Investor Forum: Cycle protection

With real estate prices and capital markets at a cyclical high, risk management is pertinent. Rachel Fixsen speaks to six investors and advisers 

Finding assets that offer fundamental long-term growth is a key to limiting risk in real estate investment, according to Anne Breen, head of real estate research and strategy at Standard Life Investments.

“For the funds we have that are only mandated to invest in the UK, regardless of where we are in the cycle, we are always looking at those markets where there are fundamental growth prospects,” she says.

In Europe, on the other hand, there are opportunities to gain access to assets that are higher yielding but where the growth prospects are not yet priced in. “Where we see most opportunities in Europe is in strong locations, where there are fundamentally strong indicators but where the asset may require capital expenditure,” says Breen.

Standard Life Investments has been focused on measuring risk in real estate, she says, doing much work in particular on the risk of investing across multiple jurisdictions. “It means that if we are investing on behalf of our client in a number of markets, we have a better ability to price the risk,” she says.

Breen notes the weight of capital looking to invest in real estate, and the subsequent risk of being drawn into secondary assets.

“In previous cycles, we’ve seen that capital inflows can result in yield compression in secondary assets, which might perform for a while, but what we’re looking at is the fundamentals because that is what will perform over the long term,” she says.

Major risks for real estate investors are recessions and global macro shocks, Breen says. “The other risk, further through the cycle, is that capital chasing property might go into building stock rather than buying stock,” she says, adding that this is more of a medium-term risk.

“Risk is always perceived as somewhat of a negative, but real estate development is a function of the economy, and it’s important to have some exposure to that growth and not lock down all the growth.”

Three years ago, the School Employees Retirement System of Ohio (SERS) took steps within its real estate portfolio to address risk management, says Nancy Turner, senior investment officer for real estate.

“The steps included clearly defining the role of the asset class within the total fund and establishing investment-implementation guidelines to achieve the role,” she says.

The primary role of Ohio SERS’s real estate portfolio was defined as providing a stable income return from tangible assets.

“The role guides portfolio construction and reduces the risk of constructing a real estate portfolio that is out of line with what it is expected to do for SERS, [which is to] provide current cash yields that are used for retiree benefits,” Turner says.

“While defining the role seems simple, it really is the highest level of risk management and drives all implementation decisions.”

The implementation guidelines were developed to control measurable risks in the property portfolio, including strategy allocations and property type exposure relative to the NCREIF Property index.

“SERS has systems and reporting that can measure and track these specific risks quarterly,” she says.

The main risk in real estate investment now, he says, is pricing. The fact that capitalisation rates are below 5% spurs investors to reach further out on the risk spectrum.  

But Ohio SERS’s implementation guidelines will help control that desire, he says. “We are slowing the commitment pace and making sure our managers are performing rigorous hold-sell analysis,” she says.

The real assets portfolio consists of a core portfolio, which has elements of stability and downside protection, and a non-core portfolio, which is more total-return orientated.

“In addition, to avoid some of the temptation to go for higher returns while taking on more risk, Ohio SERS has an opportunistic portfolio that is designed to include investments going through short to medium-term dislocation or market opportunities,” Turner says.

Varma Mutual Pension Insurance Company is targeting particular segments of the real estate market to manage its risk levels at a time when so much institutional money is being directed into property.

“We like to focus on assets in more liquid markets where volatility in yields is lower than it is in some secondary or tertiary properties, or locations and assets where we can see some rental growth happening,” says Ilkka Tomperi, Varma’s investment director, real estate.

“We are not investing into the most prime and dry properties but prefer multi-tenanted assets with some value-add angle through active management.”

Style drift within underlying investments is one of the main risks in real estate investment at the moment, he says. Investors may opt to buy core-like assets at core pricing, but these assets are likely to be hit significantly when risk is re-priced, he says. 

“Additionally, the increasing loan-to-values in new investments will ultimately lead to higher volatility in equity returns as we have learnt during the financial crisis,” Tomperi says.

To keep risks in check, Varma is trying to avoid excessive use of debt, and is targeting value-add investments with solid cash flow. “Focusing on appropriate downside protection is always healthy,” he says. “This means, for example, sensitivity analysis supporting the underwriting of deals.”

Tomperi says that diversification over time can help the overall performance of the portfolio. “Since the European interest-rate environment is likely to remain quite supportive of real estate as an asset class, stepping completely out from the game and moving to the sidelines is not really an option.”

Looking at risk in general, Tomperi says taking the overall mega-trends into account is never likely to be the wrong thing to do. “These might include the global wave of urbanisation, digitalisation and demographic changes, for example,” he says. “As well as this, there are themes such as the growth in online shopping which are already noticeable.”

