The need for income and protection against inflation is even more acute for charities than for pension funds. Charities and endowments are therefore likely to increase their exposure to property, reports Richard Lowe
According to latest estimates at the end of September 2010, approximately 4%
of UK charity assets were invested in real estate. This figure masks a huge variance of property weightings among the investor community but it is a useful indication as to the relatively small exposure many charities have. This might well rise in 2011 as charities find themselves under pressure to find high-yielding, income-generating investments and a protection against inflation.
"My perception is they are interested in UK commercial property for similar reasons to other traditional institutions - pension funds and insurance funds - probably for two common reasons," says Guy Morrell, head of multi-manager at HSBC Global Asset Management and manager of the HSBC Open Global Property Fund. "One is the diversification benefit that property brings in a multi-asset portfolio in terms of reducing the overall volatility of returns - the weak correlation to other asset classes and so on - and secondly, the ability to deliver attractive returns over the long term."
Morrell says that what is particularly appealing to charities and endowments in the current environment is the high-yielding nature of commercial property. "That is particularly helpful to investors such as charities and others that rely on steady and, hopefully, growing income profile over time. In that context, commercial property, is probably quite attractive. It probably punches above its weight in terms of the income it generates - or has the capability of generating - compared with other asset classes, not just at the moment but over the long run."
John Kelly, head of client investment at CCLA, the biggest asset manager of charity assets in the UK, broadly agrees. "One of the features of our world over the past 12 months has been the increased popularity of property and there are a number of drivers for that," he says. "What charities are looking for is what every-one else looks for: they want good returns and they want relatively controlled levels of risks. But there is this concept in the charity world of the endowment fund that is effectively infinite. Whereas a pension fund matures and comes to an end - or even a life insurance company pays out when an individual dies - some of these endowments have gone on for many hundreds of years and will go on for many hundreds more."
It is widely acknowledged that pension funds are long-term investors and so are not overly concerned with short-term fluctuations but have a need for income-producing investments and always have one eye on inflation. Charities are even longer-term investors, given their potential to exist indefinitely, and so the above considerations apply even more strongly.
Pension funds have become increasingly concerned about the potential for rising inflation to eat away at their investments and make the task of meeting their pension liabilities all the harder over the long run. This has been one of the driving forces behind a recent surge in core real estate investment among the pension fund community, or at least why many institutions are viewing property as an attractive alternative to government bonds, as a high-yielding inflation hedge.
But James Thornton, fund director at Mayfair Capital Investment Management, believes that the issue of inflation is even more marked for charity investors. Thornton, whose firm has both pension fund and charity clients, says that inflation is a much more immediate issue for the latter. "We are hearing a lot about this from charities," he says. Charities have wide-ranging activities and invariably need to fund any number of projects, which is a different requirement to covering pension liabilities, for instance.
For this reason, property, along with other ‘real' asset classes, is likely to look attractive as we go forward. "In an environment of high inflation, we expect real assets to remain in favour, with property, equities and commodities being sought by investors," Thornton says. "We are still bearish on the prospects for gilt yields amid ongoing sovereign debt issues in Europe, coupled with the expectation that interest rates in the UK may rise towards the end of the year."
Thornton expects to see allocations to real estate among charities rise in 2011 as a result of this concern over inflation and says asset allocators and consultants are currently deliberating over this issue.
But does real estate really offer a hedge against inflation? Not so, according to the latest research commissioned by the Investment Property Forum (IPF). A paper by Neil Blake, director of economic analysis at Oxford Economics, found that UK commercial property was in most cases not a hedge against inflation, although it was able to deliver positive, long-run real returns. The research also suggests that property performs best in a low inflationary environment.
Thornton says that there is a need for the real estate investment industry to "hold our hands up and admit that rental growth does not match inflation", but he says investors that are particularly concerned about inflation can concentrate investments that involve secure, inflation-linked rental uplifts, such as super-market leasebacks. Mayfair Capital made a number of investments with fixed rental increases in 2010 for its charity fund, including a Sainsbury's supermarket, Co-op convenience stores and a car showroom.
Kelly also stresses the particular pain that inflation can cause charities. "The key feature of the sector at the moment is the need for income, and donations are under pressure," he says. "An awful lot of the charity sector gets help one way or another from central government or local authorities, and that support has either been reduced or is under significant threat."
He says that, historically, approximately 40% of charity assets have been held in cash. "This was fine when interest rates were 5% or 6%. It's very difficult when they're 0.5%." Add to this the fall in dividends from UK stock market investments in recent times, and charities are looking for high-yielding, income-producing investments.
"They've had two years of negative domestic equity income flow, which has left them pretty pinched, and from that perspective the attraction of property is that it is the highest yielding of the major asset classes," he says.
But Kelly admits that trustees have other concerns about ramping up their property exposure. "It's not all in one direction," he says. One factor potentially driving in the opposite direction is the lingering concern over liquidity. Many were surprised by the speed at which the UK real estate market corrected between 2007 and 2009, and many were also affected by the redemption freezes imposed on a number of open-ended real estate funds in the UK.
"A lot of charities had their fingers burnt, in effect," he says. "They assumed property had lower volatility than has since actually proved to be the case. As nerves were tested and some of them tried to withdraw assets, they definitely had a bad experience."
Charities might be long-term investors, but they do value liquidity and are not keen on tying their money up too much. "Some of them have just had unpredictable cash-flow needs," Kelly says. "Sometimes things change and they always recognise that they can get their money out of bonds and equities if they need to - sometimes at disadvantageous prices. But they couldn't get it out of property and there's definitely a legacy of concern or distrust from that."
Kelly says that despite these concerns the incentives to invest in real estate will be convincing for many charities. He finds that the main question charities are asking their advisers is, effectively, how they can increase their income: "What can you do to take my yield from X to Y?"
One solution facing charities is to move into higher-risk bonds, but Kelly says that the term ‘higher risk' is not something they like to see. Furthermore, these bonds are providing a high income at the moment, but this is likely to decline in the future.
"You can have a temporary respite from your income problem by buying bonds, but that's not attractive on pricing and it doesn't work on a two-year view," Kelly says. "So the asset class that is pretty much in front and will remain there is property."
Kelly adds that some charity trustees are resisting the pull, because of the liquidity issue, while others are already attracted by a 7% income and growing dividends. "That is the sort of drive we are experiencing at the moment," he says. "It's not a case of falling in love with the asset class; it's a case of falling in love with the particular characteristics of the asset class."