Pension funds and charities differ in their allocations to property, writes James Thornton
On the face of it, charities and pension funds have a similar appetite for property. The WM Index of charities currently has a 3% weighting to commercial property whereas, on average, pension funds have a 7% allocation. However, these allocation percentage figures hide the fact that the two universes are vastly different in size. Charities are estimated to have approaching £100bn (€116bn) of assets, while UK pension schemes own nearer to £1trn (source NAPF).
The data also hide the range of appetite for property within the investor type, as large numbers of charities and pension funds have no commercial property exposure, while those that do tend to have an exposure of 5-10%. Furthermore, there are marked differences in the approach to asset allocation. This is in part a result of size but also due to other criteria - for instance, charities might own operational property while some endowments may be made in the form of gifts of property.
Pension funds are principally driven by actuarial models that impute future liabilities. Strategic asset allocations are then devised to meet long-term investment return and risk criteria. Furthermore, scheme sponsors will normally have a legal obligation to make up funding deficits.
Charities, on the other hand, are not legally bound by their spending plans and do not have fixed liabilities. The majority of charities devise asset allocation policies to maintain the real value of their endowments. At a time when inflationary pressures persist in the UK economy, charities are therefore allocating more to real assets such as commodities and property.
Property typically has an allocation of up to 10% within the segment of the portfolio designed to protect against inflation. This proportion might be higher than other real assets on account of trustees being more comfortable investing in property because they have a higher degree of understanding of the asset class compared with alternatives.
Charities are no longer bound only to spend their income. Even so, there is a general reluctance to use capital to meet income requirements. This often means that charities are income-biased rather than total-return focused.
Property is therefore acquired for its relatively high income and its diversification benefits compared with other asset classes. This is evident in coefficient correlation analysis where property performance is only weakly correlated with equities (0.28) and even less correlated with gilts (0.03). A perfect correlation factor is 1.
In making real estate investment decisions, the majority of UK charities are not large enough to achieve risk-diversified exposure on their own. Around £50m is required to do this, since to diversify away stock-specific risk it is necessary to own 12-15 assets. As a result, investing in pooled funds is the principal means by which property exposure is obtained.
Furthermore, the last tax advantage available to charities, following the withdrawal of tax credits on dividends, is the exemption from stamp duty land tax on property purchases. This tax is currently levied at 4% on all commercial transactions over £500,000. There are a small number of pooled property funds specifically designed for charity investors that take advantage of this exemption.
These funds currently distribute between 6-7.5% - attractive yields in the context of other asset classes. Charities will typically use these funds for their core exposure and may add specialist funds in order to gain exposure to particular sub-sectors of the market, such as central London offices or shopping centres.
As with the large US endowment funds, some of the larger charities in the UK employ more sophisticated strategies with their real estate allocation designed to match their desired risk/return profile. Accordingly, they might divide their own portfolio into core, core plus, added value and opportunistic components of the portfolio, according to their risk and return objectives.
Target returns under these strategies range from 6% to 15% and more. To illustrate, at the low end of the risk curve there are core ‘annuity style' buyers of properties let to very good tenants on long leases (20 years plus) with annual increases often linked to inflation. At the other end of the risk curve, opportunistic funds might invest in vacant or partially let property or development.
To conclude, while first impressions are that there are common criteria that apply to charity and pension fund investors, there are also a number of differentiating factors that drive the asset allocation process. These relate to size and to legal and tax issues. Both types of investor are generally united, however, in their desire for income, particularly at a time of inflationary pressures. While cash, gilts and equities are generally low yielding, rental yields from property provide consistent income that also has the potential to rise with economic growth.
James Thornton is a director of Mayfair Capital Investment Management Limited