The property research societies of the UK, Germany, France and the Netherlands met in Vienna to discuss the changes in the asset mix of institutional investors. Cléo Folkes and Peter van Gool report
What is the optimum asset mix for investors now and what will it be in the future? The answer depends very much on the home market of each investor. Despite globalisation and cross-border transactions, the property market is not a level playing field.
In early July, representatives of SPR, GIF, AREIM and VOGON (the societies of property researchers from the UK, Germany, France and the Netherlands respectively) discussed the topic at the ERES conference in Vienna in July. The article below is based on these discussions.
Property allocations look set to rise in the short to medium term. Investment in the developed world is forecast to be tempered by low growth, with new alternative sectors and regulation playing significant roles. GDP and property investment growth is set to move from ‘old world’ to ‘new world’ as the latter matures. Allocations to different property sectors will continue to be driven largely by domestic factors and global ‘megatrends’, and will remain dynamic. There is, perhaps, no such thing as an optimum property allocation mix.
The relatively small size of the property market in the Netherlands has prompted Dutch investors to develop relatively high portfolio weightings to cross-border investments. By contrast, investors in the UK have the advantage of a large, liquid and transparent home market with a relatively attractive lease structure, and so they have less of a need to invest abroad. Investors often retreat to the safety of their home markets during a downturn, and heightened risk aversion following the financial crisis reduced the number of cross-border transactions.
The current and forthcoming changes in the asset mix are the result of cyclical and structural shifts. The following (extracts)attempts to cover all the various aspects that influence the asset mix selection for institutional investors in a variety of countries in Europe, taking into account their specific situations. Some aspects will be more obvious than others.
The insurance industry dominates the German, French, Swedish and Italian property markets, while the pensions industry dominates in the UK, the Netherlands and Finland.
The French property market is thus highly influenced by domestic life insurance funds and real estate investment trusts (REITs), for example, and therefore differs strongly from the market in the UK or Germany.
Some countries save more than others. Countries ‘age’ at varying rates. In some countries the unaffordability of pension provision is more acute than elsewhere. Pension provision will have to change in many countries, with more money saved for the future and thus more money available to invest.
Additionally, property is currently benefitting from increased allocations by institutional investors.
Peter van Gool: No clear consensus in the Netherlands
Professor Peter van Gool from VOGON informs us that approximately 10% of total Dutch institutional assets are held in property, with the majority of that (approximately 70%) in indirect investments. Of total property holdings, 52.4% are in non-listed funds and 17.5% listed funds, which are mainly invested abroad. Just over 30% of property investments are held through direct ‘bricks-and-mortar’ investments, with two-thirds of that in the Netherlands itself. Dutch investors tend to use non-listed property funds as a tool for international diversification.
In the last 10 years, the trend has been to move from direct to indirect property investment in the Netherlands, especially by pension funds which now hold approximately 10% directly. Generally, less is being invested in offices and more in residential and retail. Of the indirect holdings, more was allocated to non-listed funds, mainly by the smallest – as they are unable to build a diversified property portfolio directly – and largest funds. Indirect investments have various challenges associated. These challenges might affect asset allocations in the future.
Insurance companies have less exposure to non-listed real estate funds than pension funds as they are chiefly concerned with liability matching. Dutch investors were made aware that listed property behaved more like equity, resulting in greater return volatility compared to direct property investments. The assumption that non-listed property would behave more like ‘bricks and mortar’ was proven wrong when in 2008 the funds across Europe, on average, suffered a total return of roughly -20%. The problems encountered were manifold. As a consequence, institutional investors want to return to direct investments, but this is hard to achieve. Thus club deals and joint ventures became popular in the Netherlands, as they have done in other countries.
Institutional investors in the Netherlands are having important discussions on the best way forward for asset allocation. The outcomes from these studies show too wide a range of suggested optimum allocations to provide clear guidance to institutional investors.
Opinion is leaning towards holding more direct property rather than indirect funds – especially those that use leverage – as the former approach has less in the way in governance issues and as indirect funds can have its own liquidity problems. However, investors need size to achieve a diversified portfolio.
