Evidence suggests that pension funds remain committed to real estate in the medium term despite the recent turmoil in the markets. Yet, in the short term many are finding it difficult to commit to new investments as the denominator effect takes hold. Richard Lowe reports

As the world's financial system begins to go through a painful and protracted de-leveraging process, real estate markets across the globe are feeling the effects: transac-tions have dried up, values are forecast to fall and heavily indebted investors and companies are     destined to become distressed sellers.

In the face of scarce liquidity, attention naturally falls on investors with large cash reserves. These players - be they pension funds, sovereign wealth funds (SWFs) or others - stand not only to benefit from others' losses but are also seen as the necessary saviours, preventing real estate markets from stagnating and bringing about a recovery more quickly. But what if these potential white knights are reluctant or even unable to put their hands in their pockets?

The prospect is worth considering. Certainly, the emphasis on the likelihood of SWFs buying up swathes of cheap western real estate over the coming months and years looks to have subsided. And while there are undoubtedly many pension funds in Europe intent on increasing their real estate exposure, those with large portfolios may be finding themselves over-allocated, such are the losses in their equity holdings.

The ‘denominator effect' is a well-known phenomenon in the pension fund industry, whereby sharp falls in equity investments inadvertently increase an investor's level of exposure to other assets that are less volatile. But rarely has its potential to disrupt the balance of multi-asset portfolios been demonstrated quite so dramatically as it has over the past 18 months.

Many European institutional investors have been in the middle of a drive to increase their real estate allocations, allowing them to cope easily with the denominator effect. Allianz Real Estate, for example, which manages the property investments of the Allianz insurance companies, is aiming to double its current 3.5% allocation over the next three years. Pension funds such as Nordrheinische Ärzteversorgung (NAEV) in Germany, or the University Superannuation Scheme in the UK, are also currently underweight property for strategic reasons.

Others, however, are now over-allocated. IPE Real Estate knows of one large Nordic institution that was approximately 2% above its real estate allocation of 15% towards the end of 2008, and for this reason - along with the general uncertainty in the markets - it is not looking to make any further real estate investments in the near future.US pension funds, in particular, are visibly struggling with the denominator effect - many have built up close to full exposures in recent years.

For example, the California State Teachers Retirement System (CalSTRS) has temporarily increased its real estate allocation range to prevent the need to sell assets during a downturn. The pension fund's exposure to real estate currently stands at 14.4%, overshooting its previously set allocation range of 4-13%, in part due to falling values in its equity portfolio. Consequently, the board at CalSTRS made the decision in November to raise the upper limit to 17% temporarily.

A similar move was reportedly being considered by fellow US giant California Public Employees' Retirement System (CalPERS), whereby the pension fund would lift its real estate allocation limit from 13% to 15%.

"What we have seen in the last couple of months is that all of the pension plans are really having to take a hard look at their portfolios across all asset types," says Jason Spicer, managing director of DTZ Rockwood. "All of the US pension plans are now over-allocated to real estate and bonds and that is because of the massive drop in stock prices."

The moves to temporarily expand real estate limits are only short-term solutions, Spicer says, likening it to a "band aid". This has staved off any significant forced selling of assets by US pension funds, but there have been a number of fund redemptions as a result of the denominator effect.

There seem to be three possible medium-term solutions to the current scenario, two of which pension funds will have no power over. First, stock prices may recover, reversing the situation. Second, real estate prices could be written down. There is a general consensus this will definitely happen to some degree, but will it be enough and will it happen quickly enough? The third solution is for pension funds to sell significant amounts of their assets.

"I don't think funds themselves know which path is going to be the one that comes to pass," Spicer says. "They are waiting to see how much of that happens outside the realm of their decision making."

Ian Gleeson, chief investment officer of global multi-manager at CB Richard Ellis Investors, is cautiously optimistic about the situation and believes the denominator effect may appear to be a greater problem than it actually is.

"Property valuations are generally lagged, so the valuation may be higher than it actually is and the real estate may have a slightly higher weighting in the portfolio than it would do normally," he says. "As those valuations adjust it will go some way towards adjusting this denominator effect."

A recent research report by the European Association for Investors in Non-listed Real Estate Vehicles (INREV), painted the following picture of the situation for its European investor members: "In the short term, the denominator effect is having consequences for real estate with increased allocations to other asset classes reportedly happening in place of real estate or by selling real estate and keeping the other asset classes stable. However, most investors report that, in their organisations, the case for real estate compared with other asset classes has not changed over the last year."

However, in the short term the denominator effect looks likely to continue to have a significant effect on real estate funds. There have been a number of institutional redemptions from funds in recent times. New Star Asset Management, which is now owned by its four bank lenders, was one of the latest fund managers to reveal an increase in institutional redemptions from its global fund.

