Pension funds want something more from today's investment managers: it is important that they understand bricks and mortar, as Shayla Walmsley finds

Ask a pension fund today to describe what makes a good real estate investment manager and they will tell you something significantly different from what they would have told you before the financial crisis. Transparency, sector knowledge and local knowledge are all still important. But now investors want to be involved in operational decision making as well.

In fact, it is easier to identify what pension funds do not want in property investment managers: financial engineers. To be a good real estate investment manager, you have to know your bricks and mortar.

"Investment managers need to have good assets," says Herman Gerlauf, global real estate strategist at pensions manager MN Services. "It has to come down to the property management - to networking with tenants, for example. You have to have the right skills first, then perhaps use leverage a bit to enhance returns. Leverage could come in handy but you have to know property."

Working with tenants has taken on increased significance for Cushman & Wakefield Investors (CWI) in Paris, where the fact that rents are linked to the construction cost index results in high indexation. Rents rising 6-7% on the index alone might be good for owners - but it also drove rents in many cases above market level. David Rendall, CEO at CWI European, says: "When market growth was slow, or in some cases went down, the index kept going up so you have an over-rented situation. What do you do - sit there and hope the tenant doesn't notice? Or do you take some action, approach the tenant and do a deal?"

In some deals, CWI has traded part of the rent for longer lease terms - favourable when it comes to valuations, for example. "You're seen to be constructive, and you're alleviating pressure on the tenant's cash flow. Sometimes you reorganise the space. It's a partnership, rather than a landlord trying to get the most rent," he says.

But knowing the property market will not be enough to satisfy investors, says Rendall. Investment managers also need to know the peculiarities of the sub-sectors they are investing in. "You need to know the occupier market, what's driving demand. Skilful managers work with the tenant. If you lose your tenant, it's an expensive business. The balance of power has shifted in favour of the tenant. The skill is to be able to harness that, to be able to do something positive with it rather than being hit by it."

Knowing property means getting your hands dirty, says Linda Selman, senior investment consultant with Hymans Robertson. As a consultant looking out for the interests of a pension fund client, she says, you look out for "managers who like property - who make site visits and who can sweat the assets because property does need to be managed".

Given the sharpened focus on investment managers who know their assets, having been part of the property industry matters now more than it did before the financial crisis.
When Partners Group, the Swiss-based private market asset manager, decided in 2004-05 to establish real estate as an independent business line, it first considered poaching from its own private equity team.

"After all, you're using similar Excel models and similar fund structures, and you're facing largely the same tax issues," says co-head of real estate Claude Angéloz. "But then we looked at the physical properties and their dynamics, and asked: what does it take to invest successfully in real estate?

"It was absolutely clear that you need an in-depth understanding of property, which you can only have if you have spent your career in that business and you have gone through several market cycles. It isn't sufficient to take private equity or other investment people and just change their hats."

The will to spill
Even once pension schemes have selected specialist real estate managers, they want more detail, and transparency on leverage, occupancy rates, rental turnover, and expiration dates. "In other words, they want operational details," says Gerlauf. "A couple of years ago, they were interested in valuations and returns. Now they're interested in what drives those returns."

Pension funds want to understand what generates performance but they also want to know how that performance is generated, agrees Selman. "When it comes to reviewing the manager, they realise that performance numbers are only part of it; they want to see what's behind the performance," she says.

This emphasis on control is not without its problems. Gerlauf says: "The question is what investors want to accomplish with it. Where is the responsibility: with the client or with the manager? That question hasn't really been raised or discussed. Investors are steering away from direct investment but now it feels as though they want to go back to having control over decision making, but to leave the investment manager with the responsibility. The trend is towards more control."

Pension funds are unlikely to buy the idea that increased investor control is a bad idea, but this involvement in operational management raises an issue over the split between control and responsibility - in short, over fiduciary management. Especially with funds, investment managers enjoy a degree of freedom they lack with the mandate constraints associated with separate accounts, according to Jan Meulenbelt, global CEO of ING REIM Select. "The best way - the only way - to operate is to optimise the portfolio for the client," says Meulenbelt. "The problem is that when the investor asks you to put the money into the market, you only get your fee when you invest it. It's a management fee, not a commitment fee.

"So the question from the investment managers is, should you invest and collect a fee or do the right thing? If the investor and the investment manager were perfectly aligned, it is in the interest of both the manager and the client to optimise the portfolio but then there could be a period of three or four years when the manager doesn't invest. It's possible going forward that investors will ask managers to optimise the portfolio and manage it - and they won't care where you put it."

Not least because real estate is a less transparent market than, say, listed, you have to do the work, and put in the resources and hours, says Angéloz. "It's a labour-intensive business. It requires the skills, the experience, the brains and people. That's why it's not my belief that fees in the industry will come down significantly, unless it's for an indexed product.

"I believe you need to find the right balance between management fees and performance fees," he says. "We want to be sure that our clients understand the rationale behind our fees. If they're not comfortable with the fees, they either won't do business with us at all or they would but with a sour taste from the beginning of the relationship. That sour taste would not be a good basis for establishing a long-term relationship in a long-term asset class.

"In real estate, we're talking terms of up to 10 years. It is critically important to find the right formula with your business partner - and not just on fees - or you'll be confronting questions and renegotiations from the very beginning."

Angéloz is not alone in thinking fees are unlikely to come down despite pressure from investors shifting the bias from management fees towards performance fees. Meulenbelt claims the commitment (versus performance) fee will not take hold until all managers demand one. "If you're the one manager in the market demanding a commitment fee, investors will say: why are we paying you to do nothing?"

Meulenbelt identifies two trends in the market. The first is for pension funds to work with boutique firms, such as sector-specific managers. The second is to work with outside consultants, in the UK or fiduciary managers elsewhere. He points out that in the UK you have a consultant-driven market; the Netherlands is a partly consultant-covered market, while in France you do not have consultants.

Across markets, investors are demanding more bangs for their bucks. Rendall claims new mandates tend to be "more probing and more demanding", seeking more transparent fee structures and "using that transparency in terms of benchmarking and in terms of the value they're going to get".

On the point of value-add, he reckons investors are less content to rely on the old combination of track record and promises. "They want to see your credentials," he says. "If you talk to managers looking to win new business, the question investors are asking is: what do you bring to the table?"

For some investors, bringing a credible proposition to the table is not enough. As much as they want investment managers to justify the numbers going in (fees), they want similar justifications for the numbers coming out (returns). "The important thing is that investment managers deliver what they promise," says Selman.

It is driven partly by previous experience of non-performance and partly by pension fund managers finding themselves under increased scrutiny. If fund managers failed, so too, in some sense, did portfolio managers who invested with them.

"Investors are thinking more carefully about decisions" says Rendall. "They're going to have to take it to an investment committee or board; then the investment committee or board will ask, how did you come to this decision? So in the investor's decision-making process, people are under much more scrutiny. It's driven by the investor but it means that we're brought into their processes."