Multi-employer pension fund UMR Corem has transformed the real estate portfolio since it was inherited in 2003 from a simple collection of Parisian apartments into a well-diversified, dynamic and purposeful allocation that returned nearly 30% last year - almost five times the average return of the whole fund. The architect of this change, the fund's CIO, Vincent Ribuot, sets out his investment strategy and ambitious longer-term goals for the organisation to Martin Hurst

What are the origins of real estate in Corem's portfolio?

In early 2003, after UMR had been restructured, Corem, a DB/DC hybrid, inherited a portfolio of assets and liabilities which consisted of directly held residential real estate in central Paris. As this was not diversified geographically or by type of real estate it didn't meet our needs in terms of return and diversification.
Our first step was to carry out a major ALM study: this generated a model showing how our liabilities will evolve over the next 30 years; the results of the study showed that we should have an allocation to real estate of around 10%. For diversification and inflation hedging purposes we decided to have a much more diversified real estate portfolio than the one which we inherited.
It was decided that the aim was that the real estate portfolio should provide a stable yield over the long term, as opposed to short-term buying and selling for capital gain. The aim is to keep the funding level above 100% on a very long term basis. All this will depend on Solvency II - and the discount rate we have to use on the liabilities side. We will have a second bucket for making capital gains to invest the funding over 100% but this will be invested mainly in private equity and listed equities; the real estate and bond portfolios are the basis of the long-term income strategy and maintaining the funding at least 100%.  
The first step in restructuring the portfolio was to sell our old real estate portfolio building by building, which produced capital gains - and losses!
We selected AEW to manage the real estate portfolio because we do not have the expertise in house. They are our consultant and provider of real estate opportunities throughout the eurozone.
Yes, real estate is one of the asset classes we outsource, the reason being that real estate is a very specialist business requiring local knowledge and we do not have the human or financial resources to manage it ourselves.

What benefits do you derive from co-investing?

We favour so-called club deals: we always invest alongside three to five big institutional investors who share the same long term objectives with us.
Although we know that our chosen manager would only present good opportunities we do not have the in-house resources to check to see that a given opportunity really meets our needs. Being alongside other big institutional investors like big Caisses d'Epargne or insurance companies which have the in-house resources dedicated to real estate provides us with the reassurance that a given opportunity really is suitable - or not as the case may be. So we rely on their expertise: if they like a given investment opportunity then we are very pleased to invest with them. Furthermore we know that our four big co-investors are stable and will not want to sell buildings after a year or two to realise capital gains. It is like a shareholder pact between us.
This arrangement also makes it possible for Corem to access very big real estate opportunities both in France and abroad. In November we bought a portfolio of shops from French retail operator Casino for €455m. We would not have been able to buy this on our own. So the five investors put in €50m each with some debt on top. The portfolio consists of 255 supermarkets with a 12-year rental income linked to supermarket sales and which we have the option to renew up to four times; this makes it very long term and linked to purchasing power, which is exactly what we need to pay the pensions of our customers.

What other sorts of assets do you target?

We target prime core office by buying headquarters of major companies, such as the headquarters of the German financial newspaper Handelsblatt in Frankfurt and that of the French company Alcatel near Paris. A lot of big listed companies like this want to arrange sale and lease-back of their headquarters because of new international accounting rules. Right now we have 45% of our real estate in offices, 42% in retail, 11% in logistics and only 2% left in residential. Housing does not meet our needs in terms of yield and revenue; it might be interesting in terms of capital gain but that is not what we are looking for right now. 

Why do you target these large companies? For example, Alcatel is in a very cyclical industry.

When I buy a corporate bond I ask myself two questions. First, will the company in question be able to pay me back the principal in 15 or 20 years? I don't have to ask this question in the case of a real estate investment because I already own the building. Of course I don't know what the building will be worth in the future but hopefully it should be more than 100% of what I paid for it. Second, will this company be able to pay me the yield of the bond? In the case of the real estate the question is simply: will Alcatel continue to be able to pay me the rent? If not we will look for another tenant. Of course I will lose some rent but I know that I have a very good quality state-of-the-art building near Paris and I know that many big French companies will be very happy to use it for their headquarters.
Yes, Alcatel is in a very cyclical industry which is why I would not buy their corporate bond.

Do you plan any other geographical diversification?

We will not invest outside the eurozone because we do not want to manage currency risk. Furthermore our customer base is in France right now. I want my assets to match my liabilities and my liabilities are linked to inflation in the eurozone on a long-term basis.
We will try to invest more in southern Europe which still offers opportunities; we think there are opportunities in Greece, for example. Italy and Germany are cheap compared with other markets and there were more opportunities and facilities to build an income-generating real estate portfolio. By contrast Paris offices are very expensive at the moment; the spread is not big enough because there is fierce competition from investors from Spain, Australia, the US, etc.
We also looked at Poland where there are very high yielding opportunities with income denominated in euros but we did not trust the stability of the political or economic situation. With UK real estate the problem is the currency: I'm not sure if we are in the eurozone or a US-dollar satellite zone when we are investing in the UK.