Opinion is also leaning towards non-listed over listed funds, even though listed property has superior liquidity and can offer access to superior property assets, higher returns and greater diversification. The main problem with listed is that it suffers greater volatility and is more closely correlated to equities. The choice by each investor depends on the volume of assets under management, access to and quality of property management, willingness to pursue active asset management and the capacity to invest in foreign markets. This choice is made within the restrictions of accepted correlations with other asset classes, the risk-return profile of the fund, the level of acceptable illiquidity and time horizon. This seems to confirm that there is perhaps no such thing as an optimum asset allocation mix.
Ramón Sotelo: Germany no longer the ‘sick man’
Turning our attention to Germany, professor Ramón Sotelo from GIF explains how capital growth in Germany has been different from the rest of Europe over time. Germany changed from being the ‘sick man of Europe’ in the 1990s, plagued by poor economic performance, and fell back in favour with cross-border investors relatively recently.
The poor German performance in the 1990s was, in part, due to the cost of the reunification at the time, but mainly due to the phased convergence from the Deutsche Mark to the euro. When Germany joined the euro it was the only big European economy with a currency that was held in foreign exchange reserves by other countries. Upon introduction of the euro, interest rates across the euro-zone became almost uniform, but the rate was too high for the German economy. Only after the differentiation in interest rates within the euro-zone appeared, as a result of the financial crisis five to six years ago, that the tables turned. Germany’s economy now sees low bond yields and relatively superior economic growth.
The financial crisis led to a disintegrated market with fewer cross-border investments, less financial engineering, fewer portfolio transactions, less debt and thus a lower residential investment volume (since residential is mostly traded in large portfolios dependent on financing). Looking forward, investors focus on superior growth and so Germany and the Nordics have been the beneficiaries of higher levels of property investment. As the Nordics represent a small market, Germany has benefited most.
Between 1993 and 2000, German open-ended funds (GOEFs) saw growth as a sector, which ended with the crash of the stock market in 2001. Between 2004 and 2007 the next trend in property investment became clear, as foreign investors became a strong growing part of the local investment market. They mostly invested in residential using large amounts of leverage, causing a boom in 2006 and 2007. In recent years, the share of foreign investors in Germany has risen once more, albeit more modestly. Germany is now seen as a ‘safe haven’ in the euro-zone, in the way London is seen as one outside of the euro-zone.
GOEFs became strong due to the special tax position they enjoyed. There was also a tax subsidy available for new construction in East Germany. After the stock market crash of 2001, money often found a home in the GOEFs. The question is: where will that money go now?
Retail property proved popular at the start of the financial crisis as its income stream is generally steadier than it is for offices. In 2012, 44% of transactions were focused on offices and 36% on retail as a whole, however. How much investment there will be in the retail sector in future is a big question due to the growth in online shopping.
There is still significant demand for prime retail, but demand for secondary retail is dropping away. Secondary retail has greater exposure to the rise of online retail, and supermarkets have diversified their offerings, capturing market share from the high street.
The way consumers shop in the future will affect the kind of retail property investors will buy. Dominant regional destinations will still flourish, and the best shops will be successful in multi-channel retailing. Out-of-town retailing and outlet malls will also do well, as will discount stores in general.
A unique aspect of the German market is its polycentric market. Sotelo argues that this is now changing, with Berlin coming more to the fore as the city where new business, politics, arts, fashion, the tech sector and people want to be. He also argues that, faced with different capital costs across countries, investors are experiencing different opportunities for investment in different countries.
The quality of the domestic market environment also determines the investment style: investors in more troubled markets such as Spain or Greece are more risk-averse, and thus seek more core investments. The preferred fund style in the better performing Germany and the Nordic countries show more interest for value-added investment styles.
With the economy seeming to improve in 2013, value-added strategies and larger portfolio deals are gaining ground across Europe.
