Investors could tap capital structures but they are hooked on bricks and mortar. Shayla Walmsley reports

Back in November, at the IPD/IPF Property Investment Conference in Brighton, UK, Aviva Investors head of global real estate multi-manager and IPF chair John Gellatly suggested institutional investors in real estate were failing to consider the range of options capital markets offered them.

Presented with CMBS, for example, property portfolio managers didn't want the credit risk they perceived as belonging to the fixed-income team. Similarly, REITs belong to equities.

The problem, he said, was that "clients and consultants still think of real estate as bricks and mortar". As a result, they missed the point in the cycle at which they might benefit from one of the other of these options.

So did they listen - at least about the more exotic of these instruments?

The reality, of course, is that debt is still a dirty word for many European pension funds. "Trustees are nervous of debt, even though it will be a big asset class in future," says Stephen Ryan, principal at Mercer. "They are especially nervous when there is no middle step. If their only experience is important property funds, their instinct is to stick with unlisted funds in neighbouring markets. It's the most common form of diversification, especially from investors in small markets, though not so much for investors in large markets."

Contrast this with their US counterparts, which are investing in real estate debt because property markets proper aren't offering enough value. The $10bn (€7.3bn) Maine Public Employees Retirement System, for example, in October announced that it would allocate US$75m to the commingled Prima Mortgage Investment Trust (PMIT) in expectation of a 7-11% return. The $630m vehicle invests in debt, including whole loans, mezzanine debt, CMBS and REIT paper. The PMIT allocation was the scheme's only real estate investment in 2010, even though it is underweight in property.

The debt market has compelling drivers. It offers lower risk with equity-type returns, either via origination, trading in existing bonds issued by real estate companies or by trading private debt secured against real estate. M&G, Duet and Pramerica have targeted mezzanine debt. Investors in Pramerica's £150m debt fund include APG, the asset managers of €231bn civil service scheme ABP.

At the same November conference, -Westimmo managing director Peter Denton predicted that Solvency II would encourage European insurance companies to take on lending on property as banks try to reduce loan books that currently collectively make up around £280bn (€331.8bn) in the UK market. Just weeks before that, CBRE had estimated the funding gap for non-core assets at €35bn, €20bn of it in the UK.

"There's a possibility that with the impact of Solvency II insurers and pension funds will start to provide real estate debt," says Gellatly. "Whether it will be sufficient to fill the hole left by banks I'm not sure. I don't know how big the appetite among investors might be - or might have to be - as a result of Solvency II. There isn't enough debt capacity anywhere. Full stop."

There is certainly no shortage of demand. PwC/ULI* found a largely bleak outlook on debt, but suggest that new sources of funding, including from insurance companies, will emerge in 2011. Of those polled for their report, 83.7% identified a lack of debt capital available for refinancing properties with vacancy or in need of refurbishment, compared with 79.5% last year.

But pension schemes are right to be cautious about the risks associated with the asset sub-class. According to Moody's, there was a 79% increase in the CMBS delinquency rate last year - 8.7% at the end of the calendar year, up 4.9% from 2009. Much of it, admittedly, came from H1. Although the rate increased month on month in H2, it increased more slowly in the same period the previous year.

Yet despite the current delinquency rate, Moody's forecasts news CMBS insurance worth $37bn (€27.2bn) in 2011, and delinquency at year-end of between 9.5-11%. Although the delinquency rate will moderate as capital markets improve, we can expect a spike in defaults in 2012-13 as CMBS from the peak of the market reach maturity.

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Alex Moss, head of global property securities analytics at Macquarie Capital, claims small- and medium-sized pension schemes need derivatives to provide exposure to listed in direct but exclude stock-specific and timing issues.

Pension schemes are far short of clamouring for derivatives. (At best, you could call it mild curiosity.) In the past, says Moss, this could be attributed to the absence of mandates to invest in derivatives. That's changed. "Asset managers are trying to get as wide a mandate as possible so they can have all the tools in their box, even if they don't intend to use them short term," he says. "At the same time, investors want to know what the asset manager is doing. The default setting for a number of asset managers is you should be aware of derivatives and capable of trading them even if you don't intend to use them often. To compete, they need to be able to show capability in that area."
While they're deliberating, markets - or rather regulators - are moving.

EU regulations that will require all over-the-counter derivatives to be cleared centrally - effectively shifting them onto bourses - potentially lessen their inflation-hedging potential. EPRA forecasts the measures could pull €64.9bn of working capital out of the market if the regulations class property companies owned by funds as financial institutions because in that case it would require them to cash-collateralise their interest-rate hedges.