But doesn't a fully diversified portfolio necessitate its being fully international?

Yes but I am diversified in Asia and the US through stocks and bonds. In terms of real estate I want to concentrate on what we know, which is real estate in the eurozone, and we will maintain this strategy for the foreseeable future.

What benefits does the OPCI* bring to the institutional investor?

When Casino sold its real estate to us they paid less tax by using the OPCI which made it cheaper for us. The OPCI also makes it easier for us to maximise income from the investment. The main advantages of the OPCI over its predecessor, the SPCI, are fiscal. It is a perfect vehicle for us to buy real estate in France. When we buy real estate in Germany we create a special holding company in Luxembourg which makes the rental income fiscally transparent, while maintaining the ultimate goal of becoming owner of the building.

What is your view of debt in a portfolio in the current situation?

The less debt the better - after all we are cash rich. A small amount of debt is good to maximise the internal rate of return, but the ability of debt to enhance return is declining. It could increase revenue but that is not our priority. We are here to put our cash to work: when someone offers us a €50m investment I am very happy to put that amount on the table but if they only want €20m of Corem's money this is less efficient for us because I have to find more investments for the remaining capital.
We want to have a very pure core physical real estate portfolio so we are not looking at structured products where debt is securitised, or derivatives, etc. We might have used derivatives if we had not been able to find the properties we want to invest in or need to adjust our exposure in the short term, but this has not been the case to date.
The sub-prime crisis has not really affected our thinking for the time being. Its impact has been widespread in the structured financial product markets but in the physical real estate market which is our prime target in the eurozone we have not seen any effect. That said the credit situation has deterred us from investing in Spain or the UK where the real estate housing market is financed by variable rate debt and where the credit situation may affect the pricing of the real estate in the future.

What is your view of listed versus unlisted real estate?

We want physical properties; if you invest in a listed real estate company you are more or less linked to the stock market; we would then lose the diversification we get through investing in real estate. Even if it represents a very good investment it is not what we are looking for when we invest in real estate.
Listed real estate does offer liquidity but I am not looking for liquidity when I invest in real estate - I am looking for long-term stable revenues linked to my liabilities with the revenue linked to inflation.

How do you ensure good corporate governance?

Together with our manager AEW we are on the board of every investment where we are in partnership because investing in this way gives us a great deal of confidence in the way the real estate is managed.
They are a big solid company with a long history, and belong to one of the biggest financial groups. Of course, key person risk might be a concern if they lose their team but this is inherent to any organisation.
For our investment in the French regions we work with Lazard, which created a dedicated fund for that purpose - some €350m, of which we have invested €50m. Lazard has more expertise on that level; we use AEW for the big European cities such as Frankfurt, Paris, Barcelona, Milan, etc.

What are Corem's strategic objectives?

There are countries in southern Europe - Italy, Spain, Greece and Portugal - that will have to think of new ways to provide for retirement on an individual level. We aim to be the number one provider in France and seek new business in southern Europe. We are talking with governments there to encourage them to incentivise investors on an individual level to provide for their retirement.
Meanwhile the opportunity here in France is huge. We have just created a product on a company level along the lines of the Perco [recently created structure for corporate pension schemes] and we are targeting companies all over France.

What are the main challenges facing your organisation?

Solvency II might be a very big concern in terms of the capital we have to commit, and on a European level we are doing all we can to avoid having to be part of this. We are a long-term investor with long-term liabilities and we don't want to be hindered by short-term solvency obligations which the proposed legislation would impose.
The main issue is the discount rate for liabilities. If we were located in Belgium, the Netherlands or Luxembourg we would be overfunded because of the discount rate used in those countries. In France our legal funding is 92% because of the discount rate of 3% which is too low. It means we have to generate a return of 3% for the next 30 years which is quite easy: I will buy government bonds, match all my liabilities with returns of above 3% and go and play golf.
Another way to look at our funding status is to calculate what return we actually need on the long term to be 100% funded; this gives us a result of 3.3%.
The discount rate should be based on the liabilities and the available investment universe. A good way is to take the 20-year swap rate, which is around 4.8%. On this basis we would be 129% funded.
The logic of the current discount rate of 3% is that the French government does not want a funding problem in an insurance company while they are in office - in other words they are protecting their reputation. They say the rationale behind the 3% discount rate is customer protection but that is ridiculous. It prevents us from distributing a part of the wealth of the fund to its members.
The objective of a pension fund is not to be overfunded for the next 30 years but to maximise stable revenue over the long term to be distributed to its members while they are retired (and alive!).
Solvency II is a short-term view which does not work for pension funds. It would be a very expensive way to provide retirement income. It will have an impact on all alternative investments. For example we have 5% allocated to hedge funds to reduce volatility but Solvency II states that this is very high risk and that we must therefore have 45% additional capital for each €100 invested to cover the perceived risk.

* The OPCI (Organisme de Placement Collectif Immobilier) is a new regulated non-listed collective investment vehicle investing in real estate.