Is now the time to move up the risk curve and consider value-add strategies? Shayla Walmsley talks to a number of investors, managers and advisers

Stephan Brendgen
Allianz Real Estate Germany

*Despite overpricing, Germany remains a stable market
*Good credit and secure income remain the insurer's priorities
*CEE markets offer selective opportunities - but beware bubbles

German core may be overpriced but that doesn't make Allianz Real Estate Germany any less of a core investor.

"Germany is losing traction month-by-month because of increasingly aggressive underwriting," says CEO Stephan Brendgen. "This market is everyone's darling again after not being the darling for quite a while. As an investor, we see Germany as a stable, dependable market that will not show significant volatility in its core segment but we do not follow some of the current prices for a core product."

There are exceptions to the core focus. Although most Alllianz Germany transactions involve multi-tenanted assets with long leases, it recently acquired a shopping centre in Hungary and an office development in Frankfurt (albeit for an Allianz tenant).

Although the Hungary acquisition "moved us a bit up the risk curve in terms of country risk and macro risk", it didn't indicate a shift towards a riskier investment strategy. "We are ready to invest but we will not support pricing bubbles," says Brendgen.

"We are not a value-added investor - it's just not a market we want to be in. We're cash flow investors rather than IRR investors and we like the inflation hedge that comes with real estate. If there's an increase in value, good; but it's not the idea to double our money by taking unnecessary risk."

At least for now, that is. "We'll properly take another look at other real estate markets and other asset classes, but that has yet to be worked out," Brendgen says. "I'm not saying we won't invest in non-core real estate, but for now core is the best strategy."

Eric Adler

*Investors deterred by pricing in ‘hyper-major' cities are looking to Madrid
*Risk-averse investors ‘aren't going anywhere' outside core
*Debt is emerging as an alternative to core

Core investors are "not going anywhere", according to Eric Adler, European CEO at Pramerica. Yet he acknowledges that it is "a frustrating space to invest in. The picture is nuanced but there is a broad recognition that core feels expensive. There is a frustration with prime in hyper-major cities.

"What happened was that people ploughed into that space. Now investors are looking at Madrid for core. It has risk characteristics but there are more opportunities than there are in London. There is fear but it isn't attenuated by the market."

In the meantime, committed core investors such as sovereign wealth funds will tolerate declining yields. "When they get out of core, it might not be for [another category of] real estate," says Adler.

Adler identifies two trends among investors willing to take on slightly more risk. The first is a steady influx of cash flows into asset classes with higher yields "but which aren't dangerous". This might include secondary, but investors are afraid of residential assets so it will mean investing in, for example, student housing and hotels.

The second is to invest where there is risk in the capital stack as a way of manufacturing yield. "There's been a serious lack of senior lending for the past two years so we're seeing an important move to the mezzanine space," said Adler.

"As the pressure ratchets up on banks and governments, which will have to implement austerity measures in Europe, Solvency II is holding back traditional real estate investors until they understand what the regulatory issues are. The result is constrained capital investment. For bolder investors, the option could be mezzanine with equity."

Anders Strömblad
Second Swedish national pension scheme (AP2)
*‘Opportunistic' equates to volatility
*Essential to be ‘value focused'
*Fees for core funds are too high - joint ventures offer an alternative

AP2 invests exclusively in core because it offers more stability than value-added or opportunistic investments.

"We're looking for value over time not extreme volatility," says Anders Strömblad, head of external management at the SEK222.5bn (€24.3bn) AP2 buffer scheme.

Strömblad continues: "The more opportunistic strategies we have in the real estate portfolio, the more volatility it will have when what we want is stability."

Although Strömblad acknowledges the pricing is currently an issue, it is up to the investor to be value-focused. "If you're buying at too high a valuation, you will come off the worse for it," he says.

The buffer scheme frequently invests via three-way joint ventures involving another pension fund and an external manager. In one, agreed in March with sister fund AP1, the schemes collectively invested in European property via a joint company to be managed by Catella. The company will focus on centrally located, core, liquid offices in major European cities with a war chest of €500bn and the same amount in leverage.

Although higher fees could make sense for an opportunistic investment, he is sceptical about the level of fees for core investment structures. The pension scheme has no fund investments. "For core investment the right structure was a joint venture," he says.

