British funds to set sail?
As pension funds in the UK put more resources into property investments, Rachel Fixsen finds they are increasingly looking to broaden their horizons.
For defined benefit pension schemes, rental income streams are arguably a natural match for liabilities and the asset class offers diversification from equities and bonds. The inflation-link that property can offer makes it a target for pension funds, whatever their benefit structure.
The collapse of bond yields since the beginning of 2011 has motivated pension funds to hold property, with cap rates easily outpacing Gilts and even corporate bonds. Increasingly, pension funds are fine-tuning their allocations to gain exposure to particular geographies, sectors and investment types.
In December, the Kent County Council Superannuation Fund increased its allocation to property by placing two £30m (€36.7m) commitments in two property funds: Fidelity’s UK Real Estate Fund and the Kames UK Active Value Property Unit Trust. The pension funds already had a £316m portfolio run by DTZ Investment Management, and the new investment almost enabled it to reach its target allocation of 10%.
The National Employment Savings Trust (NEST) has decided to allocate a fifth of its assets to real assets, of which a significant portion will represent real estate, in a bid to achieve above-inflation returns. Last year, it mandated Legal & General Investment Management to invest in UK property as well as a global real estate investment trust (REIT) strategy.
The Strathclyde Pension Fund is still building up its property exposure, aiming for a weighting of 12.5% of total assets. Its latest strategy review increased the target allocation from 12%, at the expense of the equities allocation, which was reduced by 0.5%. At the end of March 2013, the pension fund’s property investment was still some way below the target at 7.6% of total assets. The Strathclyde Pension fund has property worth a total of around £1.17bn compared with its total fund value of about £13.5bn.
Richard McIndoe, head of pensions at Strathclyde, says the fund has a well-established UK property portfolio and has, more recently, built up a global portfolio. “Both the UK and global portfolio managers continue to invest selectively for the fund to build their portfolios towards their target weights,” he says. “Our UK portfolio was created in the late 1980s and is currently managed by DTZ Investment Management.”
The portfolio is made up of some 50 proper- ties worth around £950m. The properties are spread across the main sectors of office, industrial and retail, together with some leisure. The holdings are spread throughout the UK, although there is some concentration in London and the South East.
Strathclyde’s global strategy, however, was started more recently. Since its outset in 2010, it has grown into a portfolio worth approximately £225m. It is managed by Partners Group and comprises investments in regional and global property funds.
Last autumn, the London Borough of Ealing pension fund added real estate as a new asset class to its portfolio by putting out three mandates totalling £80m, or 10% of the scheme’s £800m of assets. The aim was to achieve diversification and longer-term inflation protection, it said.
The three managers were Lothbury Property Trust, taking 40% of the total investment, and Standard Life Investments and the Hermes Property Unit Trust, which were given 30% each.
The Transport for London pension fund has set itself a target allocation to property of 2.5-3% of the fund, to be divided between listed and private investments, with the listed portion held more opportunistically. The pension fund has been building up the allocation over the last two years, and said it will continue finding new investments this year as well.
Other pension funds are staying put at current allocation levels. The West Midlands Pension Fund, for example, has an allocation of 8.6% to property which at the end of its last financial year was £838m in absolute terms. The exposure is through 22 property funds, and diversified globally by region and sector.
West Midlands says that as a return-seeking fund with a long-term horizon and the ability to invest in illiquid asset classes, property has been and will remain an important asset class. But it is satisfied with the allocation level of around 9% and does not expect this to change in the foreseeable future, a spokesman says.
Out of the comfort zone
“We sense money is going to direct real estate rather than to listed funds,” says Simon Hedger, managing director and global portfolio manager for property securities at Principal Global Investors. Younger pension funds are more willing to invest in listed real estate, he says, whereas the longer-established UK pension funds tend to be biased towards direct property holdings.
While there may be a cultural aspect to these preferences, Hedger says pension funds that already have an in-house team to manage property and have the established capability to do so, are less likely to pay the fees involved in external management. “Global listed real estate is increasing in terms of its profile,” Hedger says. “Pension funds would be more aware of it now, but they’re slow to take it up.”
Principal Global Investors views the asset class as a long-term game. “Over time they will come to view the sector as an alternative to direct real estate,” Hedger says.
Mark Meiklejon, investment director of real estate at Standard Life Investments says property as an asset class is now satisfying a wider range of needs for UK investors than was the case before.
Not only is it being used for traditional income-focused returns and long-term inflation protection, but it is also used to provide capital growth strategies for investors looking to benefit from an improving global economy. “We have seen demand increase across the risk spectrum in recent quarters and a move into growth-oriented strategies,” he says. At the same time, demand is still strong for traditional beta-type open-ended funds or high lease-to-value strategies, Meiklejon says.
“It’s more difficult now to consider property as just property. Things have become much more granular.”
