Home or away?

Continental Europe is the obvious next step for UK pension funds keen to diversify their domestic-based portfolios. But, as Richard Lowe discovers, its deteriorating outlook has strengthened the case for ‘going global' while many are seeking opportunities at home

In many ways pension funds in the UK have been blessed with having one of the most efficient, transparent and mature real estate markets in the world on their doorstep. It is therefore  understandable that the country's largest institutions have built up substantial direct portfolios in the UK, especially given the years of unbroken rental growth and capital appreciation.

Unfortunately, this benign situation could not be sustained for ever and by 2006 UK consultants were advising their clients to look across the English Channel to diversify amid signs tha the UK property cycle was looking ripe for a shift and yields were becoming too compressed. Consequently, one of the strongest themes in recent years has been the growing number of UK pension funds investing indirectly in European real estate.

Today, however, the picture is much less clear. A number of factors have combined to complicate the situation: dramatic repricing and yields moving out in the UK; the unattractiveness of continental Europe relative to other major global markets fuelled by a sharp economic downturn; the proliferation of products enabling pension funds to access markets in Asia Pacific - another key diversification route. New pan-European mandates are still coming through but many pension funds are looking back at their home market for opportunities, while for others the negative outlook for Europe has strengthened the case for going global.

If you want to know what is at present topping the real estate agendas of UK pension schemes, the Property Working Group of the National Association of Pension Funds (NAPF) is a good place to start. The group meets periodically throughout the year and includes members of large pension funds, consultants and asset managers.

"The focus of what they have been talking about has been around trying to find realistic valuations in the current climate of UK property," says David McCourt, policy advisor for investment and governance at the NAPF. "So the focus has been firmly on the situation at home at the moment."

Consultancy firm Hewitt Associates is certainly talking to its pension fund clients about the UK as an opportunity today, which is in contrast to the broader theme of its advice over the past three years.

"We had advised clients to stop investing new funds into the UK market in early 2006, and focused on investment principally in continental Europe," says Richard Cooper, property specialist at Hewitt. "However, we are holding off advising new investment into continental Europe as the credit crunch is predictably weakening values and there are increasing uncertainties over rental growth prospects."

He continues: "Our most recent instructions have been focused on the UK… Our focus has returned to the UK market where the price correction is creating a far wider range of opportunities."

The Universities Superannuation Scheme (USS), one of the largest pension funds in the UK, with some £30bn (€38bn) under management, has spent recent years building up its continental property exposure so that today it is approaching 10% of the overall real estate portfolio (including some modest commitments to pan-Asian funds), with the balance invested in the UK.

Between the end of 2006 and October 2007, USS sold close to a third of its UK portfolio, amounting to approximately £900m of assets. "I wanted to reduce our retail weighting and we were also concerned about UK pricing," says Graham Burnett, head of property at USS. "I felt the market was conducive at the time to reduce that exposure and take advantage of what has proven to be quite an exuberant market, looking back. We got out just in the nick of time really, particularly the larger lot sizes."

For example, Burnett reckons that the mid-2007 transaction whereby USS sold its shopping centre in Telford to a joint venture between Apollo Real Estate and Hark Group for £442m would not have been possible in today's market environment.

During the period 2006-07 USS was not only selling UK real estate - it purchased two office buildings; developed its flagship shopping centre scheme with Grosvenor, the Grand Arcade in Cambridge; invested in alternative sector funds, such as Unite and Quercus; and acquired Eden Walk shopping centre in Kingston-upon-Thames for £80m.
But overall it was a net seller of UK property. "We were also growing in confidence with Europe in terms of the investments we were making," Burnett says.

Those investments included commitments to sector-focused funds, as well as a joint venture with First Property targeting on central and eastern Europe. But now the pension fund is seeing great potential for new investment opportunities in its home market, not least from distressed situations that might well emerge. And it is in a very good position to capitalise on this, still being cash-rich and below its target property weighting.
"We are in a good place, because our current weighting in property is under 6% with a benchmark of 10%," Burnett says. "On that basis, we have a significant amount of firepower to re-enter the UK market."

But getting the timing right is of paramount importance and USS will not be rushing. "We will make some commitments shortly but these will be reasonably defensive, targeting those areas we feel comfortable with," he says. "The issue is timing. It is quite clear the market is pretty challenging at the moment. From an occupier and investment standpoint it is quite difficult to read. But it is certainly moving one way at the moment and, of course, I want to time our re-entry as well as possible."