Douglas Crawshaw

*Pension funds in deficit should consider opportunistic investments
*Core portfolios demand skilled management
*Leverage should be an element in some core funds

Core isn't a risk-free route to meet liabilities, according to Douglas Crawshaw, senior investment consultant at TowersWatson - and he quibbles at zero-leverage assumptions.

"There's an assumption that a core fund should have no debt," he says. "Overseas, though, there is clearly some advantage to having debt to mitigate tax disadvantages."He argues that, in mainland Europe, a debt level of 30% would be appropriate to a core fund, even though an appropriate level might be 0% in the UK.

With or without leverage, pension funds running a deficit are unlikely to meet their liabilities without shifting up the risk curve. For these, it makes sense to go after return-seeking assets via value-added and opportunistic investments.

However, the due diligence required for an opportunistic fund is far greater. "It's a time-consuming process. You need to delve into the specifics," says Crawshaw. "For that reason, a good asset manager at a balanced fund probably wouldn't be appropriate for a specific opportunistic fund. The deals are more complex and you want to know they know what they're doing."

But it would equally be a mistake to underestimate the skill needed to manage a core portfolio. "You have to manage a low-risk portfolio properly, rather than sitting on it and waiting for the rent to jump into the bank account," he says.

Fees are a moot point, both for core and for value-added funds. If the target is cheap beta diversification, "you want it as cheap as you can get it - with skill", says Crawshaw. "But cheap is a relative term. If you're paying high fees and effectively tracking the market, you're underperforming the market. Risk with high fees is not equivalent to market beta."

Nico Tates
Aberdeen Asset Management

*Economic growth is too weak to make riskier markets attractive
*Investors are still looking for core
*Liquidity will become more important

 Nico Tates, head of direct property for continental Europe at Aberdeen Asset Management and manager of the European Balanced Property Fund, isn't in principle opposed to investing in riskier markets, but the fact that core markets are overpriced isn't sufficient reason to do so.

"It isn't time to move up the risk curve," says Tates. "Riskier markets rely on a stronger economic growth and I don't see that now. We're seeing only modest growth."

He compares contemporary Europe - "though to a different extent" - with Japan 20 years ago, when investors acquired trophies but found they were unsellable when the investment market ran into trouble. "We're focusing on liquid assets because they're much easier to finance. Finance will be the issue in future."

The point of investing in property in the past two years has been to bring diversification away from equities and bonds, with a relatively high direct return. "There is no need any more to invest in opportunistic real estate where you have high levels of risk, oversupply in office, and a high vacancy rate. Why take the risk?"

Tates adds: "We're not in a hurry to make deals. We have cash in balanced funds to invest but we never sit on capital - we invest it."

In the meantime, institutional investors are also looking for a reduction in leverage, say, from 50% to 40%. "Funds with high gearing levels will have to refinance, and to dispose of assets," says Tates. "Everyone knows now that property is attractive in the right mix - with mitigated risk, diversification, and long leases. But you only diversify if you're going to property investments that really do diversify."

Morag Beers
Composition Capital Partners

*Avoid assets you don't have to do anything with
*Risk appetite based on whole portfolio - not just real estate
*Misleading to categorise investors as core or otherwise

"What we enjoy is creating real estate rather than just buying property with a stable income," says Morag Beers, director at Composition Capital. Not only does the fund manager prefer niche to core, it eschews real estate that "you don't have to do anything with".

The firm invests in small and medium-sized partners with developments or redevelopments in niche markets. "These are not stablised properties. It's a skills-based business," says Beers.

"We're accustomed to taking factors such as time, income, value and costs into account."

She acknowledges that there is a broad range of risk and return appetite evident among institutional investors. Many are looking to spread risk outside their core portfolios. A typical investor could have 60% in core, for example, and 40% allocated to higher-risk, higher-return investments. "They're all institutional investors, so they're all looking at the quality of risk assessment and reporting, for example," she says.

"Investors are making personal choices based on broader questions about return requirements, not just the real estate element of their portfolios," Beers adds. "It depends on the CIO or trustee risk and return requirements. If investors have enough risk in one part of the portfolio, they may not seek more in another."

She adds: "It isn't strictly a real estate question. I wouldn't categorise investors in broad categories at this point in time."