatile periods of the property market cycle, there is a greater appetite for more transparency and analysis of market and portfolio performance.

International Property Databank (IPD) is well placed to deconstruct the various drivers of property performance by fund type using its rich dataset derived from the longest running indices, the IPD UK Annual Index. In deconstructing performance by fund type, the relative risk-adjusted top performers can be revealed and, using an artillery of performance metrics, this article will explain how this is achieved.

To level the playing field among the different investor types - life and pension funds, unlisted funds, traditional estates and charities, real estate investment trusts (REITs) and listed property companies - total returns will be considered purely at the property level.

This requires stripping away the performance amplification effect, which gearing contributes to overall returns, and the impact of investment fees or other costs incurred at the vehicle level.

Unpacking the performance for the last full calendar year, direct investment in UK commercial property produced a total return of -22.2% over 2008 - the lowest recorded return and biggest fall in values in IPD history, and the largest inflation-adjusted fall in values since 1974. The biggest underperforming investor group, relative to the IPD Annual Index, were large life and pension funds, which delivered -25.8%, including indirect investments. At first this might seem a little surprising; these funds, which are at least £1bn in size and, in total, constitute 19.2% of the entire IPD universe, typically hold prime assets, which could be expected to retain their value best in a downturn.

However, these ‘prime' assets also tend to be large lot sizes - including landmark city offices, super-regional shopping centres and big-box retail warehouses - which, in a market suffering dramatically tightened credit supply, are even less liquid than usual and subsequently have not sold on easily. This ‘lot-size effect', coupled with the underperformance of those segments as a whole over 2008 (-25.%, -22.7% and -25.5%, respectively), has left large life and pension funds carrying ‘underperforming' assets which few other investors would have been able to buy even if they were willing. It is possible, however, that these funds will seek some comfort in the relative security of the income stream of these assets and the valuation uplifts these prime assets might enjoy when the recovery manifests itself.

The relatively high indirect property exposure that large life and pension funds had over 2008 is also another significant factor behind their unwelcomed record of ‘weakest performer over last year'. This investor grouping had an average 24.3% exposure to indirect property during a year when indirect investment returns averaged -39.4%. This indirect exposure often implicitly introduces gearing into the equation (via the vehicle being invested), explaining a further 180 basis points performance drag on their annual returns for 2008.

The stories for small and medium-sized life and pension funds are aligned. The factors affecting the performance of medium-sized funds (between £250m and £1bn in size) are the same as those affecting smaller funds, albeit to a slightly lesser extent. Medium-sized funds had less exposure to lumpy stock, which proved a performance drag for larger funds.

At the end of the year they were one of only two investor groupings to make net purchases, the other being REITs and property companies. Over the final two months of 2008, medium-sized funds purchased assets worth 2.1% of aggregate capital value. Anecdotal evidence suggests these purchases were funded through sales earlier in the year and were discounted assets, possibly in firesales from distressed sellers.

The combined unlisted property fund sector is the biggest component of the IPD Annual Universe at 41.2% for balanced and specialist funds, as collated by the IPD UK Pooled Pension Fund Indices and other unitised funds. At the pure direct property level, stripping away the impact of gearing, the balanced, specialist and other unitised funds returned -22.0%, -25.5% and -21.2%, respectively. Together, this investor grouping were the clearest distressed sellers over 2008, disposing of £6.3bn-worth of assets, representing 11.2% of their aggregate real estate holdings.

Perhaps unsurprisingly, the greatest pain was felt among the specialist funds, which, by definition, held the most niche sub-sector assets, which proved least liquid in a challenging trading environment. Specialist funds' ‘held' positions alone contributed a -2.7% drag over 2008 compared with the IPD Annual Universe. In fact, specialist funds were the only investor type to have suffered performance drag in each of six components of their portfolios - held positions, partial transactions, purchases, developments, sales, indirect holdings. By comparison, balanced unlisted funds actually recorded a marginal 36 basis points uplift from the combination of performance of their held positions, partial transactions and purchases, while other unitised funds insulated their overall losses by 1.4% from the same components, plus sales.

The final two investor groupings of the eight under review - REITs and property companies, and the traditional estates and charities - both again have somewhat surprising stories behind their numbers, albeit for different reasons. It is surprising the listed sector, which returned -20.9% over 2008, outperformed the IPD Annual Index by 130 basis points, given that the property equities market has fallen off -46.5%, as measured by the FTSE UK Commercial Property Index. Of course, this significant differential can to a large extent be explained by the impact of gearing at the balance sheet level on exacerbating losses. And as Schroders' head of multi-manager, Jenny Buck, suggested at the recent IPD UK Benchmark Results Launch in March, this outperformance of the benchmark could also be partly explained by the security of the underlying income stream of such portfolios, given the long leases in place.

