The increasingly global nature of real estate makes successful property allocation ever more challenging. Steven Grahame reports

Pension funds have historically relied on investment in equities to generate most of their return, and thus equities have also been the main contributor to risk relative to their obligations. This article identifies the benefits that should follow from including a wider range of asset classes in an investment portfolio and focuses on real estate as a useful ‘asset class' if implemented globally.
Traditionally pension funds have invested predominantly in two asset classes - equities and bonds. Equities were chosen to provide additional return, while recognising their associated risks. Bonds were chosen largely to limit risks relative to liabilities. The average global pension fund is (end 2006) made up of approximately 60% equities, 26% bonds and around 14% in other assets, mostly real estate. In this average fund, risk is typically dominated by the asset allocation decision - policy risk - with the majority arising from equity volatility.
There are, however, an increasing number of other asset classes and strategies that pension funds could invest in to improve diversity. Examples include different types of bonds (eg, high-yield debt, emerging market debt, distressed debt and secured loans), global real estate, private equity, hedge funds, commodities, PFI/infrastructure and timber. Figure 1 shows the returns and risks expected from some of these assets, based on the Watson Wyatt Global Asset Model assumptions.

The main support for diversity comes from consideration of the different risk-return drivers to which each asset class is exposed. As there are a variety of drivers, pension funds have a choice depending on their risk appetite and scheme profile. The main drivers which trustees should consider when thinking about global real estate are:

Liquidity risk-return driver - the additional return investors require to compensate them for an asset's illiquidity;  Credit risk-return driver - the additional return investors in bonds require for taking on the higher level of default risk associated with ratings lower than AAA government grade;  Skill risk-return driver - the additional return expected as a result of manager skill;  Equity - the additional return investors require for the uncertainty in future corporate earnings, dividend payments and capital values;  Real estate - the additional return investors require for taking on the uncertainty associated with rental income and capital values;  Insurance - the security of investing in a tangible fixed asset.

These drivers are not all universally available simply by including real estate in a portfolio; rather, exposure to the drivers is via the means by which real estate is allocated - or accessed. There are a number of ways of accessing these drivers, including via unlisted real estate funds, REITs, mortgage debt and collateralised debt obligations. Indeed a comprehensive global approach to real estate incorporates some of these and can be a useful way to access these risk premia.
When allocating to real estate, pension funds should be aware that a structural change is occurring in this area. Typically, they are now trying to invest more globally by seeking non-conflicted advisers to assist them in finding skilful investment managers that can allocate to different real estate segments worldwide.
For some time now, investors have recognised the inefficiency of their existing real estate allocations, which are dominated by ‘buy and hold' investment strategies, either through direct assets or via core funds. Moreover, a real estate investment manager's financial reward has been more heavily biased towards asset accumulation rather than the quantum of the investment return.
This structural misalignment between the investor and traditional real estate fund manager has been a catalyst for some investors to seek alternative investment managers and strategies and has moved them towards investing across the real estate cycle and in different regions through a diversification of managers and strategies.
However, implementing a real estate investment programme globally does present new challenges to an investor, including the need to question the imbedded assumptions relating to their established direct real estate portfolio. In addition, funds will need to accept that the transition to working with a global opportunity set can be made more complex by such factors as the agency interests of tied product advisers and incumbent investment managers.
There are also a number of myths that have grown up around international property investment, so it is helpful to challenge these and put them in perspective before commencing such a programme.

