Unlike most asset classes, property is a real and tangible asset that investors can touch and feel, a feature that should give comfort to pension fund trustees looking to guarantee present and future payments, says Neil Cable
The England rugby coach, Martin Johnson, recently said that he was "feeling more pressure than Luiz Felipe Scolari did before being sacked by Chelsea". Highly paid people in the world of sport like to talk about the pressure of their jobs, but it can hardly be much tougher than the pressure pension trustees will face in the coming years.
A trustee must not only consider complex issues such as longevity and the relative future performance of different global asset classes, but must
also make decisions in the middle of a recession which many believe to be the worst since the Second World War.
Many schemes remain in deficit and ageing scheme members are all now feeling slightly poorer and increasingly anxious about their pensions. They will be looking to trustees to reassure them about their retirement income.
So what will be the key drivers for the asset allocation decisions of pension schemes in the coming months and years? There will be a natural inclination towards risk aversion, with memories of over-exposure to equities in the 1990s still fresh.
Yet the lowest risk options of cash and government bonds will not generate the return necessary to provide members with decent pensions in future years. Three themes are likely to drive asset allocation decisions in this environment, all of which have particular resonance for real estate: diversification and risk; simplicity; and income generation.
Diversification and risk
The idea of diversification for pension schemes is hardly new, but the dynamics are constantly evolving. When George Ross Goobey pioneered modern investment practice in the 1950s with the Imperial Tobacco Pension Fund, most schemes were immature, people did not live long after they retired, and the liabilities, against which funds had to match assets, were therefore neither large nor immediate.
Liquidity was not therefore a major requirement and schemes could afford to take a long term view. Nowadays an increasing amount of steady, reliable income is required to pay pensions to the steady stream of fit and healthy retirees. At the same time, returns must be maximised to meet future pension claims.
Pension trustees have had to deal with innumerable changes in the investment landscape. Over the past 20 years, the rate of change has accelerated: simple strategies such as balanced management have been replaced by a focus on specialist
managers; high alpha, portable alpha and liability-driven investment (LDI) solutions have came to the fore; hedge funds and private equity have grown in significance; absolute return funds, ‘Libor-plus' funds, and even ‘new balanced' funds (presumably very different to ‘old balanced') have been advocated.
Diversification in the past few years has implied investing in an array of new and more complex areas to maximise the upside. In the next few years, diversification is more likely to be focused on minimising the downside.
Figure 1 shows some selected equity, bond and property market performance. Rather than showing the usual standard deviation measure of risk, it shows the average return over the past 10 years, with the vertical lines showing the best and worst years in that period.
A pension fund trustee looking at this chart should be drawn to the property numbers. Not only has the average performance for mature markets such as the UK been good, but the best and worst years have been within a much narrower range than that for equities.
And that includes 2008, the worst year on record for UK property. In other words, in an environment where pension funds actually need the cash to pay out to pensioners, property should help trustees sleep a little easier at night. It minimises the downside risk, and also provides decent returns through the cycle and, crucially, a steady income.
Simplicity - and its close cousin, transparency - have moved right back up the agenda. It is notable that many of the world's most successful fund managers, such as Warren Buffett, only invest in "things they understand".
In contrast, the past few years have seen an increasing trend towards complex models, the increasing use of exotic derivatives, long/short strategies and absolute return funds. The tempting lure of the Libor plus fund has also proved to be illusory in the recent downturn (although proponents will argue that they just need time to test their rolling three or five year targets).
The Madoff affair has also brought into sharp relief the need to be confident about some basic fact: for example, "can you prove you actually own the asset"? With property, you can literally touch and feel it.
You can also produce a title certificate. Similarly, there is no great mystery about where the performance comes from. Buildings have an intrinsic value derived from land, and generate income in the form of tenants paying rent.
In an environment where pension funds are likely to focus much more on issues such as governance, risk controls and transparency, trustees will try to ensure they understand fully what they are investing in, that it can be explained and evidenced easily and that they can make reasonable judgements about future performance. Real estate ticks those boxes.
Property has traditionally been priced to provide a yield premium to government bonds. When modern methods of valuation for property emerged in the 1970s and 1980s, a common rule of thumb was to start with the risk free rate of return (government bonds) and add a premium to the yield in order to take account of risks - and costs - such as depreciation or obsolescence. Typically, that premium was around 2%.
In more recent years, valuation methods have become more sophisticated to take account of the correct pricing for different lease structures and lease terms, such as tenant options to break the lease. The basic principle still applies however - that property should yield more than bonds.
This is good news for pension funds, since it means that most of the return is derived from the income, not the capital growth, and is therefore likely to be less volatile and more reliable. Unlike equities, where growth in the markets is relied upon to provide the appropriate level of total return, most of the return is already in the bag with property.
Although the harum-scarum years of property between 2004 and 2006 delivered high returns in the region of 18% annually, those were driven in large part by leveraged buyers driving up prices - and therefore driving down yields. These were aberrant years for real estate as an asset class and although the high level of returns were undoubtedly welcome for investors, the asset class was not performing the function it should.
Now, however, with the yield premium over government bonds back to over 3% (at least in the UK), property is reverting to its traditional role - that is, an asset class which yields more than government bonds, exhibits low volatility and is uncorrelated with equities. UK property is now yielding 7% according to the IPD Monthly Index, although on the basis of deals being offered for sale in today's market, the real figure is more like 7.5% and still rising.
This would provide a steady and attractive return for any pension fund portfolio. Yields in the rest of Europe are also catching up (and have the added attraction of annual indexation of income in line with inflation).
There are a number of compelling reasons why property should win in competition with other asset classes for allocation within a pension fund portfolio:
As John Templeton, the successful investor and philanthropist remarked, "buy when others are despondently selling and sell when others are greedily buying". Yet we are also always told that trying to time markets is a fool's game. So should pension funds be rushing back into property now, or waiting for more evidence that the bottom has been reached?
There is increasing evidence to suggest that investors should be starting to consider real estate again now. Property differs from equities and bonds in one crucial respect - it takes time to buy and sell. So if investors wait for more evidence to emerge in the indices, they will likely have missed the best opportunities.
The property recession is now 18 months old (values started falling in July 2007) so most of the correction could already be behind us. Property has already reclaimed its status as a higher yielding asset class.
Looking forward, therefore, it seems clear that real estate has all the characteristics to claim its rightful place in a diversified portfolio. Pension funds will be keen to ensure they are not caught out in future being over-exposed to one or two asset classes, so diversification is likely to be more important in future, not less.
And with all the choices open to pension funds, picking property might be an easier job than picking an international rugby team.
Neil Cable is head of European real estate at Fidelity International