Despite some bad returns in the wake of the property crash, UK pension funds are not losing faith in the asset class, as Gail Moss reports

"We are seeing consistent demand for property from institutional investors," says Rod Ross, director at Aberdeen Property Investors. "UK pension funds are holding, and in some cases increasing, their property weightings."

Admittedly, last year the UK market - the linchpin of UK pension fund property port-folios - performed strongly, returning 14.5% over the 12 months to 31 December 2010, according to IPD.

However, Ross says the downturn has left its mark, with investors chasing quality and security. "In addition to location, the tenant covenants and length of leases have become the criteria of quality," he says. "Furthermore, other funds are looking at UK investing via direct holdings rather than pooled funds. There is a growing recognition that this gives an extra layer of diversification, from a variety of different assets, each with its individual character."

Andrew Jacobson, investment consultant, LCP, agrees: "The trend is towards high-quality properties, often with long lease lengths - 20-25 years. With index-linked gilts yielding only 0.5%, and bonds expensive, pension funds are latching on to the bond-type characteristics of property. Previously, it was the equity characteristics - growth - which attracted them."

A further attraction of real estate is its inflation-proofing abilities. "A lease that indexes rental income to inflation over 25 years looks really attractive," says Jacobson.

The Teesside Pension Fund is an example of the trend towards indexation. Its £135m (€158m) property portfolio includes a Tesco store in Gloucestershire, leased for a rent linked to RPI. "We are cautious on inflation and were expecting it to rise faster than the market did, although the market is now catching up with that view," says Fred Green, the fund's head of investments.

The fund has also placed its faith in the economy in the southeast of England by acquiring a Mercedes-Benz showroom in Essex, bought last autumn for £7.25m on a 5.25% yield.

"We thought Mercedes-Benz would do better there than in some other parts of the country," says Green. "We were also attracted by its covenant, and the return looked good."

Green says there is more life in the UK market than before; the fund's own property weighting is down to 6% of its £2.3bn total assets because of the stock market recovery over the past year, but the medium-term target weighting is 10%. "We are looking for real estate opportunities in the UK, but are quite selective in what we want," says Green.
In terms of location it is still, according to Jacobson, "London Calling", potentially leading to a severe dislocation between southeast England and everywhere else.

"Over the past 18 months, around 35% of commercial property transactions by value were in central London offices, according to Property-data.com," he says. "Outside London and the southeast, there are concerns about what type of impact the low level of growth in the wider UK economy will have on the property market nationwide."

According to Ross, prime central London offices are now achieving 5-5.25%, with the best potentially even more expensive, while prime office properties in the provinces are yielding 6.25-6.5%.

However, Angus Henderson, head of business development, F&C REIT, says that regional offices are being used as a value-added play.

"We're noticing a slight focus up the risk curve where pension funds see value," he says. "If they've got a core portfolio of prime property, they might sell a percentage to invest into something yielding more punchy returns."

He says that strongly located secondary properties offering 8%-plus yields and some value are popular candidates for the core-and-satellite approach. "If you're buying the best regional offices with strong fundamentals, say in Birmingham or Manchester, it's an interesting area for pension funds to get into."

Alternatively, opportunistic plays could include areas perceived to be particularly hard hit by the downturn. "Places with large government tenants such as Glasgow and Leeds could see an oversupply of offices," says Henderson. "But nationally, there is very little supply coming online in the next three years. So if you can get access to good-quality stock in specific areas, you could potentially get good returns."

Ross says: "The focus on quality and security has increased the relative size of the secondary market. More property, even in a relatively good location, is now regarded as secondary because of the lease length or tenant. So the valuation gap between secondary and prime has also increased. So there are opportunities for strong returns from secondary markets, but at a level of risk that investors aren't willing to take."

One feature of the market causing concern is the quantity of assets controlled by the banks as security for loans. These assets dominate the secondary markets, says Ross. "And the future of the banks remains unclear, as does their divestment policy," he says.

"In the next two to four years, a lot of property will come up for refinancing," agrees Jacobson. "If it is released too quickly during a period of weak demand, it might have an adverse effect on the market."

While offices are still considered the backbone of commercial property investment, other sectors, notably retail, can be a good investment in certain situations, despite the expected downturn in consumer spending.

"If the pension fund trusts its manager, there's a willingness to consider meeting objectives by being less constrained from following the benchmark or IPD weightings," says Alan Tripp, UK managing director, LaSalle Investment Management, which is a member of the NAPF's property committee. "So a lot of thought is going into real return-type strategies. We support investment in retail, albeit carefully targeted, because of longer leases, and real rental growth that outperforms inflation over the longer term."

Tripp says that owners of retail properties spend less on these assets over time than do owners of offices and industrial warehouses, and the sector has less cyclical volatility.
Residential, such as student accommodation or private rental, has also proved a very good match to wage inflation, says Tripp, as it mirrors pension fund liabilities.

One reason for UK property's domination of real estate portfolios of British pension funds is the perceived currency risks involved in owning property abroad, as well as the lower degree of market transparency and shorter lease lengths.

Another issue is the higher levels of debt in continental European property funds, says Jacobson. He says: "For UK funds, in our experience the debt level is no more than 10-15%, whereas in continental European funds, it is 50-60%. That's not palatable for UK funds."

Nevertheless, there is now more appetite for venturing abroad. Tripp says: "A number of pension funds are starting to look at continental Europe and beyond. Some are doing it to diversify, some for higher returns. But you need significant commitment to ensure diversity."

Henderson says: "There is a tendency to stick to core western European markets such as France and Germany, then take a satellite approach to high-return plays elsewhere."

"There is more appetite for comprehensive global exposure," says Ross. "They are using the UK as their core base, but we see limited returns here for the next three to five years. So continental Europe, the US, the Far East and emerging economies are being used to get those returns."

He says, however, that continental Europe is to some extent perceived as being affected by the same issues as the UK, whereas China and, potentially, India offer greater future growth. "But transparency there is more limited, and liquidity less certain," says Ross.

Merseyside Pension Fund's strategy is an example of investing abroad. Over the past two years it has accelerated its overseas holdings with purchases in Asia, Brazil and its first venture into the US. Indirect assets are held in a variety of vehicles, including limited partnerships. "Indirect holdings are more of a growth play and to provide diversification, whereas our direct assets - all located in the UK - are held for income," says Susannah Friar, the fund's property investment manager.

The fund is slightly underweight in property, with a 10% allocation, which it is seeking to increase. Direct investment makes up approximately 70% of the fund's real estate allocation.