The latest PRUPIM/PMI survey indicates that pensions funds are keeping faith with commercial real estate, while a back-to-basics approach will be used by those increasing their allocations over the next three years, says Paul McNamara

Despite a tumultuous 18 months of declining property values, illiquidity, retail receiverships and dismal forecasts, pension fund managers and trustees are continuing to keep the faith with commercial property, according to the latest report from leading real estate investment manager PRUPIM and the Pensions Management Institute (PMI).

The 2009 ‘Real Estate Investment for UK Pension Funds - What's on the Horizon'* report has revealed that more than half of UK pension fund managers and trustees plan to increase their allocation to commercial property in the next three years.

The survey, which was conducted during summer 2009, attracted more than 200 responses from a range of small to large UK pension funds and investment consultants. This is significant because the funds and consultants surveyed manage an estimated £140bn (€154bn) in assets between them - which accounts for about 15% of the entire UK pension funds assets under management.

Even though institutional investors appear to be bruised as a result of the collapse of the UK's commercial real estate market and its well-documented liquidity challenges, fewer than one in six respondents expect to lower their fund's exposure to commercial property, according to the 2009 report.

This attitude is reinforced by more than 81% of pension fund managers and trustees surveyed who indicated that the recent changes in the UK commercial real estate market have done little to alter their views on commercial property as an investment.

However, approaches to investment in the sector are changing markedly with many respondents showing a preference for a ‘back-to-basics' approach to commercial property investment, favouring more mainstream vehicles over exotic alternatives, and expecting lower and steadier returns. This suggests that there will be significant flight to size as pension fund managers and trustees seek real estate investment managers with a sizeable scale of assets under management who can proffer secure, safe hands.

Pension fund managers and trustees are more likely to invest through pooled funds and other unlisted investment vehicles, double the proportion of respondents who use property funds of funds and four times those who take direct ownership of real estate. They also appeared to be attracted to the relative cheapness of this asset class compared to other alternatives, presenting bargains for cash-rich institutional buyers.

Interestingly, UK pension fund managers and trustees are showing an increasing appetite for global property markets, with 23% of respondents indicating that they have exposure globally, sharply up from 14% a year ago. A further 24% expect to increase their global investments over the next three years.

The movement overseas, coupled with a changing appetite for risk similar to the UK, seems to indicate that there will be a significant change in how risk is approached in general, especially for overseas investment, in order to best cater to pension fund manager demands.

It comes as no surprise that diversification continues to be the main reason pension funds are investing in commercial real estate. Nearly 95% of pension funds of all sizes cited diversification as the most important reason for investing in real estate because of its low correlation of returns with other asset classes, compared with 80% last year.

This is striking when you consider how commercial property performed over the preceding two years when, broadly, it correlated startlingly with other asset classes. Diversification is followed closely by steady total returns, which pension fund managers and trustees rated more important than ‘potential for higher returns compared with other asset classes'.

Expectations about commercial property returns have also changed in comparison to the 2008 report. Last year, almost three-quarters of funds said they were looking to receive market-level returns plus a modest level of outperformance. While a percentage of respondents are still seeking these returns, these expectations have dropped by more than a fifth, with an increase in the expectation of index/market returns between 6-8%.

Commercial property is one of the most carbon-intensive investment sectors and amid increasingly dire predictions for the impact of climate change, four out of five pension fund managers and trustees believe sustainability is likely to have an impact on the long-term investment returns from their property portfolios.

Pension fund managers and trustees ranked sustainability credentials fifth in a list of 11 characteristics that pension funds associate with a successful real estate manager. Other favourable highly valued characteristics include clear investment processes and strong operational risk management.

The findings suggest that the investment community as a whole wants more clarity about sustainability issues when investing in property. Pension fund trustees should be asking property fund managers difficult questions about the extent to which they are addressing climate change when making investment decisions. As commercial property typically forms from 8-10% of a pension fund investment portfolio, there is an opportunity for many funds to reduce their environmental footprint and manage the reputational and financial risks inherent in running a portfolio of inefficient buildings.

There have been suggestions that, given the current economic environment, sustainability might have become something of a luxury and would therefore be slipping down the agendas of many investment market participants. However, the report indicates this is not the case.

Less than 2% of pension fund respondents (and less than 5% of consultants) felt that sustainability issues had become less important over the previous 12 months. The 2008 survey suggested that these investors were keeping faith with commercial property despite a downturn that was, at that time, gathering pace. For many it might come as a surprise to learn that pension fund managers and trustees still believe this, despite property capital values falling more than 40% in the past year alone.

It is not an overstatement to say that the UK commercial property market has experienced one of its strongest corrections and subsequent recessions to date. However, the 2009 report has revealed that when it comes to sector, pension fund managers and trustees believe in the strength of commercial property to deliver long-term performance and secure steady investment returns.

*Visit: http://www.prupim.com/whatsonthehorizon to access ‘Real Estate Investment for UK Pension Funds: What's on the Horizon?' 2009 report