Greater Manchester Pension Fund (GMPF) invests only in UK real estate and is similarly biding its time on new investments, having made no acquisitions or disposals in the past 12 months. "In terms of the market, we are sitting on our hands," says Bob Thynne, property surveyor at GMPF. "The advice we have is that we are not at the bottom of the cycle and as a consequence now is not the time to invest or, in some respects, to put property on the market for sale, because you are unlikely to get fair value."

There are still many UK pension funds maintaining UK-only investment portfolios. Contrary to what might be expected, this is not necessarily symptomatic of smaller pension schemes with more modest resources but is often applicable to larger institutions that have heavy direct ‘anchor' portfolios.

"The perversity of real estate has been that a lot of the larger schemes were the only ones capable of establishing large, meaningful direct real estate allocations," explains Steven Grahame, senior investment consultant at Watson Wyatt. "In many ways, it is some of the smaller and medium-sized schemes that are in a position to invest in funds internationally. Because the larger schemes established large real estate portfolios, they have bigger anchors."

Grahame describes such pension funds as the "super tankers", explaining how they "take a longer time to move" and thus for them moving away from a heavy exposure to the UK can entail a gradual process.

USS, with its £30bn or so of assets under management is certainly a sizeable vessel, and it has so far made what Burnett calls "modest commitments" in Asia Pacific - namely investing in two opportunistic pan-Asia vehicles. "We are relatively new to this," he says, describing the pension fund's initial foray into the region as "baby steps".
That said, the current global market environment has played its part in the speed of these developments. "What has happened over the last 12 months has increased our cautious stance," Burnett says. "I do expect we will be making further commitments overseas, but we are happy to sit back at the moment and focus back on the UK."

However, a number of local authority pension funds are daring to target a ‘global' real estate portfolio - albeit outsourced to an external manager on a discretionary basis - even if they have hitherto invested within the British Isles. UK consultancy Mercer confirms that most new mandates in recent times have been targeting pan-European investments, as opposed to UK-only, as might have been the case in the past.
"Activity has been relatively light," says Greg Wright, principal at Mercer. "We have still had some continuing interest in setting up new mandates, although they have tended to be more European in nature than they were in the past."

But a number of local authority pension schemes have tendered for global mandates in recent months. For example, the £1.49bn Berkshire Pension Fund is looking for a manager to run a £70m global property portfolio. The pension fund already has continental European exposure and this will be "rolled into the global mandate", explains pension fund manager Nick Green, potentially rendering the overall property portfolio 60% domestic and 40% global.

More surprising are those pension funds that are moving from a zero real estate exposure to what could be a global one. The £1.2bn North Yorkshire Pension Fund and the £2.2bn Avon Pension Fund are two examples. The latter has been without an exposure to direct or non-listed real estate since it liquidated its small direct UK portfolio in 2000. Earlier this year it revealed that it intended to create two segregated multi-manager real estate mandates, one UK and one global, each to represent 5% of total assets under management.

"The overseas mandate is intended to be genuinely global, including the three main regions of Europe, Asia and the United States," says Tony Worth, who retired last month as investments officer at Avon. "The manager would, however, have a degree of discretion regarding the timing and weighting of investments in each region."
Schroder Property has already been appointed to manage the UK portfolio but the decisions over the global mandate are taking more time.

"The committee has asked for more information on the tax implications of overseas investments before making an appointment," Worth says. "The chief challenges are the administrative work involved in setting up the management arrangements for each portfolio and then establishing how much work - tax and legal - we will be required to do on an ongoing basis."Wright expects the global mandate to be "the next big theme to come". However, he also believes the marketplace might be three to five years away from offering the right solutions for pension funds, particularly where onerous tax issues in the US - as alluded to by Worth - are concerned.

"The problem we have had is trying to find a way of doing it that really works," he explains. "If you are going global you are really looking at a predominantly indirect solution. Trying to find ways to gain exposure to US unlisted funds has proven to be the real problem area - there are all sorts of tax issues that seem to be very difficult to resolve and therefore you probably wouldn't want to go into US investments unless you had found a way of doing that. Hence, most of the money is tending to be going to Europe and Asia, with the US to come in when that has been sorted out. So we are still a little bit away from genuinely global mandates on product grounds as much as anything else."

ING Real Estate claims it has resolved these issues with its global fund of funds product, Global Osiris Property Fund, for which the London Pension Fund Authority (LPFA) has acted as seed investor, committing £150m.

"The complexity of tax for direct property is much more complicated than it is to invest in shares globally," says Vanessa James, investment director at LPFA. "One of the reasons we chose this vehicle is because of that."

Wright expects that Mercer will be "encouraging clients to go completely global in nature" in the future. "It is one of these examples of where pension funds can only really go as fast as the products available," he says. "In three to five years' time we will, I expect, be looking at predominantly global solutions for most clients."