If and when pension schemes do invest in capital structures, they're likely to do it indirectly. Already vehicles are growing up to meet expected demand. LaSalle, for example, last year raised £100m for its UK special situations fund, which will target mezzanine, preferred equity and debt. Pacific Real Estate Capital is launching a vehicle that will invest across capital structures within real estate, including REITs, CMBS and derivatives, citing "significant frustration" among pension funds over the poor performance of direct vehicles.

Inprop Capital launched the first pure real estate derivatives fund last October with capital from SWIP, Prupim and Skandia, claiming to offer an alternative to traditional funds with lower liquidity constrains and management costs (with no subscription fee). For pension funds, it claimed to offer simple balanced real estate exposure.

At the time, Inprop partner Paul Ogden told IPE Real Estate: "We are providing an opportunity for people who wanted to get involved, but found the whole business of entering into derivatives contracts just too daunting."

"Property investing is becoming more joined up. All these options are designed to do different things. When you talk about debt or derivatives, you're not talking about every single scheme investing in them. What you're talking about is new blended products coming to market. If a product takes off, the competition will decide they need to launch one, too," says Moss.

"What appears to have appeal at the moment is a liquid, property-related income fund that could use derivatives to hedge out some of the risks," he adds. "It isn't betting everything on red. It's using all these structures to mitigate some of the risks. What funds are worried about is protecting capital, generating income and using whatever they can — be it debt or equity or direct or derivatives - to achieve it."

In the meantime, who should be educating pension funds about these structures? In Europe many pension funds need help even to understand the options available to them. "Some investors are beginning to look at other horizons, unprompted," says Ryan. "Others don't know where to start, and that's where consultants can help - by showing a range of outcomes with derivatives, REITs and property debt, for example. Investors can say to you, ‘The one I like is number two'. It clears away the confusion."

He adds: "DB schemes especially are most comfortable extending their current investment style to other countries - core properties in mature markets. On the other hand if you're a large pension fund with five or six in-house experts, you either do it alone or in an informal clubs - effectively, self-help schemes. You might call in the consultant near the end of the process and ask them to find a manager. But medium-sized investors call you in earlier and want help finding what options there are."

The problem is, because real estate had debt and equity characteristics, it doesn't sit comfortably in existing allocation models. Often, what's behind the thinking of pension schemes that are exploring alternative capital structures in the quadrant model: public, private, debt and equity.

The four quadrants strategy has become the model du jour, at least in the telling. The model - adopted recently by Hermes, the BT pension fund-owned asset manager with £24.1bn in AUM - divides real estate into public equity (REITs and property companies); public debt (CMBS and RMBS); private equity (joint ventures, private equity funds and direct investment); and private debt (commercial loans).

"Why don't my clients want me to invest in debt? Because that's what the fixed income portfolio does," says Gellatly. "There's a lack of clarity and a limited number of houses and managers with the capability to provide solutions across the four areas: REITs, private equity, direct and fixed income. So as an investor I would have to find four different managers.

"Large investors and endowment funds run by smaller teams can see the pricing anomalies. They can see the picture and question why it's so but they don't necessarily know the answer."

"You have different approaches — buildings, listed, unlisted, private equity, REITs — either strategically or as a tactical play — and CMBS, which is theoretically a long-term stable coupon," he adds. "There are also the private debt markets and around 25 mezzanine real estate funds. Each category exists in its own right already but very few have yet been joined up."

Low-cost and liquid
The timing for capital structures is apposite. Moss points out that different capital structures — listed, unlisted, direct, derivatives, debt — has emerged at a time when there appears to be a complete reassessment of investment products. DC schemes can't simply opt for direct as default, as DB schemes theoretically can, because they require more liquidity.

"Pension funds know property is a good idea because of its inflation-hedging characteristics and solid returns. But a DC scheme can't afford to spend six months trying to buy a building, then another six to 12 months trying to sell it again. The question is, how do you make property more liquid, and that's where the capital structures come into play."

Even if they don't invest like this, they need to understand it, according to Moss, because returns on listed property provide an indicator of direct performance. As a result of the financial crisis, investors now have to be aware of capital markets and their influence in a way that historically they haven't had to be.

"Before, if they owned a building, they had to worry about the length of the lease and the next upward rental review," says Moss. "Now, as a contribution to total return that's minute if you can't get debt refinancing."

As for pension schemes, it's up to consultants to bring enlightenment - but only to those that are ready for it. Although none would admit to giving into it, consultants face the temptation not to frighten investors by mentioning, for example, property debt.

"We don't not show options," says Ryan. "We say: tell us how much you are willing to invest in what we call the governance budget. If it's 20 days this year, that will affect the options open to them. We look at the level of commitment first." He adds: "If you're adventurous in equities and bonds - if you're looking at emerging market equities and small-cap equities, for example - you're more likely to be adventurous with property. Once you're brave in one sector, it's easier to be brave in property. If you're not brave in equities, you won't be brave in property."
*Emerging Trends in Real Estate Europe