Has the financial crisis changed the way investors treat real estate as part of their portfolio, and if so, how? Richard Lowe talks to an asset manager, a pension fund and a consultant

Ronald Wuijster
Real estate is wcurrently attractive relative to other asset classes
Allocations are arrived at through a qualitative and quantitative process
Property is a hedge against inflation only over the long term

For APG, the Dutch pension asset manager, real estate is currently attractive relative to other asset classes. "It had a very decent performance last year, but we still find it relatively attractive," says Ronald Wuijster, APG's head of strategic asset allocation. "It is always a relative game, but we still find it relatively attractive, and it has an important place in the portfolios of all our clients."

APG manages investments for a number of Dutch pension funds, including ABP. "All clients have a substantial position and always a combination of listed and non-listed real estate," Wuijster says.

APG arrives at asset allocation weightings to real estate through an in-depth process, starting with the building of an economic outlook and different global economic scenarios that lead to expectations around interest rates, economic growth, inflation and other variables. "That translates into expectations for different asset classes, including real estate - both listed and non-listed," Wuijster says.

These expectations cover not only the investment returns of various asset classes but also their associated risks, including volatility. These are fed into APG's asset liability management and portfolio optimisation models, always considering an individual pension fund's liability structure.

"We do several runs with many scenarios, often up to 50,000, and then come up with an optimal portfolio in terms of statistical variables like return numbers, numbers for the expected coverage ratios and numbers for the probability that clients can keep indexation to their pension entitlements of their participants," Wuijster says.

APG then introduces a more qualitative assessment to this "quantitatively optimal portfolio". He adds: "We look at the quantitative optimisation, the economic environment, then we look at factors like: how can we improve the portfolio construction? Have we taken liquidity considerations into account sufficiently? Did the quantitative optimisation result in things that we would question if we looked at it from a more qualitative perspective and that can lead to some ideas about potential changes?" Finally this is fed back into the ALM model and APG examines how these qualitative changes or adjustments influence the statistical variables of the ALM outcome. "That leads to the eventual strategic mix," Wuijster says.

The financial crisis has not fundamentally changed APG's opinion of real estate. The past few years certainly raised a few question marks over whether the true benefits of diversification have been overstated, while the unprecedented volatility in the UK commercial property market was a cause for concern for investors seeking stability. But this has not led to the asset manager viewing real estate in a different light.

"It's also not our approach to change the opinion about an asset class recklessly. We will look at valuations, so at times we feel there are overvalued assets. We will take them into account in our portfolio construction, but we are not really taking short-term bets on it. Maybe some minor weight changes, but we try to steer for the long term." He adds: "We tend towards a long-term outlook on every asset class. We still believe in diversification, not only within asset classes, but also for the whole portfolio. We were very well aware that diversification does not always work during a deep crisis when correlations increase."

Investors need to be aware of this and build it into assumptions. "If you take the long-term perspective, we still feel diversification works and we have to diversify our approach to real estate: worldwide investments in all regions and in all segments of the real estate market, from the more core stable investments to more opportunistic, higher-risk investments."

There has also been some debate about the ability of real estate to hedge inflation. In October 2010, Johan van der Ende, outgoing CIO of Dutch pensions manager PGGM, told an IVBN (Dutch association for institutional property investors) conference that real estate did not offer a very good inflation hedge, while the Investment Property Forum in the UK has recently published research suggesting that UK real estate does not provide a hedge against inflation.

But Wuijster argues that real estate does provide an inflation hedge, just not short term. "Long term it is a good inflation hedge. The majority of real estate is not really a good inflation hedge for the short run. But there are certain exceptions, such as social housing."

Günther Schiendl
Real estate is attractive in a low interest rate environment
Recent volatility shows it is not as defensive as once thought
VBV has changed strategy to focus on European markets

Real estate is an attractive asset class for VBV, -Austria's largest pension fund, predominantly because of low interest rates and issues surrounding credit quality of bonds. CIO Günther Schiendl says the potential for inflation hedging through index-linked rents adds to the appeal of the class.

That said, the Austrian institution has learned some important lessons about the asset class during the financial turmoil of recent years and these are likely to feed through into how it invests in the future.

One such lesson concerns the volatility of valuations seen in some funds. This volatility, Schiendl says, was restricted to funds run by ‘Anglo-Saxon' managers who effectively mark to market the underlying assets, in contrast to the German-style Spezialfonds that "have a rather more conservative valuation policy, smoothing price changes up and down".

VBV invests in both types and consequently this had an impact on the behaviour of its real estate portfolio. "We found after the crisis that there was a wide variation in the way real estate assets were being priced by real estate managers," Schiendl says. "So what we found out was that parts of the real estate portfolio were not behaving as stably or as defensively as we expected."