One of the key themes in real estate investment for UK pension funds is adding inflation- linked income streams, according to Paul Jayasingha, global head of real estate at Towers Watson. “UK institutions have found they can take on some liquidity risk and get higher returns than they can from bonds for a similar expected cash-flow profile,” he says.
Buying supermarkets, for example, and leasing them back to large retailers such as Tesco has become a popular strategy for pension funds, he says. The approach typically yields inflation plus two percentage points on a 25-year lease — providing not only contractual index-linked cash flows, but also the security of owning bricks and mortar should the retailer go bust, according to Jayasingha.
“But appetite is reducing a little as pricing becomes an issue in those strategies,” he adds. “The yield relative to bond yields is smaller than it was two or three years ago.”
This has, in turn, encouraged investors to diversify their property holdings globally, resisting the natural and historic attraction of their domestic property market. “We have seen an increased willingness to consider Asian real estate strategies,” Jayasingha says.
The Pension Protection Fund (PPF) has been making moves to increase the geographical diversification in its property portfolio (‘Lifeboat fund takes opportunistic approach’). The £39.6bn BT Pension Scheme, mean- while, has been undertaking deals recently to help increase its international diversification by freeing up capital from UK-based real estate holdings. At the beginning of this year, it signed an agreement with AustralianSuper, whereby the Australian fund took a 50% stake in a £270m shopping centre in Milton Keynes from the BT scheme. In the summer of 2013, the scheme had halved its stake in a portfolio of eight London office buildings, selling the interest to Canada Pension Plan Investment Board for £174m.
Hermes Real Estate, which manages the BT Pension Scheme’s property investments, says the most important matters in property investment now are sustainability, the cyclicality of the asset class and its liquidity.
Chris Taylor, chief executive of the property investment manager, says: “Sustainability is a key issue. We are also conscious that real estate is an inherently cyclical asset class and therefore seek to anticipate cycles. Liquidity is important and our investment approach is very much occupier-driven as it is the income component of the total return which we are most attracted to as an investor.”
Jayasingha says pension funds are increasingly willing to consider real estate debt as an investment, rather than property itself. The opportunities have arisen as a result of banks deleveraging following the global banking crisis. Banks, which typically undertook 95% of commercial real estate lending in Europe, are retrenching, leaving the market open for other potential lenders.
Hermes Real Estate is interested in real estate debt as an opportunity, Taylor says. The bank deleveraging being seen in Western economies could offer attractive risk-adjusted returns, he says, “particularly where we are able to deploy our proven real estate underwriting skills in assessing the underlying real estate risk”.
At the end of last year, property investment firm GreenOak had raised £138m from 10 UK pension funds for a fund to invest in senior debt secured against non-core property in the UK.
“It’s more difficult now to consider property as just property,” says Jayasingha. “Things have become much more granular.” Yields for different categories of property investment now diverge widely. A return-seeking global real estate strategy, for example, can target annual returns of 10-14%, while European senior real estate debt yields 4-5% and inflation-linked income strategies can target 2-2.5 percentage points above inflation, Jayasingha says.
“Before the financial crisis, the approach might have been to target a property allocation of, say, 5%, but now the conversation is about what kind of return is important to you,” he says. “Things have become much more solutions-led.”
‘Lifeboat’ fund takes opportunistic approach
The Pension Protection Fund (PPF) has been diversifying in its real estate investments. The statutory scheme, established in 2005, has been hiring new managers to oversee fund investments in Europe, Asia-Pacific and US.
The PPF, which had total assets worth £14.86bn at the end of March 2013, has a target for alternatives of 20%, which includes property — an allocation that has now been met, says Barry Kenneth, the PPF’s CIO. Of that allocation, 5.25% is in global property.
“Now we can be a bit more targeted in terms of where we put the money”
“In the last couple of years, its been constant in terms of our allocation to the asset, but as we grow its always a challenge to keep with up that allocation,” he says. “But whether or not we grew, we would always be looking at different opportunities in the market.”
The PPF – unofficially dubbed the UK’s lifeboat scheme – is designed to protect members of corporate pension schemes that are put in danger by sponsor bankruptcy. The pension assets under its care can change significantly over short periods of time, and this has meant its real estate strategy also differs to those of most UK pension funds.
“When we take on new schemes, we just need to deploy; we can be a lot more opportunistic in the way we deploy capital,” Kenneth says. When the PPF takes on new managers, it wants to ensure they are able to deploy capital in areas where there are opportunities at the time.
“There might be more of an opportunity in southern Europe, given the hit to property values there as a result of the financial crisis.
Kenneth says that the PPF is now able to be more specific about the real estate investments it picks than it was at an earlier stage of the fund’s evolution. “We are constantly challenging ourselves to invest in the right way, for stable returns,” he says. “Now we can be a bit more targeted in terms of where we put the money.” This is partly because of the experience the PPF has gained and the result of having tested how it deploys money, he says.