The weighted contributions of performance versus the IPD universe indicates that the strength of property companies held positions contributed 1.5%, while the only significant drag was a 29 basis points hit taken owing to their development pipeline. Despite the overall turbulence, REITs and property companies were net purchasers in six months of last year and were, in aggregate, only net sellers to the tune of £136.6m.

But the most resilient survivors over 2008 were the traditional estates and charities, which managed to outperform the IPD universe by 4.7 percentage points, at -17.5%. A shallow victory it may be, but the fact that they beat the nearest performing rival investor group, the listed sector, by 3.4 percentage points is noteworthy at the very least.
Although the smallest overall contributor to the IPD universe, representing just 2.4%, the asset allocation of traditional estates and charities are materially different to the rest of the universe. In particular, they have little or no exposure to the most vulnerable retail segments of last year (retail warehouses and shopping centres), while holding the highest proportion of IPD's miscellaneous property category, including rural farmland and residential property. Capital value falls in these niche sectors have been less dramatic.

In the past two decades there have been only five calendar years which have recorded negative annual total returns. Prior to last year, the record in that period was -9.2% in 1990. More recently, continuous falls in yields, from December 2001 to June 2007, have been the precursor to an unbroken series of subsequent yield rises that have almost offset all previous capital gains. This was to such a far-reaching extent that, by the end of last year, capital returns from the IPD Quarterly were up just 1% on December 2001 levels in a correction much sharper than witnessed in previous recessions, and also one that has, to date, been uniquely coupled with only minimal rental growth triggers.

Three-year annualised investor performance remains negative for all investor groups, bar one, due to the sheer scale of capital movement. The period, as noted earlier, was evenly split into two parts; the former driven by indiscriminate yield compression across the sectors pushing values up and yields down, followed by a radical reversal. The performance spread between investors was 8.2 percentage points over three years. It is only when we start to look at annualised total returns over a five and 10-year period that all investors return to positive performance. But the more notable feature of investor performance over longer periods is the narrowing in variation between differing investor groupings.

Over five and 10 years, with the exception of the outperforming traditional estates and charities, the variation of the IPD Annual Index is slight; other unitised unlisted funds returned 3.5% over five years, while small life and pension funds returned 5.3%, compared with a full universe benchmark of 4.6%. The traditional estates were the only investor group to record double-digit returns over any of the annualised periods under review. For the remainder of the investor groups, the performance variation spread narrows further over 10 years, at 130 basis points either side of the IPD benchmark of 7.5%. That spread of performance variation narrows even further over 20 years, with even the consistent outperformance of traditional estates and charities - which more than doubled the benchmark over five years - having contracted to 2.1 percentage points higher than the IPD Annual Universe.

Even just over the span of the decade to date, the pattern of liquidity has shifted dramatically. The volume of sales has been maintained by funds contributing to the IPD UK Quarterly Index, but the volume of purchases has collapsed and the fund types comprising this activity have changed dramatically. Through the upswing it was the unitised funds, sourcing capital predominantly from retail investors, that drove purchase activity to dramatic heights. To an extent, ‘other' funds, often using leverage, also drove purchase activity upwards, but this activity had waned by 2006.

This purchasing was partially offset by heavy selling from insurance funds. While they have now stopped disinvesting from the market, they have not yet begun to invest again. Given the long-term decline in these funds, now that the endowment mortgage market has shrunk dramatically, it is unlikely they will once again dominate net investment into property.

The picture revealed by the numbers over the very long-term remind us of something fundamental about property as an asset class - its core value as an income producing asset. As the graph, below left, illustrates, indexing together UK capital value growth, including depreciation on assets held over time, shows negative capital value growth over the very long term. Therefore, if over the very long term capital values do fall, when factoring in the ebbs and flows of economic cycles, the role of property in an investment portfolio must be considered primarily as an income provider.

Finally, if history can provide one more insight as to the direction of capital values over the short term, it is that once we enter a period below the trend line - which, as the graph illustrates, we have now entered - it is some while before an upward trend in capital values re-emerges.

Malcolm Hunt is an associate director and head of UK client services at IPD