The turmoil has not fazed investors that are considering an increasingly broad range of investment options. The consultant perspective of a largely UK-based investor client base is provided by Greg Wright
A great deal has happened to real estate markets in the past year or so. Look back to mid-2007, just before the yield re-rating started, and what do you see? For the UK market, three-year returns were around 17% per annum, inward investment was incredibly strong, real estate returns were outstripping equities and bonds and it had been many years since investors had seen negative returns.
Admittedly yields were looking low (both historically and versus bonds) but the economic situation was still strong. Investors were expecting a reduction in returns but there would be a soft landing. We would just have to put up with annual returns of 6% or so for the next few years.
As we all know, things turned nasty much more quickly than most people were expecting. A ‘perfect storm' of higher borrowing costs, lower liquidity, the exit of major market participants such as banks and runs on funds from (retail) investors have completely changed the look of the market. Moreover, there is a fear of a "double dip" in returns caused by distress in the occupier market. Suddenly, even those 6% returns do not look achievable for now.
So how have our clients been reacting against this backdrop? How have their views and possible actions changed? Is there a difference between clients in mainland Europe and the UK and Ireland? We have separated our experiences into the various "conduits" into the real estate markets but begin by talking about disinvestment.
Clearly clients in closed ended funds, or in the drawdown phase of closed ended funds, have had no option but to sit tight. Encouragingly, clients have not shown a knee-jerk reaction and looked to disinvest at the first sign of bad news. Possibly this is a function of the speed of decision-making but many clients have noted the cyclical nature of the investment, and many had experienced ‘supernormal' returns before mid-2007. In any event, many open ended funds delayed redemptions, which probably acted as a barrier to action. So, unlike retail investors, most clients have remained exposed to the asset class.
While we have seen an ever increasing level of activity from our clients, the mandates have been changing in nature. We have carried out few UK-only searches as clients are embracing a pan-European and global approach. This has led to increased use of pooled funds and multi-manager approaches rather than direct accounts.
The wider scope of the mandates protects against the risks of a downturn in one country or economy, and has meant that there was client momentum even with an expectation of lower future returns. It has probably also meant an increased focus on non-core approaches, as core type returns would look unappealing.
Our experience is that clients have avoided making significant new investments over the past 12 months. Those who are targeting a new mandate are deciding to wait until it has become clearer that their chosen markets have stopped falling in value.
This was originally expected to be around mid-2008 but is now projected to towards the end of 2009, possibly even 2010. The same story has been true for new contributions to existing mandates - there has seemed little point in handing over contributions that are very likely to lose value for the next couple of years. We now turn to each of the various conduits into the global markets:UK - conventional/balanced mandates: As noted above, there has been relatively little activity; UK - bond proxy mandates: clients have continued to look at using property as a bond proxy. There are now a number of pooled funds which, in different ways, aim to produce more-bond-like returns or arbitrage between the bond and property markets. Unfortunately, these too have been caught up in the yield re-rating and, although performing better than balanced funds, have still shown some weakness. Client appetite is still there but again many are waiting on the sidelines at this stage; UK - derivatives: There was some interest late in 2007 when clients could achieve the IPD return with a substantial return on top. Clients with physical holdings found the total costs involved meant the opportunity was marginal for them; clients with cash to invest looked more closely at these. We expect clients to either invest directly into these instruments or use them as part of a wider mandate, particularly as the derivative market continues to expand (both within the UK and now globally); Pan-European mandates: These have replaced the traditional UK only mandate to a large extent. Whether this would continue to be the case if the UK were to emerge from its downturn before continental Europe is perhaps open for debate. Clients are tending to focus on funds of funds and balanced pooled funds (roughly equally split) with a minority making direct investments into closed ended funds. These tend to be funds run by their existing property manager. There is no clear preference for truly pan-European or UK/Continental mandates; Global mandates: Clients are, to some extent, looking to bypass Europe and go straight to global solutions as more product emerges. They value the potential for the highest returns and greatest diversification by maximising the opportunity set. The preponderance of closed ended funds has been a drawback to date, as many schemes are not set up to run a portfolio of funds on this basis, but that is changing. A number of the specialist global players, which have not been headline names in the UK and Europe, are starting to attract client interest. The development of more fund of funds solutions will accelerate the trend.
In summary, our experience has been that clients have not panicked but have stuck with the asset class. They are, however, being cautious in the timing of new investments. Clients are starting to acknowledge and work their way through the rapidly developing range of investment options and this leaves little clear pattern of overall investment behaviour.
Greg Wright is principal at Mercer