Schiendl stresses that he is not advocating a rejection of frequent, mark-to-market valuations in favour of the German method. "The point to be made is that so many real estate investors have realised that the stability they were looking for post-2008 actually was not there to the extent they expected," he explains. "Of course, valuations have gone down, but they have gone rapidly up again as well, so we tend to be back more or less where we were before."

Schiendl's stance is backed up by VBV's activity in 2010 when it committed to a number of non-listed real estate funds in Europe, which included those employing mark-to-market valuations. It invested in three core European funds, one focused on Scandinavian property markets and two investing in Germany. Schiendl says VBV is undergoing due diligence on another Scandinavian fund and other German products; the pension fund is also looking for "one or two other products in core Europe" on top of this.

These investments should take VBV up to its strategic real estate weighting of 7% of total assets. This target is the result of a risk-and-return optimisation exercise, taking into consideration the fund's liability profile and liquidity requirements. But Schiendl says in the end the two most important factors for VBV when making real estate investments today are the higher return expectations relative to government bonds and illiquidity of the asset class. "We believe that the 7% is an allocation that helps to stabilise returns but on the other hand leaves us enough flexibility in the plan if we need to change things," he says.

Perhaps the biggest change in VBV's outlook for real estate is the increased attractiveness of core European real estate relative to emerging markets. "We have initial rental yields of 6% or so in continental European core real estate," he says. "This is quite attractive, so there is less need to go abroad, to go to Asia or to go farther out in the risk spectrum to more opportunistic real estate funds. In terms of risk and return, there is an attractive window still open."

Consequently, VBV has altered its real estate strategy in terms of its drive towards global diversification. The fund has made investments in Asia before, but it unlikely to do so in the foreseeable future. "We are much more concentrated in Europe than we have been before," he says. "We have changed our real estate strategy. We originally envisaged it as a global real estate strategy. Now it is a European real estate strategy with some non-European elements in it."

Schiendl avoids making any assertions as to how long this change in strategy will last. "One tends to be very careful about statements about long or short term," he says.

Douglas Crawshaw
Towers Watson
The consultancy increased its strategic allocation last year
Towers Watson believes in global diversification
Post-crisis perceptions of the asset class are positive

Towers Watson's strategic allocation to real estate increased considerably last year, according to senior investment consultant Douglas Crawshaw. Pension fund allocations and the advice that the consultancy offers varies from client to client, but Crawshaw says that as a result many UK pension funds were positive on the asset class.

Crawshaw emphasises that this applies mainly to core property. For UK pension funds it would be predominantly looking at the domestic market, although there are clients looking across the entire risk spectrum. "There is a desire for security," Crawshaw says.

"There has been a quite a bit of repricing in the long-term, secure-income-type funds, so investors are still looking at the more traditional core balanced funds."

But real estate is not only attractive because of current pricing in core markets. A number of fundamental characteristics remain true: it is an effective diversifier; it is based on real assets that can be repositioned; it offers a level of inflation protection. "It has a degree of security from the point of view of it being a real asset and all these other benefits," Crawshaw says. "This makes it attractive in its own right. So it's not just one reason but a mix."

Towers Watson believes in investing in real estate globally. "Our central philosophy is that real estate is a good diversifier and diversifying globally is a good thing," Crawshaw says. How pension funds gain a global exposure depends on their particular situation and requirements.

"We believe in global diversification and we need to get that in the most efficient and appropriate way. I don't necessarily believe that one organisation or one product is capable of delivering that. I think some have tried, but I'm not a total believer that that really exists. So you're talking about a solution that will probably involve regional-type products or something along those lines.

"Style-wise, whether it's core, value-add, opportunistic or whatever it might be, depends on each individual client. Some might want more risk than others; they might see their fixed income as giving them the low risk and they want to use real estate to do a little bit of a return-seeking role. Others might not, etc. So it's not one-size-fits-all by any means."

As for how the experience of the financial crisis has affected perceptions of the asset class, Crawshaw believes real estate has emerged quite strongly, as has the argument for diversification despite correlations increasing.

"When you go through a crisis like the one we've just had, everything does move, in a sense, by definition in the same way. But I think with property, you do have the security of it being a real asset," he says. "OK, real estate dropped in value by 44% in the UK, but other asset classes hit investors a lot harder."

He adds: "It has its risks and it's far more intensive and expensive to manage, so one has to be sensible about the extent to which you hold the asset class. But there are certain benefits now that I think people are recognising coming out of the problems that we've had."

He cites the fact that even if a tenant defaults on a building it is possible to bring in a new tenant, and even theoretically increase the rent. This is a characteristic not shared by corporate bonds, for instance.

"There are criticisms levied at real estate, particularly in terms of valuation, and the fact it's an appraisal-based valuation that's periodic, quarterly or monthly - in some cases, annually - and that does mask what is actually going on behind the scenes," Crawshaw says. "It's not perfect by any means, but I think it does offer investors some benefits that equities and fixed income, etc, do not."