Recent evidence that property doesn't necessarily offer an inflation hedge is getting through to pension funds, says Shayla Walmsley
Inflation tops the list of pension fund concerns, according to a 13-country survey published by Mercer at the beginning of May. The study of 1,100 pension schemes, with aggregate assets under management of €550m, found that 80% of them were more concerned about inflation than they had been the year before.
Are they right to be worried? Yes and no, according to Peter Damesick, EMEA chief economist at CBRE.
The idea that real estate provides a hedge is based on a finite supply of land, and the likelihood that construction costs would increase more quickly than prices. The problem is that demand, rather than supply, drives price inflation, and the inflation currently besetting Europe is the result of inflated oil and commodity prices, rather than coming from strong economic growth and pressure from the demand side. According to the OECD, energy prices increased by 12.4% in March, compared with 10.2% in the previous month.
"The inflation we're now experiencing will probably be a drag on growth. There's inflation in pricing but without the demand push," says Damesick.
In mainland European markets where rents are indexed, this could provide short-term protection for income, but underlying market rents are not subject to uplift, so index-linked inflation will tend to fade away. This was the argument made by outgoing PGGM CIO Johan van der Ende back in October. Rents rise with inflation, he suggested; values do not.
"Housing is the only sector to show a correlation, because rents are indexed in the Netherlands. The only protection is in housing," says Peter van Gool, professor of real estate economics at Amsterdam Business School, managing director for real estate at Dutch railway and public transport pension fund manager SPF Beheer, and supervisory board member at the PNO Media pension fund. "Even where contracts for office or retail are indexed, at the end of the contract they return to market levels."
As van Gool demonstrates, there is a certain amount of scepticism that real estate is the hedge it has been cracked up to be. "Everybody thinks real estate offers good protection and we want to keep on believing that but there's hardly any evidence," he says. "It's unfortunate, but the figures don't show what we want to believe."
He believes, as Damesick does, that it correlates, but only in an ideal world. "In theory, there is a link between real estate and inflation. There is a wide belief that direct real estate will protect against inflation but consider the short-term and long-term figures and there's hardly any correlation between total returns and inflation," says van Gool. "In most countries, the correlation is at most 0.2 or 0.3."
In any case, what pension funds need to take into account is the likely response to inflation. If inflation triggers a change in interest rates, the impact on commercial property will be negative because it will dampen demand and hit capital values. "It's the worst combination," says Damesick, pointing to the pump-and-slump of the late 1980s and 1990s.
A sharp rise in interest rates is unlikely either in the UK or in mainland Europe. "As a general trend, there is no serious risk of a steep rise in interest rates," he says. Given the current state of the UK economy, for example, it is likely that there will be a temporary increase in inflation but the Bank of England will take a measured view on the need to raise rates.
"We won't stay at extremely low rates forever but interest rate rises are probably months away and then they will rise slowly," he says. The European Central Bank is likewise taking the first steps towards raising interest rates - but again the increases are likely to be slow and progressive.
In the meantime, there's plenty of fund activity in the market to meet demand for real estate as a presumed hedge. Aviva Investors has announced that it will target UK pension schemes with a series of funds comprising
long-term assets with inflation linkages. The strategy was initially devised for the Aviva Staff Pension Scheme.
Ben Jones, manager of M&G Secured Property Income Fund (SPIF), reckons pension schemes are looking to rising rental income and long-term leases. His fund targets prime properties, often on sale-and-leaseback agreements, as an alternative to index-linked government bonds.
M&G launched its inflation-linked fund four years ago. It now has assets under management of around £800m (€889m). Investors in the fund are mainly "big institutions with inflation worries", according to a spokesman for the company.
Although pension funds invest for different reasons and for different buckets or portfolios, a common reason is as an alternative to long-term gilts. "It isn't a perfect substitute but pricing is attractive," says Jones. "It's the same as a very good core UK real estate holding from a traditional real estate allocation perspective."
He adds: "There is substantial latent demand for the asset class. The requirement is that pension funds protect their long-term liabilities against inflation and there are limited sources that will enable them to do it. We're unlikely to see this asset class underperforming gilts in the medium or long term."
Yet, even if the prospect of higher inflation - and higher interest rates - is losing pension fund managers sleep, they won't necessarily look to real estate to mitigate it. What was surprising about the Mercer survey were the conclusions that European pension schemes drew from their concern over inflation. They were looking to increase their exposure to bonds and debt, including distressed and mezzanine debt, as well as high-yield and emerging-market debt.
According to the report, 18% of pension schemes concerned about inflation intended to increase allocation to inflation-linked bonds, 5% to inflation-sensitive assets and 3% to inflation swaps. Over the same period, 22% of European pension funds will increase their allocations to emerging market debt, while 6% intend to increase their allocations to distressed debt.
In other words, what no-one planned was an increase in their allocation to real estate. Instead, the report forecast, over the next 12 months the inflation-hedging European pension fund cash would go to bonds and ‘non-traditional' asset classes.