Real estate is a local asset and is best implemented locally via a domestic allocation: Investors do value local specialists. However they are not necessarily seeking the specialist fund managers physically closest to them, realising instead that a global allocation can be implemented via local specialists in various countries.  Real estate research is often focused on local markets when it should be capital markets focused : Investors do value local research and knowledge (particularly absorption rates), yet they are most concerned about yield shifts. Many property researchers have either failed to forecast these successfully or have lacked the confidence in their forecasts to embed them in totality into their funds' investment strategy.  Investing in regions with an established real estate benchmark is better:Investment managers tend to anchor themselves to benchmarks rather than seeking good investment returns. In many ways, a benchmark is useful in measuring risk but it is not necessarily ideal in promoting performance or in achieving the investors' objectives of a real return.  Open-ended funds are always superior to the illiquidity of closed-ended funds: Real estate is an illiquid asset class, with its liquidity being a function of the underlying direct real estate market or the speed and price at which units/shares can be transferred. However, in periods of stress, the liquidity advantages of open-ended funds (excluding REITs) disappear. Performance fees always align interests:Having a performance fee does not immediately mean that the investor and manager are better aligned. If the manager believes they will not meet the hurdle, or the investment team does not receive a large portion of the fee, the motivation and purpose of the performance fee diminishes. Alternatively if the performance fee is not well structured it can reward managers that have strong market driven returns, but have not added any value themselves.  Investment managers seek to allocate to geography with implementation and manager skill a secondary consideration:No single investor can or would desire to invest in every country of the world. Therefore, an investor focuses much more on the quality of an investment idea and the risk associated with its execution. Funds of funds are the only mechanism for global real estate diversity:Funds of funds are a mechanism to get access to a diversified portfolio of investments via ostensibly skilful investment managers. However, it is becoming increasingly common for large investors such as sovereign funds or large schemes to make direct real estate investment or co-investment, or form club arrangements with like-minded investors.  Investments to non-domestic real estate markets are tactical investment decisions:This ignores the fact that real estate is a global asset class and so to invest globally is not in itself a tactical decision, whereas investing in a single locality and manager limits the opportunity set and the potential return. But by default a tactical preference. Currency fluctuations introduce volatility:Currency fluctuation can be hedged either at product or investor level and so reduce volatility significantly. Pension funds do not want to invest in geared funds and complications of tax are not fully understood:Investors who look to invest in a real estate fund should strip out the effects and costs of debt (including the potential tax leakage) at a property, fund and investor level. It is only by calculating the net costs and net returns that the investor will be positioned to better understand the risk and return trade-off. Referencing the net investment return or investment target is meaningless by comparison.

Having addressed the myths, we turn to arguably the most important aspect of institutional investing, governance. In seeking superior investment returns investors are increasingly acknowledging that they should align these strategies with their governance arrangements first so that they do not risk inadvertently destroying value.
Allocating to global real estate is somewhat more complicated than its domestic counterpart, more often than not resulting in the need to enhance governance through increased internal resources or delegation to experts. This is particularly true given the increasingly dynamic nature of the real estate industry and the need to constantly search for new ideas and innovative investment approaches.
Once their governance arrangements are satisfactory, there are typically three key investment decisions that funds need to take when implementing a global real estate allocation:


Which investment managers are there likely to provide the best opportunities now and in the future;  How and over what time frame to implement their allocations (especially relative to other asset classes returns as well as prospective returns);  Whether to hedge currency risk associated with an allocation and whether to use synthetic alternatives to manage allocation risk.

These decisions are fundamental to a successful execution and should be addressed through an effective manager selection and implementation process. Selecting and constructing a real estate allocation requires investors to have confidence in their manager selection process and an awareness of the factors that could cause unexpected systematic correlations between new funds and existing allocations. Additionally, investors need to consider four key aspects of practical implementation for a global allocation to property:

Portfolio construction must be based on the ability to identify and execute quality investment ideas;  Investing in those funds which meet the required investment targets and hurdles based on investment objectives and governance;  Selected investment managers must be specialists in their activity and locality, as identified through detailed manager selection processes;  Cash flow management and active participation in selected funds is essential as well as an awareness of opportunities in the capital markets.

Importantly, the investor is in control of the investment decision-making process and can appoint discretionary managers and advisers to assist in key components of the investment implementation. The investor has the freedom to ensure that the portfolio is constructed to customised criteria and has the ability to terminate the manager based on the terms of a carefully construed investment management agreement.
In constructing and implementing the planned allocation, investors are constrained by the quality of available investment ideas and their own appetite for investment risk. In practical terms, a mature investment in real estate will take some years and therefore a path of implementation needs to be decided upon.
Also, many investors have recognised that capital markets are periodically mispriced. They can turn these to their advantage if they use the right tools. These include making provision for the use of REITs and real estate derivatives as components for implementing and managing long-term real estate allocation.
When deciding on the appropriate path it is important for investors to realise that a planned and staggered route of implementation may require disinvesting from direct real estate at the same time as making capital commitments to illiquid funds. An example real estate allocation may include a core real estate portfolio, which will over time be supplemented by a satellite portfolio that grows to represent a larger and more significant element of the total real estate allocation. Figure 2 illustrates how this might be work.
The critical point is that some components of the real estate allocation process deliver immediate investment returns, while others may include a draw-down arrangement. In effect, the real estate weighting needs to be managed and implemented dynamically.
Real estate is a global asset class that accesses multiple risk premia, and though investors have been thinking globally for their other asset classes they are now putting it in to practice for real estate. And as these allocations increase, investors will begin to appreciate the importance of well-selected skilled investment managers that can help them address the many associated challenges.

Steven Grahame is a senior investment consultant at Watson Wyatt