Portfolio: Let go of the benchmark

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Investors should consider liberating themselves from the IPD benchmark and their long-held fixation on office and retail, says Paul Jayasingha

The 1999 cult film Office Space took a seemingly glamorous and exciting office working environment and exposed it for having the more political and mundane aspects of real life. Similarly, institutional investors could be over-emphasising the glamour and excitement from their office portfolios, given the long-term fundamentals for the sector.

Many UK institutional investors benchmark their UK property portfolio against a form of the IPD index. This index is dominated by three main property sectors – retail, office and industrial. We believe that investors should be more wide ranging in their consideration of property sectors and less driven by the index and peers in order to achieve a better portfolio and to take advantage of key thematic trends. A key part of this shift would involve reducing the strategic weight to offices relative to current index representation.

UK institutional investors typically benchmark their UK property portfolio against one of the two indices shown in figure 1. We find that property managers have limited flexibility to deviate meaningfully away from these benchmark sector allocations and as a result many portfolios broadly have the sector allocation shown.

Although originally used for performance assessment, there is a risk that property indices are increasingly being used as a reference point for asset allocation. We believe the persistence of a peer group approach to investment has led to a concentration of institutional investment into three main sectors, allocated in weights that have more to do with investment ease (lot sizes tend to be larger) than long-term investment rationale.

The case against offices

Volatility. Office rents tend to be the most volatile and slowest growing of the three main property sectors over the long term. This is driven by office rent cyclicality over the business cycle (figure 2) due to the link with the development cycle and occupier demand.

Long-term trends. An important office trend which should be understood is the long-term decline in required office space per worker, given flexible working, hot desking and general pressures on cost reduction. The British Council for Offices has noted that “densities have risen over recent years as demand has responded to the need to reduce property costs, and as technology has enabled flexible working styles”.

Depreciation. Offices tend to have relatively high depreciation, requiring meaningful capital expenditure over time to limit or offset obsolescence (figure 3). As a result, over the long term, offices tend to provide a relatively poor risk-adjusted return (figure 4) – this has been shown in data from the US as well as in the UK.

Offices tend to have reasonably large lot sizes, making it easier for institutions to invest in property, which could indicate why they represent almost 30% of property indices when long-term fundamentals support a lower strategic weighting.

However, we accept that it is not all negative. The volatility of offices can provide outsized returns for those brave investors capable of timing cycles. Further, we do accept that the evolving sub-sector of flexible office hubs or workspaces may have more attractive long-term fundamentals in being a solution to corporate cost management and flexible working.

Most institutions have two main objectives when investing in property:

• To achieve a reasonable excess return over corporate bonds for the additional risks being taken (liquidity, leasing, tenant).
• To maximise the diversification benefits from investing in property relative to equities (given equity risk typically dominates investment risks for many institutional clients). In a very broad sense this second criteria could be approximated to maximising the property portfolio’s Sharpe ratio.

“There is a risk that property indices are increasingly being used as a reference point for asset allocation”

Given these objectives and our views on the various property sectors, we believe that relative to an index starting point the strategic sector allocations should be altered as follows:

• Office – lower strategic allocations;
• Retail – lower strategic allocations;
• Industrial – higher strategic allocations;
• Alternative sectors – higher strategic allocations.

Alternative sectors include residential (in certain markets), student accommodation, car parks, data centres, leisure and healthcare. Allocations to these sectors have grown from a low base in recent years. Data from US listed real estate companies highlight that alternative sectors have outperformed traditional sectors by 2.4% per annum over 15 years.

We believe certain alternative sectors are likely to be better supported than some of the traditional sectors. Thematic trends such as increases in overseas students derived from emerging country wealth growth (benefitting UK student accommodation), urban population growth combined with planning constraints (helping certain forms of residential) and ageing population/longevity (benefiting healthcare) are likely to be supportive.

UK property has had a strong run in the last few years benefitting from both yield compression and rental growth. The return from the IPD UK Annual index was 18% for 2014, taking five-year annualised returns to around 11%. As expected, offices have led the way over the past five years, given their pro-cyclicality.

We believe now may be a compelling time to review strategic property allocations.