But in addition to redemptions, there are very real fears that the real estate funds industry will begin to experience the problems that have plagued private equity funds, where investors are reneging on their equity commitments when fund managers issue capital calls for new investments.

"We are already seeing the first signs of that," says Colin Thomasson, managing director at DTZ Rockwood. Thomasson explains that a number of limited partners in real estate funds are urging their fund managers not to invest at the moment, because they would prefer not to have to provide the capital in the short term. Some investors are apparently asking for investments to be delayed until 2010/11.

The next and more extreme step in this development is for pension funds to seek to negotiate their way out of the commitments they have made to new funds, either suggesting they want to make a smaller contribution to the fund than previously agreed or attempting to withdraw their commitment from the fund altogether.

"We are certainly in the midst of that," says Thomasson. "I don't think it has played its way out yet and I think we will see that during the course of 2009."This brings the issue back to an earlier point: are the cash-rich institutional investors the markets was depending on to kick-start them not as plentiful or eager to invest as had been hoped?

"The difficulty is, perhaps, in contrast to other downturns, there are very few people who are unaffected by this," Thomasson says. "You would normally expect there to be a certain band of investors who were waiting to take advantage of this distress. But at this moment we are finding it difficult to find the guys who are ready, able and willing to have the appetite to come into the market."

The short-term complications of the denominator effect only serve to confuse the longer-term overall picture of pension funds' real estate allocation trends. In the long run the majority of institutions are planning on maintaining a stable level of exposure to the asset class or are in fact looking to increase their property investments. This view is supported by a number of recent surveys.

INREV has reported that in the coming two- to three-year period their investor members' allocations to real estate "are set to continue to increase despite deteriorating economic and market conditions". The vast majority (71%) of survey respondents said they have a medium-term strategy to increase their real estate allocations, while only 8% would be reducing their exposure, leaving a balance of 21% that intend to remain unchanged.

The previous issue of IPE Real Estate explored the results of a survey by the UK's Pensions Management Institute (PMI) and Prupim, which found that roughly three-quarters of UK pension funds are either maintaining or increasing their current level of exposure to real estate despite the high level of turmoil experienced recently in the asset class, not least in their own domestic market.

"That was the encouraging, comforting message to come out of the survey: that after a year's worth of difficult news for the property market they weren't running away from the asset class," Paul McNamara, head of research at Prupim, said when the report was released.

A recent survey of pension funds by bfinance shows that, within the next 12 months, 41% intend to maintain their current real estate allocations, 19% intend to increase allocations and 15% plan to decrease allocations. Over a three-year period, 44% revealed they planned to maintain allocations, 30% would increase allocations and 11% would decrease allocations. The balance for both sets of figures is made up of investors with no real estate exposure to start with.

Long-term investors are unlikely to move away from the asset class, because they have the appetite to invest through the various investment cycles, including the downturns. Perhaps the only catalyst to change the role of real estate within pension fund portfolios would be if its characteristics, or investors' perceptions of it, were to change fundamentally.

One of the attractions of real estate as an asset class is its low volatility relative to equities, a characteristic it benefits from despite its ability to generate fairly high returns. However, some real estate markets - particularly the UK, Spain and Ireland - have been extremely volatile lately when compared with traditional expectations. Has this development challenged the reputation of real estate as a low-volatility asset class? If it has, there would surely be implications for multi-asset portfolios.

But Gleeson says this volatility should be seen in the wider context of capital markets. "I think all asset classes seem pretty volatile at the moment," he says, pointing to the fact that although International Property Databank (IPD) figures show that commercial property capital values in the UK have fallen 27% since their peak, this still pales in comparison with losses in global equities."On that basis, real estate is still less volatile compared with other asset classes," he says confidently.

Furthermore, one of the reasons blamed on the recent volatility is the aggressive use of leverage in recent years and the way in which this has speeded up cross-border capital around the globe. But if tighter regulation is introduced to financial markets, as is expected by many in the industry, there could be less complex financing and more conservative use of leverage in real estate markets.Gleeson believes this might well lead to a "dampening" of volatility, whereby capital moves at a slower pace around real estate markets.

Stein Berge Monsen, senior portfolio manager at Norway's Vital Eiendom, confirms Gleeson's suggestion that institutional investors are likely to be more concerned with the acute volatility demonstrated by equities in recent months. Monsen says such volatility has been unhelpful for an insurance company's investment portfolio. And he is certain that real estate will continue to play an important role for institutional investors.
"Real estate seems still to have its place in a diversified portfolio," he says.