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:
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.
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:
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