EUROPE - Pension funds investing in European real estate should diversify across 15 countries and all sectors, and should combine UK and mainland European real estate for the highest risk-adjusted returns, according to a UBS report on pension fund investment.

Unleveraged property in mainland Europe will deliver an annual average core return of 4% - between those of government bonds and equities - over three and five-year periods.

Despite underperforming UK real estate for the better part of a decade, continental European property combined with UK exposure offers higher risk-adjusted returns because of a low correlation between the two markets.

Anthony Shayle, who authored the real estate chapter of the report, cautioned against single-country portfolios with three-way sector bets because these sectors have not delivered a wide range of returns.

However, diversification across 15 countries and three sectors has provided "powerful risk reduction", he said.

Even taking into account valuation smoothing, a broad portfolio of office, retail and industrial across Europe showed a standard deviation of 7.5% over a 10-year period, compared with 20.8% for two returns for a single-sector, single-country portfolio.

Yet Shayle acknowledged that returns from individual sectors varied significantly.

Because the major European office markets are highly correlated, the report recommends pension schemes look to regional cities in polycentric markets for more diversified economic structures and less reliance on one economic sector.

Cross-border retail investment requires greater due diligence than local investment because of the prevalence of retail brands unheard of outside their home country.

Meanwhile, European logistics is beset by shorter leases - an average of five years, compared with 10 years a decade ago.

In the meantime, pension fund demand for infrastructure assets will continue to increase in 2011 as like-minded investors attempt to increase diversity in their portfolios.

However, increases in the number of infrastructure funds and assets under management "does not necessarily reflect a disproportionate supply of capital chasing infrastructure assets", according to the report. 

It adds: "The market expansion reflects the rapid development of the asset class from a low base, rather than an oversupply of capital.

"The outlook for the infrastructure asset class in 2011 is strong and, on a risk-return basis, infrastructure is a compelling asset class."

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