The market correction has prompted polarisation of risk appetite among investors: some favour safer core investments, others prefer potentially high-risk distressed opportunities. David Skinner explores what this means for the market
The extent of capital value falls in the European real estate market over the past 18 months has taken the vast majority of institutional investors by surprise. Investors have been made more uneasy by the financial market turmoil experienced in the post-Lehman Brothers environment and the prospect of further substantial value falls over the next 12 months. It is still too early to know with certainty how this will affect institutional investors' demand for real estate and appetite for risk, but increasing use of de-risking techniques, particularly among pension funds, is likely to have an impact.
Recent years have seen an increase in the use of de-risking within pension and life fund portfolios. As a result, liability-driven investment has become much more widely used and synonymous with sensible investing. In part, increased market volatility and a change in the regulatory environment have encouraged companies to seek greater stability in their pension schemes and made them less inclined to try to ride out the fluctuations that result from an aggressive investment strategy. At the current time, when most schemes are substantially underfunded, de-risking seeks to ensure that deficits do not widen further.
The technique has focused on three unrewarded or under-rewarded risks - namely inflation risk, interest rate risk and longevity risk - and is achieved principally through swap-based hedging strategies. In theory, these risks can be reduced without compromising expected returns. In reducing unrewarded or under-rewarded risk, pension schemes can use their risk budget more efficiently to enhance the expected return on their assets.
More efficient use of the risk budget is a key objective of under-funded pension schemes in an environment in which very few sponsors are willing and/or able to increase their contributions to schemes. It also provides schemes with the objective of narrowing the gap between the present value of scheme assets and liabilities. It is against this background that pension fund trustees, advised by consultants, are increasingly choosing to allocate a proportion of assets, usually between 5% and 10%, to an "opportunity pot".
This capital is being set aside for attractive investment opportunities emerging from the current market dislocation, particularly in alternatives such as high-yield credit and secondary units in private equity vehicles. Today, these assets carry an exceptionally high risk premium, and while this reflects a greater risk of default in the underlying investments, it also reflects the increased compensation investors require for the current lack of liquidity in these instruments. To the extent that pension funds are longer-term investors, they are able to withstand the liquidity risk and capitalise on the opportunity that distress presents.
A recent survey of 650 UK defined benefit pension schemes conducted by Mercer supports these trends. It reports that schemes are reacting to the current crisis and continue to reduce risk with an acceleration away from equities to bonds (corporate bonds in particular). The survey also showed that larger schemes continued to increase their exposure to alternatives (defined here to include real estate and private equity).
It is still too early to anticipate where investors' preferences, vis-à-vis real estate, might lie once the correction in market pricing abates. At present many investors are spending most of their time and energy managing issues in existing portfolios (both in real estate and other asset classes) rather than allocating new capital. The trend towards de-risking, however, is one factor that might contribute to a polarisation in pension fund appetite between low-risk beta products and higher-risk alpha products.
While it is difficult to generalise, investments in the first group might include funds with relatively secure income streams and low (or no) gearing, or direct investment in less management-intensive sectors and in more liquid and transparent markets.
A stronger preference for prime over secondary quality assets, and for balanced over specialist funds, may also emerge. Some of these preferences are already observable: investor interest in geared products, in particular, has fallen very significantly and this is having an impact on current funds (as witnessed in their attempts to reduce gearing) and in future product design.
As the cyclical trough in real estate capital values approaches (expected to be within the next 12-24 months, depending on the market) prospective returns from low beta strategies will look appealing relative to long-term sustainable returns, driven by a high income return and yield compression, as tenant default risk and the liquidity premium that investors require normalise.
Other pension fund investors are likely to recognise the current period as one in which there is an unprecedented opportunity to buy risk in the real estate sector and will seek to use part of their opportunity pot to do so.
Funds that look to achieve a high level of alpha through stock selection, intensive asset management and financial engineering are likely to be more appealing to this investor group. With the bottom of the capital value approaching, these investors recognise this is precisely the point in the cycle when gearing is likely to be most effective. Commitments to blind opportunity funds, secondary units in well managed existing geared funds, or the provision of equity, preferred equity or convertible debt to funds, or assets in need of recapitalisation and investments into emerging markets and sectors, would fall into this category.
The ability to capitalise on distress and the very high current liquidity premium, combined with the use of gearing at the optimal point in the cycle should, among other things, provide investors willing and able to take this route with attractive risk-adjusted returns. The risks around strategies of this type remain elevated currently, and robust due diligence will be a key driver of success.
Polarisation in pension fund appetite between low-risk beta products and higher-risk alpha products, however, will probably result in a thinning of the product offering aimed at satisfying the middle ground. Of course, there will still be room for traditional value-add-type products. The investment offering, however, will need to be more compelling than has been the case in recent years as investors become considerably more discriminating in an environment where capital is much less abundant.
Against this background, innovative or niche products that offer unusual or unique investment characteristics (for example, strategies supporting socially/environmentally responsible investing, infrastructure-related investment and products with long-term inflation-linked income streams) should do relatively well.