Pension funds are increasingly considering the role of property in an LDI or inflation hedging strategy. Julie Henderson examines some of the issues

Pensions funds have actively included real estate as a key element of their asset allocation for many years. But the volatility shock and significant shift in valuations have caused many executives to revisit the asset class and review whether the sector can be included in a liability-driven investment (LDI) strategy. The impact has been a significant boost in the prospects for real estate as an inflation-linking asset and a move that could change long-term rentals.

One of the difficulties pension funds have faced since the credit crunch began in 2007 is a major surge in volatility around the pricing of valued properties and in listed stocks. So treating real estate as a single low-risk asset class is no longer possible - a concept Belgian's Pensioenfonds KBC grasped ahead of the pack.

"We have always included real estate in our asset allocation and never considered it as an alternative in an alternative asset class," says Edwin Meysmans, managing director of Pensioenfonds KBC.

"We have always included real estate in ALM exercises and working with assumptions on the correlation on the two main asset classes, the expected return was better than bonds but less than equities. But since 2007, when we implemented our LDI strategy, we were faced with what to do with the real estate portfolio. You can use it for both getting a return and matching liabilities."

Ahead of the credit crisis, Meysmans and his team perceived real estate as able to deliver stable cash flow and to be inflation-linked. But the reality was that the investments they held, such as listed stocks and REITs, did not meet that low volatility risk. The gap between low and high valuation could be as much as 80% in two years, according to Meysmans, as prices dropped 50% in one year and rose 30% in the next. The focus on real estate therefore had to change.

"We are doing much more on the hedging liabilities of real estate, which means we will take lower yields and pay more for a building, in return for stable inflation-linked cash flows. The return aspect of real estate has become much less of an issue," says Meysmans.

Such volatility was clearly visible in 2009 as Investment Property Databank's (IPD) Q4 update on the UK Index showed total returns rose 10% by the end of 2009, yet the overall return was just 3.4% for the whole year. As IPD director Ian Cullen noted in February, the shift in record-breaking positive yields and a massive decline in rental yields appeared as though "property investment has become detached from the real economy" and was instead "driven exclusively by highly volatile shifts in capital flows which are immediately reflected in a truly amazing yield reversal". As he recognised, the volatility triggered a property activity shift from "the decade's most damaging to most beneficial impact in a matter of months".

Ben Sanderson, director of international investment at Hermes Real Estate, believes the lower volatility and benign activity of earlier years may have "lulled some real estate buyers into a false sense of security" about the position real estate holds.

And this is a problem many pension funds are now addressing in light of the market crisis, as they wish to hold assets generating steady lower-risk income and returns but feel they have to change their perceptions of what real estate now is within the asset-liability management strategy.

Pramerica Real Estate Investors is tapping a potential solution. It argues that real estate should be included in LDI portfolios because it delivers stable, long-term income returns, as well as inflation-hedging and diversification, and still helps to manage risks and deliver excess returns. Its answer was to launch the Pramerica UK Real Income Fund.

Whether pension funds can directly hold inflation-linking assets is dependent on their size, so many smaller pension funds are turning to specialist investments funds. L&G Property is the latest entrant into that space with the launch of its Limited Price Inflation (LPI) Income Property Fund, tapping long-term lease-originated income.

Pension fund interest has been sparked not just by the lower volatility of owning property with a 20-25-year inflation-linked lease but the potential 5% returns compared with around 1% gained from owning government bonds, such as long-term UK gilts.
Some pension funds which can directly hold property are entering into sale-and-leaseback arrangements. One example is the purchase of prisons, which took place in November 2009, when a consortium of seven Swedish pension funds at two companies bought a prison development leased to the Swedish Prison and Probation Service on a 25-year contract.

Ben Jones, director of real estate income at M&G - which has delivered inflation-linking investment for over 10 years - says that the average length of a lease in his fund is approximately 24 years, but more companies are opting for the advantages of a longer lease, and the market is beginning to open up.

"There is a range of sectors where there are tenants who can enter into long-term leases. We buy offices, supermarkets, healthcare, hotels, student accommodation, so there are a range of sectors where you can get inflation-linking, along with a good level of sector diversification,' says Jones.

"What we have seen is a large demand for real estate focused in this area. It has made sourcing stock a little more difficult, but that is not to say there is not the right stock. We have spent £200m (€227m) since September on new assets. It is a case of being selective about what we buy.

"We need to see this return in demand to get valuations on the upward path again, to attract supply to the market. It will encourage more corporates to enter into these transactions, particularly those with strong income requirements and occupational requirements. Tenants as well as investors like the idea of removing themselves from the five-year market review lottery."

That said, there are still some pitfalls in holding properties for inflation linking, as Hermes' Sanderson recognises.

"There is a belief that real estate works as an inflation hedge, and capital values will move with inflation. In the long run, that tends to hold but in the short term there can be a slow adjustment in income," said Sanderson.

"We diversify in locations and hold offices, invest in banks, and shopping centres. But there are risks attached too. A classic example is when M&S closed down their international operations, even though they were doing very well. It caused huge problems for landlords because of local issues."

While there are still some apparent risks to investing in inflation-linked property, pension funds want to hold it as a key element of LDI.

The complication over coming years is likely to be that this growth in interest is happening just as supply of properties in the market is tightening in some countries, according to Meysmans, because other pension funds and investment houses now seek these lower volatility investments.

"We are trying to get some sort of recession-proof real estate. Retail will hold up but residential will hold up better. We have been doing more on sale-and-leaseback, inflation-linked property, and senior housing, and they have long-term contracts with an over 100% occupancy rate as there is a waiting list," says Meysmans.

"But the reaction I get from brokers is: this is what everyone is looking for," he adds. "Multinational companies are considering sale-and-lease-backs. And people are willing to pay very high prices if they can get stable cash flows. We are looking more at social infrastructure, and we would be happy to buy prisons and schools and get a stable cash flow in return."