Founded in 1990, Austrian multi-employer pension fund APK today has €2.6bn in assets under management. Investment in real estate is driven by opportunity rather than allocation, as APK's head of investments, Günther Schiendl, explains to Martin Hurst

What role do you see for real estate in your portfolio?

Real estate is used as a ‘return stabiliser' with target returns (significantly) in excess of money market rates.

We wish to see real estate being similar to bonds but without bond-like price fluctuations on a day-to-day basis. It is our general principle not to diversify for the sake of diversification - we need to get something specific out of our real estate investment, namely ¬stable returns with a lower volatility than bonds.

We aim to enhance returns with the other non-real estate parts of our investment portfolio; we are seeking and finding return enhancement in equities. If we were using real estate to enhance returns this would be coupled with higher leverage. With interest rates rising globally we might end up being disappointed given the high original return enhancement expectations. Consequently we stick to a defensive approach with real estate.

Leverage is a selling point for real estate investments because it is easier to control, yes, but if more than half the return expectation depends on the leverage then I think one could use structured bond investments with similar arguments. It's obvious that real estate investments are working with leverage but we think leverage should not be the main return driver.

How do you determine your overall allocation to real estate?

We don't buy allocation to real estate as such; we buy into real estate products we can reasonably expect to meet our return targets. If we find, say, a focused Asian real estate project with a sound investment proposition with a somewhat higher risk, we can make room for it in our allocation by reducing the equity allocation, for example.
The allocation to real estate is 3-5% on average across all our plans. This is low in international comparison, but in line with the national average of 2-3%. Our allocation target is anywhere between 0-10% based on the quality of the investment opportunities available. Given the current environment, it looks as though we will increase our allocation to real estate, the bond market outlook being the predominant motivating factor for this.

It is difficult to find attractive real estate investments at present. We believe that the only place we can find them is in specialised niches which might be overlooked by the big allocators to real estate. Typically the providers are local and the investment proposition has been developed jointly with a lead investor. Furthermore, these investment propositions are smaller and thus below the radar of product providers and investors seeking global real estate exposure.

There are product providers and sales people telling their institutional clients that they need to have some allocation to real estate. Personally I do not like this approach because we do not need an allocation - what we need is returns. If people follow a simplistic allocation argument they may end up buying some global real estate product without any idea of where the returns are coming from and how much fees they paid across all levels.

We are giving ourselves the time we need to put together our real estate portfolio. If we don't find reasonable objects we park the money in cash-plus investments.

How do you invest in real estate and how do you optimise the portfolio?

It is important that we should understand the return components and drivers: that is, rental income, re-tenanting, restructuring, asset enhancement, leverage, etc. We do not wish to rely too much on financial engineering to achieve the target returns - the key return driver must be a sound business proposition. We ask what kind of real estate the fund manager is investing in and what leverage he is using. The strategy of each real estate product needs to make sense both geographically and in terms of its portfolio structure.

We base our real estate strategy - like all our investment strategies - on ¬fundamental perspectives that are discussed, developed and structured on a regional basis, and with regionally focused real estate products we put together and manage our real estate strategy so that it best complements our other investments. We do not have a complete top-down approach, ie, we do not take a fully global view and decide which regional markets are best - we select markets and products based on information and market insight developed in discussions with local experts. On this basis we might decide about opportunistic real estate investments in Asia, for example.

We typically use focused products: no global real estate funds or real estate funds of funds. We very much prefer funds that invest in ‘real' real estate objects versus funds buying shares of exchange listed real estate companies or REITS. We are developing more interest in private equity-type real estate products and are investing in core plus assets. We also use unlisted products; there too our decision is based very much on the underlying investment proposition.

What is your view on listed versus unlisted products?

Abetter risk return profile can be had in the private real estate market than in the public market, and we tend to see more and better chances in emerging markets such as Asia than in the developed western world.

