The inevitable shift from DB to DC pensions has major repercussions for the real estate funds industry, not least when it comes to liquidity. Christine Senior reports

The question of how to turn an illiquid asset class into a liquid investment has occupied the minds of real estate experts for years. As defined contribution (DC) pension schemes increasingly replace traditional defined benefit (DB) schemes, the issue of liquidity in property funds is becoming all the more acute.

At the moment, many property funds used in DC schemes are the same products used by DB schemes, with liquidity for DC investors provided through a separate unit class with daily dealing. Funds need to have daily dealing in order to qualify for use in DC schemes.

Currently the demand for suitable DC-friendly property funds is subdued. But demand is certain to pick up as the trend to DC builds larger pools of assets, and scheme members seek greater choice of investments.

John Styles, partner at Knight Frank Investors, recently carried out research for a pension fund looking to transfer its property assets into a more liquid fund in a bid to facilitate the winding up of its DB scheme. He found little evidence of strong demand for DC products currently: "A lot of people were saying yes, it will be a growth area, there will be lots more DB schemes converting to DC and new schemes being set up which will be DC. We couldn't really pin down what volume that demand would have. It didn't seem to be there right now."

Styles' research led him to believe that timing is an issue for the launch of DC property funds: in the present climate flows of capital into property funds are too limited.
In its 2011 Property Survey, Hymans Robertson found that many institutional property managers do not currently offer funds with daily dealing suitable for DC pension schemes. And, it says, managers who do not address this risk being left behind.

Some providers are beginning to look at the issue of suitable funds. Last year two products were launched specifically designed to fit the bill. Legal & General and CBRE Global Investors launched products in the spring of 2011, both designed with input from consultants on design and features.

The CBRE UK Property Fund has been a few years in the making. Structured as a property authorised investment fund (PAIF) to provide daily pricing and daily liquidity (see PAIFs: Broadening the investor base), the fund is targeting £1bn of assets. When fully mature it will invest in a diversified property portfolio as well as some cash and listed property securities to provide liquidity.

Nick Preston, senior director at CBRE Investors, says returns will be different from a pure direct property fund. "We are taking a reasonable level of holdings in REITs and potentially cash in the fund as well," he says. "It won't necessarily dilute the returns; it will cause returns to behave differently from the IPD benchmark. You have to build a bespoke benchmark which is part IPD and part REITs-focused so you compare like with like."

Liquidity in property funds is coming from allocations to property company shares and cash, which obviously affects fund performance and makes funds behave differently from direct property funds.

"In a rising market, cash is a drag on performance," says Linda McAleer, property consultant at Hymans Robertson. "During the downturn, cash would have benefited. Funds that held cash were able to pay out redemptions quicker, without having to ‘fire sell' assets. On the other hand, property company equities add short-term volatility to returns."

The L&G Property Hybrid Property Fund has a default 70/30 exposure to L&G Property's Managed Property Fund and L&G Investment Management's Global REITS Index Tracker Fund. Pete Gladwell, business development manager at L&G Property, says the fund differs from other property funds used in DC in being a bespoke product for the DC market.

The new fund gives a different level of liquidity from a balanced fund, which is currently the default fund choice for DC, says Gladwell: "A balanced fund is likely to have some indirect investments and some cash in it. This gives an element of liquidity but it's not the same as having a substantial component of listed REITs. That takes liquidity to a different level, providing the ability to liquidate in the case of a downturn and reducing the spread and management charges. And DC capital is sensitive to all of those factors."

The REIT element, as well as providing liquidity, also brings global diversification to complement the UK property exposure that comes from the investment in the UK property fund, giving the fund exposure to the Japanese, US and emerging market property markets.

Having a substantial component invested in direct property is vital to bring the diversification of the real estate asset class to a DC fund, says Gladwell: "There's already a lot of volatility stemming from the very high exposures to equity markets in the average individual's DC portfolio. Property must have a role to play as a significant diversifier and a component that reduces volatility, which is one of the main attractions of property in the broader investment market. But the majority of a real estate allocation has to be in direct property to draw out those characteristics. There is no point in simply relying on listed property assets because the correlation will be too high with the rest of the portfolio."

Setting up a DC fund from scratch presents challenges for fund providers. While DB schemes have substantial mandates of a suitable size to invest in real estate, the steady drip feed of capital representing the DC market would need years to gain critical mass in a brand new product. It's a hurdle that larger established players find easier to negotiate.
Gladwell claims one of the attractions of the L&G fund is that it is investing in an established portfolio, so the diversification is there from the start. The LGIM Global REITS Fund is worth £500m and the Managed Property Fund £1.3bn. "On day one, when a pound comes in it's buying a small share of a highly diversified £1.8bn total portfolio," says Gladwell. "If you launch a fund with just DC flows, it will take a serious time to build up critical mass, if you can't tap into a broader pool, into an existing portfolio."

