News analysis: The real reason UK pension funds shun residential property

UK pension schemes are still avoiding residential real estate, but don't blame the widows, says Shayla Walmsley.

The recent claim by John Lewis pension scheme's investment manager Andrew Chapman that no pension scheme wanted to be held responsible for evicting "some widow", and that the solution would be to separate investment and asset management "so we weren't held responsible in that way", amounted to a request for risk removal. But arguably he's looking at the wrong risks.

The reputational risk associated with decanting elderly widows has been held up for decades as one of the primary reasons why UK pension funds have been reluctant to invest in housing. But their mainland European counterparts clearly don't have the same reservations. Tony Key, professor of real estate economics at Cass Business School, points out that residential makes up 40% of Dutch investors and 60% of Swiss investors' property portfolios.

Nor does it explain strong institutional investor appetite, including in the UK, for sub-sectors such as nursing homes - which come with as much if not more potential reputational risk.

Cass's Key suggests residential should make up 40% of the optimal property portfolio - not least because office has an unattractive risk/return profile despite making up the greater part of the average pension fund portfolio. Housing has much going for it, including: a large and diverse tenant pool; the fact income makes up a relatively stable part of the return; low volatility; long-term rental income growth; and long-term capital growth (the latter both correlated with wage inflation).

It is just that it has plenty not going for it, too - including a nominal percentage income yield that will always be lower than for commercial. Add to that high management costs - though not as high as investors believe them to be, according to Mark Weedon, head of residential at Investment Property Databank (IPD). Typically, residential retains 65% of net income after costs and commercial 80%, but investors tend to believe commercial delivers more than 90%. Residential also (sometimes) has capital growth behind it.

Strip away the old favourites - the widows and a fragmented market - and the problem is this: investors simply cannot source the assets. "The biggest issue for investors is the lack of suitable investment opportunities - that is, units of suitable scale, age and quality," says Weedon.

Aviva Investors, which for more than a year has been looking at the prospects of raising a residential fund, was not commenting this week on whether it had moved any closer to this end. But industry rumour has it that the reason it has yet launch a fund is a paucity of investible assets. After all, two of the four funds it targeted at pension fund investors in August (in student accommodation and social housing, respectively) were residential after a fashion, even if the fund manager sees them as alternatives to fixed income, rather than real estate per se.

Unlike Weedon, Key sees product unavailability pretty much as an insurmountable market barrier because policymakers are unlikely to implement sufficiently radical measures - such as releasing land banks to communities at low prices - to allow residential bulk-building. "If you could buy chunky residential blocks - like mansion blocks in central London - just as you might in Germany or Sweden, investors would do it," said Key.

The problem is not the tenants or the likelihood of default but the fact that, to buy it, they would have to build it. Elsewhere in Europe, that is not out of the question, of course. In Denmark, PFA pension fund has invested in development projects, including the old Carlsberg brewery site, specifically because of a forecast increase in demand for Copenhagen housing. This week, an unidentified German pension scheme was announced as a €100m co-investor in a Patrizia fund targeting value-added and residential development projects. In the UK, by contrast, developers can recycle capital more quickly if they sell assets individually off-plan.

So pension funds are holding off. The Newham local authority pension scheme, reported last September to be backing a shared-ownership residential vehicle set up by the Mill Group, did not in the end. "Newham Council pension fund has not invested in housing - with the Mill Group or anybody else," Alec Kellaway, chair of the local authority's investment committee, said in an email. "The pension fund might very well do so, subject to the usual professional advice, but no action has been taken yet."

But the pension fund residential standoff could change (slightly) quite soon. The Greater Manchester local authority pension fund is expected to make a residential-focused announcement within the next month or so. The fund, which is externally managed by GVA Grimley, has been looking to invest in residential for well over a year, but so far has not for want of an appropriate residential model.

Still, one pension fund does not make a market. The problem remains: not the risk of evicting a widow, but finding the right assets in the first place.