Increasingly, investors need to be aware of political risks in developed countries as well as emerging markets, he says.

It is important to recognise that risk is asymmetrical, with both upsides and downsides, says James Maydew, deputy head of global listed real estate at AMP Capital.

AMP Capital, which is part of the AMP Group, Australia’s pension provider, analyses more than 60 factors when it researches global property stocks – including property, management and balance sheet — and then adds these up to give the stocks a positive and a negative risk score.

But overall, Maydew sees real estate valuations as robust right now, and appearing to offer good value compared with fixed income and the broader equity markets, despite the volume of investment coming into the sector.

“Given demand for inflation-linked income, returns are likely to be a constant feature for the foreseeable future, allocations to real estate will continue to grow due to its inflation-hedged, contractual rent collection model,” he says.

“We therefore feel this demand is warranted and, importantly, sustainable, especially given that many global pension funds and sovereign wealth funds are well short of the 10-15% allocation to real estate that they are increasingly building towards to truly deliver their clients’ risk-adjusted return requirements.

“We feel there is a large arbitrage between the direct and listed real estate market and given the scarcity value of direct assets this will see the valuation gap close as M&A expands in the listed market as people embrace the liquid proxy for direct assets that listed real estate truly is.”

Even though there may be volatility in REIT stock prices as the market adjusts for rising central bank rates in the US and UK, Maydew argues that the bigger economic picture will be positive for the sector.

“We are seeing a gradual recovery in developed-world growth, real estate returns are ultimately a second derivative of this growth, so we are at the momentum point of the cycle where landlords are in a position to push rents higher,” he says.

“Ultimately, the market will realise that rising rates is a reflection on economic improvement, which ultimately drives every aspect of real estate demand.”

Regardless of the asset class, pension funds are well advised to rein in temptations to make frequent changes in reaction to the latest market views, according to Kate Mijakowska, vice-president, manager research at consultancy Redington.

“Our client base consists primarily of defined benefit pension schemes, which are long-term investors with long-term objectives,” she says. “Our policy is not to react to short-term market phenomena.

“Instead, we focus on the strategic asset allocation, which is driven by long-term expected returns. Therefore, we don’t currently advise our clients to shift in or out of real estate.”

While this may be a general principle that pension funds would do well to apply to different asset classes, Mijakowska notes that real estate, in particular, is a very expensive asset class to trade. 

“A round-trip is around 7%, and therefore we don’t see value in coming in and out frequently,” she says.

Looking at the current situation with a more philosophical eye, she says that, while property is believed to be expensive right now relative to its historical levels, prices should be seen in context.

“The reality is that most asset classes are expensive at the moment and, relative to other asset classes, real estate actually looks reasonably well priced,” she says.

“The advice I would give to pension fund investors in the current environment is that they should monitor their property investment managers closely and make sure they remain disciplined in their risk management processes.”

For example, Redington has observed an increase in appetite for development in core UK property funds. “I think pension fund investors should be asking to what extent these developments are speculative,” Mijakowska cautions.

Managing risk is not specific to any one point in the market cycle, says Martin Towns, head of the asset manager’s separate accounts and partnerships business. “The principal ways in which we manage risk, at a strategic as opposed to operational level, come under the headings of: concept of long-run fair value; portfolio construction and the power of income; and leverage,” he says.

Under the first, Towns says it is important to have a consistent view on the return you need from an asset class – above both the prevailing and long-term anticipated risk-free rates. “In so doing, it is possible to identify both the relative value of asset classes, but also, at a more granular level, the relative value within real estate across geographies and sectors,” he says.

By re-assessing these fundamentals and updating them to reflect market pricing and expectations of the main variable factors – such as rental growth – it is possible to keep an eye on where to find value at any one point in a cycle. “It is vital that the signposts are treated as a guide or an aid to identifying value and the potential for outperformance, rather than the definitive answer in themselves,” Towns says.

While risk can be managed by diversifying by geography and property sectors, Towns says this strategy can be tailored to a client’s specific risk preference.

The income characteristics of a portfolio can also be a great help in delivering consistent performance long term. “Put simply, a focus on income as the key determinant of real estate returns will typically deliver more consistent performance over the long term, and help limit the effects of capital movements through cycles,” he says.

On leverage, Towns says that even though people usually think of adding debt as way to boost capital and total returns, leverage can also be used to increase income returns.

Other areas to look out for are changes in tenant creditworthiness profile, vacancies, strength of locations and tenant/asset level concentrations. “Above all, the manager should be able to demonstrate that their portfolio is consistent with the investment process to give investors confidence that the fund continues to do ‘what it says on the tin’,” he says.