New innovations hold the key
The 2008-09 liquidity crisis in UK property funds led to suspension in redemptions and was often a result of valuation prices of funds differing significantly from market transaction prices. AEW's new Core UK Property Fund has come up with a process to solve the problem of misalignment between fund valuations and transaction prices. The fund retains the standard valuation process used in the industry, but has a separate independent governance committee chaired by George Henshilwood, formerly of Hymans Robertson, which decides what a fair transaction price would be for paying in or redeeming investments into the fund in times of stress.

Richard Tanner, managing director of AEW UK calls this a "market corrector". He says: "If you don't correct for the market situation, very savvy investors try to arbitrage the difference between the transaction market and the valuation market. It doesn't mean we can make property more liquid than it fundamentally is. It still takes a month to transact properties. But it sorts out the biggest problem in property liquidity in the last downturn - the breakdown of the transactional price market from the valuation price market."

Tanner is aware of how this approach could be useful in the DC market: "It's early days, but because DB schemes are closing and insuring themselves out and DC is the future, we want to take this liquidity approach and see if we can adapt it to DC."

Another approach to introducing greater liquidity is the use of property derivatives, which is the route taken by InProp in its synthetic investment vehicle, the UK Commercial Property Fund. The fund invests in Eurex property futures, to gain exposure to the IPD UK All-Property index, alongside short-dated gilts to deleverage the fund.

"We are effectively able to access the cash flows on all the properties in the IPD index without actually owning any buildings at all," says Paul Ogden, co-founder at inProp. "The IPD index is total return, so we get exposure to capital value changes and rental income, and the futures have a daily listed closing price which means, effectively, there is a mark-to-market price available every single day from an independent source."

The fund has attracted DB pension investors, but DC investment is also within Ogden's sights. He is in discussions with major consultants and the National Association of Pension Funds (NAPF) in a bid to get greater recognition.

"The reason the fund is interesting for DC is our liquidity is monthly and we can provide daily indicative pricing. This is something that gives the DC side the transparency of pricing and liquidity they need for property exposure. The problem with the more traditional approaches to real estate is that the values put on their exposure tend to be appraised NAVs. Our NAV is marked to market of tradeable instruments. Our fund NAV is the price you can trade in and out at."

But convincing DC investors that investing in derivatives is a good alternative to bricks and mortar to access property returns might prove difficult. Investors, particularly less sophisticated ones, view derivatives as complex and risky. Their perception is coloured by past scandals and problems. As for the complexity, Ogden is convinced that derivatives are in fact a simpler asset than actual property, which he compares to investment in private equity.

"If you are buying a building you have to manage that building. The building has a huge amount of idiosyncratic risk. When you talk to property investors, they think derivatives are going to be very complex and the property very simple but it's actually the other way round. Our goal is to deliver market beta. Fundamentally, the derivative settles against whatever the IPD index publishes at the end of year."

Douglas Crawshaw, senior investment consultant at Towers Watson, appreciates the potential of property derivatives, but he has reservations about how DC investors might view derivatives in the light of recent history. "How the platforms will view them - how the end-investors, the pension fund members view them - I suspect, has not been fully tested yet," he says. "People, perhaps those less well-informed, remember headline-grabbing stories, like [Nick] Leeson, that have tainted what was designed to be a very low-risk investment, a hedging instrument."

For the moment there is no particular urgency for new, specifically-DC property funds, because the demand is not there yet. The big institutional property fund managers are generally happy to accept DC money into their existing managed property funds.
Crawshaw highlights one issue with funds that take both DB and DC pension money:

"There is a conflict between those products that can take both DB and DC money, because, of course, DB investors are there for the long term, while DC trickles in capital over a period of time. That may influence performance. A number of managers that operate DC compliant-products are thinking about that and seeing how best they can address that concern."

Andrew Jackson, manager of Standard Life's Select Property Fund, which accepts both DB and DC and retail investments, confirms that this is an issue: "Quite often we hear from our clients they don't like the co-mingling of long-term institutional type mandates with shorter-term DC mandates. It tends to be that the DB investors don't necessarily want the liquidity being used up by those shorter-term investors. It is a bit of a one-sided argument because there is the other side as well - having those flows from retail or DC investors does actually help overall liquidity of the fund at certain points of the cycle."

One development that should be a step forward for property fund liquidity is the likely conversion of more authorised property unit trusts (APUTs) to PAIFs in the coming year. John Cartwright, chief executive at the Association of Real Estate Funds (AREF), says this will improve choice of liquid property funds for DC schemes.

"Of course once they are converted to the PAIF regime, those authorised funds have daily liquidity. I would think they will add to the options for DC, adding more flexibility. They are all managed by household names, they are all sizeable; there is depth in the liquidity. All the units are tradeable, can be created and redeemed on a daily basis; they are daily-priced and daily-dealt and generally in relatively small deal sizes, so ideal for self-managed DC schemes."