Andrew Smith: Cyclical shift to core in the UK
The major themes emanating from the Netherlands, Germany and France are also dominating the UK property market, according to Andrew Smith (pictured) of SPR. The legacy of the financial crisis is that letting markets are still relatively weak, with values generally static or falling (except in central London) and developments scarce. The latter is, in part, due to a lack of finance for all but the best properties. Secondary assets and locations are being shunned. Pull factors are the level of income yields compared with low bond and cash yields, and a renewed focus on property characteristics and drivers – that is, returns achievable without complex financial engineering.
The UK shows a clear divide between prime and secondary stock, with the poorer quality real state suffering a downward spiral, especially outside London and the South East.
Asset selection is influenced by changing priorities of institutional investors. There has been a mixture of long-term structural shifts and cyclical factors, to do with risk aversion, a search for greater control and a greater alignment of interests.
Investors are being very selective towards new ventures at the moment so, generally, it has become harder for managers to launch funds. In 2005 and 2006 there was a boom in fund launches across all strategies.
These funds are now coming to the end of their life, with a peak in expiries due in 2015. The sheer weight of fund expiries is likely to lead to a shift in the market. The type of funds that are being launched has changed, with risk-averse core strategies overwhelmingly in the majority. That said, core-plus, distressed and debt fund strategies have been growing relatively strongly in recent months.
Although in the UK the weighting of property in the portfolio owned by pension funds has remained stable since the early 1990s, the sector mix has changed. Interestingly, IPD UK Property index shows a lower share invested in central London offices, but this is due to UK institutions selling to mostly foreign institutions which, typically, do not contribute to the index. As a consequence retail’s share of the average UK institutional property portfolio has risen to almost 50%, but this share is likely to decline in the future considering the threats to the sector.
Allocation to property is also growing in the UK, with more money going into alternative asset classes – such as private equity and private infrastructure – at the expense of listed funds. Most up-and-coming alternative asset classes, including infrastructure, student housing and supermarkets, have one common theme: long leases offering stable, long-term income. Since the financial crisis, the focus of investors has been on income, rather than capital growth, with the latter unlikely to appear in the same extent as in the pre-crisis bubble.
Despite the differences in the various European countries, key over-arching, long-term themes dominate and unite the countries.
Etienne Dupuy: Solvency II to be instrumental in France
Etienne Dupuy, speaking on behalf of AREIM, focuses on France’s pension system to explain what makes the national property market unique. Life insurance funds in France are the main beneficiary of people’s savings, with tax benefits received by those who contribute for at least eight years. Within the French insurance sector, more money has recently been going towards the most liquid sector of the market, although insurance savings turned negative for the first time in August 2011. This outflow means more liquid assets are sought to enable funds to deal with the outflows.
In France, Solvency II is of primary importance for insurance funds and thus the property market. Its impact in other European countries is more limited. The capital charge for property is heavy. If the capital charge level is not adjusted downward, it will negatively affect the levels available for property investment. Commercial property loans are also not treated very favourably, and leverage is prohibited or limited to 40% LTV. Insurance funds without leverage might be developed due to this restriction.
Due to Solvency II, ‘vanilla’ direct property investment is increasingly in favour for asset allocation, as its capital charge is relatively modest compared with equities. There has been a rise in private bonds allocation across all insurance companies. The property asset mix has evolved in France over time, with more money going towards covered and sovereign bonds, and marginally to direct property. Currently, the asset allocation for property in France varies generally from 3.3% to 6.3%, with an average of 3.9%, and so is relatively small.
The French have traditionally invested in their home market, and over recent years the share of foreign investors in France has shrunk. Domestic investors currently act with little or no leverage – either through design or by default – and through club deals. Specialised, niche or private-equity products, such as healthcare and hotels are becoming popular, echoing the trend to more alternative property investments elsewhere. Fewer investments take place through funds and more through club deals. Investors are actively looking for suitable operating partners.
There is also relatively high interest in listed funds, while more debt funds are being created. New products like index-linked exchange-traded funds have become available as banks retrench from the lending market.
Investors are now buying property abroad more often, with growth in funds coming from insurance firms (up from 2% of the total in 2007 to 20% in 2013) and French open-ended funds (SCPIs and OPCIs).