In the case of listed real estate we have to consider the legal structure of the product offered and the market it is listed and traded on. Typically, it is easy to buy listed real estate stocks as prices goes up, but how would liquidity and prices be when forced to sell in stressed markets? Listed real estate might turn out to be as volatile as equity. Typically, we prefer simple, direct real estate investments to multi-layered listed products. So rather than jumping late into an over-hyped REITS market we prefer to go for the opposite end, unlisted real estate. We assume there is a higher degree of critical knowledge and understanding on the investor side and thus more attractive real estate opportunities.

Real estate investments should have a return target and thus it is important to know when to get out. With an investment in REITs or exchange listed real estate companies, we tactically reduce our position and take profits if the year-to-date returns are exceeding our initial expectations. Investors often get accustomed to their profits and they let their positions build up over time. If a sudden downturn in the market happens, as happened recently in Spanish real estate stocks, they end up being surprised. Investors should be aware that with listed real estate, liquidity might typically be much smaller in down-markets than in up-markets.

With private equity real estate investments, there is (almost) no liquidity and investors have to do their homework before and work out any problems that might arise. Therefore, investors should select investments in which they can take an active role and work with the real estate managers and the other investors to improve a problem situation, or get out. The possibility of active participation is an important criteria for investments in non-listed real-estate products.

And then there are the holdings in the real estate portfolio themselves. By discussing the individual holdings with the real estate managers and understanding the financial aspects, such as leverage currently used and possible other degrees of leverage, the sources of return and risk can be better understood and ideas about how to repair the portfolio (if needed) can be developed.

To us it is important that real estate products are true to label. If we speak about real estate, we mean ‘real' real estate, not listed real estate stocks or real estate funds of funds or funds that invest in all sorts of real estate products. We see real estate as something very much at the other end of the investment spectrum - closer to the underlying physical assets and thus wish real estate not to be packaged or structured so much that it loses its very nature.

In terms of definitions, the classification of real estate into core, core plus, value added and opportunity is helpful. I see real estate investments as regionally biased - here in Austria we never had fear of investing in eastern Europe in the same way an investor based in, for example, the US, might have been sceptical of taking such a step. Successful real estate investment relies partly on geographical proximity to the regions in which one invests, and needs a kind of personal experience as a starting point.

What is your view of governance issues - for example, transparency?

Strong emphasis is put on governance in our product selection process, but it is a very complex area. One can do some due diligence in the screening of the projects that are put forward for investment and exclude this or that investment on social and environmental grounds.
In terms of transparency it is a question of who you are working with and how you structure the information flow. In real estate you get accurate information once a year about the value of your holdings and this information is quite old once you get it. If you are looking for more frequent transparency this is an illusion to some extent. But to some extent this might be why people invest in real estate - they don't want to have this urgency for daily pricing.
Regarding cost and management fees, some product providers openly show their cost and fees structures, some don't. We feel that if smaller players are involved, they have more to lose in these projects and thus keep costs at a minimum and work harder.
Investors should be careful, because increasingly hedge fund fee structures are popping up in the real estate investment world as well.
This situation is in part due to the organised real estate market portraying itself as a sellers' market, and it is helped by investors indiscriminately buying to fill up real estate ‘allocation'.
Product providers should be careful not to be perceived as being too greedy, because this could alienate investors. The level at which the performance fees kick in should be critically considered and it should not be just above money market rates, but higher than that, and it should be linked to asset class typical returns rather than the risk free rate.

What are the current and future challenges you face?

One is the task of finding sufficiently attractive products that don't rely on increasing levels of leverage to deliver their return expectations. Good opportunities are not in the mainstream any more and we have to work with smaller deal sizes. This means more administrative work. On the other hand, it may well be that exactly these products below the radar remain attractive for some time.

It also helps if whoever is offering a product has local ties to the real estate companies that are doing all the operational work - drawing up the contracts, collecting the rental income, etc. If those ties are more established because of a longer geographical presence then the management company and the real estate company putting the product together should have a better deal sourcing capability. Maybe this is one more argument for working with locally focused real estate product providers rather than with global ones.

APK won the award for best small pension fund at the 2007 IPE Real Estate Investor Forum and Awards held in Amsterdam.