Investors are cautiously increasing their allocations to property, but only in prime properties in good locations and in core markets. Christine Senior looks at the latest trends

Risk aversion is a key driver of institutional real estate investment strategies for 2010. And risk aversion is manifesting itself in different ways. Investors may be pulling back their interest to home markets where they feel more comfortable, shunning the more value added and opportunistic funds which have been ravaged by the effect of the economic crisis, or showing a greater appetite for quality properties in good locations with long leases and blue chip tenants. Anything verging on development properties in emerging markets saddled with high levels of debt is likely to be avoided.

The reduction in the risk appetite is evident from INREV's survey of investment intentions for the year, which showed 70% of investors now favour a core style fund compared with 38% in its survey a year earlier. At the opposite end of the spectrum interest in opportunity funds declined by 34% to just 3%.

A year ago the ‘denominator effect' was a big talking point. The steep falls in the value of equities in investors' portfolios meant the value of real estate holdings, with their less frequent valuations, rose as a consequence, so investors became, by default, overweight in their real estate allocations. To remedy this they had to consider selling off property in a depressed market. But this year the spectacular rises in equity markets mean the denominator effect has worked its way out, although to a degree it may still be evident in some European markets.

By contrast, equity market gains in portfolios may have squeezed real estate weightings, driving increased interest in the asset class from investors intent on returning to their target allocations.

Generally, managers are reporting greater interest in real estate as an asset class, although always with the caveat that the focus is on the core, less risky investments. A back-to-basics approach is gaining ground, with the quality of assets uppermost in investors' concerns.

"I would say in future all investors will want to make sure they are buying a property which is in good physical condition, in a good location and which has very good tenants on long-term leases," says Alessandro Bronda, head of global investment strategy at Aberdeen Property Investors. "We think secondary property will probably suffer in future also because financing will be more difficult to obtain and obviously a prime building is more likely to get good financing on good conditions compared to a building that is not fully let or in a bad location."

The evolution of the property market over the last year has provided conditions to tempt back investors. In western Europe and particularly in the UK, repricing has made the asset class attractive.

"If you look at properties that are trading, they tend to be prime assets in global gateway cities, with London being the poster child for that activity," says Allen Smith, CEO of Pramerica Real Estate Investors. "Actual transaction volume is relatively small. There is a healthy amount of capital that is focused on prime assets in London. As a result, yields have compressed extraordinarily quickly. People are buying for long-term cash flow-generating capability. A lot of people view this as cyclically a good point of entry for buying core assets."

Another factor in property's favour is the role it can take in a portfolio as an inflation hedge. "A lot of institutions are becoming more worried about inflation," says Bronda. "Once the economic recovery gains momentum, inflation is likely to pick up. Property is a good long-term inflation hedge and for that reason I think there might be an additional amount of capital to be allocated by institutions to real estate."

But real estate is also, to some degree, benefiting from the disruption that has afflicted other asset classes. Spared the volatility of equities, it offers stability in the face of uncertainty elsewhere. The asset class is benefiting from the simple fact that it is not equities or bonds. The rationale for investing is that real estate is attractive by default, according to Mike Cutteridge head of UK capital markets at DTZ.

"Real estate is coming to the top of asset allocators' list for the fact it is a safer haven or higher yielding haven than others, higher yielding than cash, safer than equities, more interesting, just, than bonds. It's the least worst option. We get to real estate by default, rather than by it being a strong driver of value - we are not exactly expecting masses of rental growth or growth generally."

Cutteridge believes investors are increasing allocations where they already invest, or thinking of coming in for the first time. He cites a couple of smaller funds that have previously accessed property through listed securities or property unit trusts now considering moving up a stage to direct investment or through indirect unlisted funds.
But this increasing interest in real estate doesn't seem to have reached the Netherlands yet. Jelle Koolstra, a principal with Mercer's investment consultancy there, has not seen any noticeable rise in allocations.

"Most people feel, especially in the unlisted investments, there are still going to be some write-downs," he says. "Some investors may wait for that to happen, and then they will increase their allocation but, as far as I can see, they are very reluctant to do so."

Recent surveys have confirmed a rising interest in real estate. Fidelity Real Estate Investment Management reported that strong performance from equity markets had allowed institutional investors to allocate more cash to property. Matthew Richardson, head of research at FREIM, picked out industrials as the likely strongest performing sector in 2010, and retail as the weakest, with the UK, France, Germany, Benelux and the Nordics as favoured investment locations.

Bfinance's survey published in January on investor intentions shows institutional investors were intending to diversify into alternatives, with property the main beneficiary. Over a quarter of the 63 investors (60% of which were European, the rest North American) planned to increase their target allocation to property over the next six months.

"Clients had talked about increasing allocation to property before the crisis," says Vikram Aggarwal, senior associate, research and development at Bfinance. "But plans were put on hold during the downturn and it seems those plans are being renewed now. It was a trend that started pre-crisis and is being revitalised."

Bigger institutional investors have lost any fondness for investing via funds, according to Kiran Patel, global head of research strategy and business development at AXA Real Estate. They are increasingly demanding more direct involvement in real estate investments, and are loath to cede control to anyone else, perhaps as a result of getting burnt from investment in smaller investment boutiques that have struggled.

"Bigger investors say they don't need to be in a fund, they want much more control of property decisions," says Patel. "They may give a separate account with some delegated authority but not full discretion. They want to sit beside managers in a co-investment deal. They are happy to put in 70% or 80% of the money up but want 20% from the manager."

Partnerships, joint ventures, club style deals involving half a dozen investors joining forces to pool resources are also on the up. Investors want to be sure their own interests and their co-investors' interests are aligned.

"If you are too small to do it yourself you can get a couple of like-minded people together, therefore you have control over what you want the funds to do, whereas in a big pooled vehicle you don't," says Douglas Crawshaw, senior investment consultant at Towers Watson. "You can do something normally you wouldn't be able to do because you aren't big enough."

The INREV survey also highlighted this demand for more investor involvement and the rise in club style deals. Nearly 80% of investors prefer high level investor involvement, and arrangements involving a small number of investors - between two and five are popular.

"People are looking to get closer to the fund manager," says Lonneke Löwik, director of research and market information at INREV. "There has been a problem with trust. In a joint venture you are close to the fund manager, but also you know who your other investors are. Some investors feel they need to know who is on board with them in a fund."

For UK pension funds the focus has been the domestic property market. Richard Cooper, a consultant at Hewitt Associates in the UK, has seen increased activity, particularly during the latter half of last year. A lot of manager selections were executed in the second half of 2009, he says.

"The UK was offering better value on long-term assumptions based on the analysis we do here," he says. "The UK was more attractively priced than other markets like the US and continental Europe, because it was clearly generally further advanced in the correction cycle. We anticipated there would be a sharp bounce back but I don't think we anticipated it would be as sharp as it has been. Naturally it takes a while to implement some decisions. We're pleased a lot of clients got in quickly."

For means of access to real estate investments, the choice of vehicle depends on the size of the allocation and the governance resources the pension fund can call on.

"Principally for smaller allocations it has been balanced open-ended property funds," says Cooper. "Clients with slightly larger allocations are looking at having closed-ended recovery or opportunity funds as a satellite holding to the balanced fund. Given the recovery that has already taken place in the UK market, we are now focused on opportunity funds in the closed-ended fund universe. For larger funds the solution is to hold property directly in a segregated portfolio."

The retreat to domestic markets is a possible explanation of INREV's findings that single country funds have been particularly in demand. The figures show investor interest rose by 25 percentage points over 2009. This seems odd in a climate where less risky assets are preferred.

Löwik comments: "If people wanted to avoid risky products you would think they would rather go to multi-country funds. But I think people are pulling back from investment abroad and they are going back to the domestic market. That might be the reason behind the single country funds."

Another possible explanation is that single country funds through their managers' specific expertise and more focused approach have outperformed the more generalist funds, thus finding favour with investors.

Those countries which have been ahead in the cycle by repricing early have benefited from investor plans for new allocations. Here the UK is clearly in the ascendancy. With price falls from peak to trough of more than 40% in commercial property, the feeling is that UK property now looks good value. And for foreign investors the UK benefits from currency advantages.

For tactical reasons foreign investors are looking at the UK, says Cutteridge. "The UK is quite popular because of currency as well, and tends to have longer leases than Europe. The economic position and likely level of GDP growth are lower than elsewhere, but that is being outweighed by currency, repricing and value."

Western European countries are regarded as having repriced or being not far from repricing to fair value. Cutteridge says Paris and some sub markets in Germany are attracting attention, while the Nordic countries are regarded as safer, steady locations having suffered less from the financial dramas elsewhere. But eastern Europe in the main is getting a wide berth, still suffering the ravages of the crisis.

"With the exception of Poland, eastern Europe - and that would include Russia - is only for opportunistic investors. People think they can find better value in other places," says Cutteridge.

And some of the regions where better value is to be had may mean skipping Eastern Europe and looking further afield.

"I think the question a lot of investors are now thinking about is: is it better to hop over eastern Europe and head straight to Asia, particularly as we see the economic story in places like China and India?" says Justin O'Connor, CEO of Cordea Savills. "It must be far more attractive to think about allocating money to Asia and such economies longer term, looking at the growth compared to the eastern European economies."