The development of property derivatives and institutional investment in residential property are key interests of Peter Pereira Gray. These are just two of his prime concerns in his role as chairman of the Investment Property Forum. He talks to Richard Lowe
When Peter Pereira Gray took over as chairman of the Investment Property Forum (IPF) in June 2009, the UK commercial real estate market had already begun to recover from its 44% peak-to-trough correction. Yields on prime assets had stabilised and begun to compress as competitive bidding for select properties finally returned to the market. By the end of the year, record monthly capital growth in December saw total returns for the year return to positive territory, according to Investment Property Databank (IPD).
In some ways, 2009 was just as remarkable a year as 2008 for the commercial property market in the UK, especially compared to continental Europe where capital values continued their gradual decline. Speaking in the first quarter of 2010, over half way through his 12-month tenure, Pereira Gray admits that 2009 was always going to be a tough year to take on the role at the IPF. "It has been a testing episode for the entire real estate industry in the UK, but it is exactly during these times of uncertainty when an industry body like the IPF comes into its own," he says.
The organisation's long-term mission is to improve awareness, understanding and efficiency of property as an investment for the industry, the government and its members. These include investment agents, fund managers, multi-managers, bankers, lawyers, accountants, researchers, academics and actuaries. What has remained at the forefront of Pereira Gray's mind during his tenure at the IPF is a desire to leave the organisation "in a good state" and hopefully improve it along the way. It's a tall order, he admits, citing the long line of individuals that have inhabited the role in previous years.
Not that Pereira Gray does not bring a wealth of experience, in-depth knowledge and investment expertise to the role. He is managing director of the investment division of the Wellcome Trust, and considering how positively the UK-based charity's investments have fared during the recent crisis, he is perhaps just the sort of individual needed at a time of financial uncertainty and market volatility. He is able to bring experience and knowledge that is directly relevant to some of the IPF's key areas of research and special interest.
The IPF has a number of special interest groups, one of which is concerned with the embryonic property derivatives market. Before the Wellcome Trust, Pereira Gray worked for the real estate arm of UK insurer Prudential (Prudential Property Investment Managers or PRUPIM), one of the first organisations to become active into the space.
"I became extremely interested in the tool and how it could enhance real estate portfolio management and construction. I was a believer then and I remain a believer," he says. At the end of 2009, PRUPIM said it had executed the largest series of sub-sector property derivative transactions totalling £100m (€115m). Total return swaps like these, based on multiple UK IPD sub-sectors, enable investors to rebalance their portfolios across real estate sectors in response to changing market conditions without having to sell physical assets. UK listed property company, Land Securities, has recently announced it is planning to enter the fray.
Such market announcements benefit the aims of the IPF's Property Derivatives Special Interest Group, which under the leadership of Nick Scarles, group finance director at Grosvenor, is striving to promote the use of the market and deliver more research on the subject. Pereira Gray says that sub-sector property derivatives are not widely used yet, but the special interest group has been "making strides" to that end.
The group also hopes to help facilitate the development of property derivatives for more speculative purposes, as their counterparts in the equity markets are used. "The nature of real estate as a relatively illiquid, heterogeneous asset does make it quite an interesting intellectual challenge, so the progress of property derivatives was always going to be slow," he says.
But Pereira Gray says they are a "very real tool" and is confident they will become a mainstream aspect of investors' investment strategies. The recent market turmoil may well have served as a catalyst. The complexities of managing real estate portfolios in an environment of such uncertainty have actually highlighted the value of property derivatives to investors. "There is a fair amount of money to be made or saved by using these tools. I'd like to think we will see the use of derivatives in property investment management continue to gain ground, and that more people will slowly adopt them. In due course they will become a standard," he says.
A champion of residential
Another IPF special interest group is committed to increasing institutional investment in residential property in the UK. The IPF is principally a commercial real estate body, but has recognised the logic of including the residential sector within its remit. In contrast to some countries in continental Europe, the UK sees a very limited level of institutional investment in residential real estate. The IPF is one of a number of organisations seeking to change this.
The reasons why you will struggle to find any UK-based pension funds or insurance companies investing in residential property are multifarious. Pereira Gray runs through those he believes are the primary ones: the market is fragmented and characterised by small lot sizes; it is dominated by individual buy-to-let investors; valuations and yield comparisons with commercial property are difficult; relatively high operating costs; lack of transparency; potential for political intervention. As well as the natural inertia that comes from not having a tradition of institutional investment in residential, there are technical stumbling blocks such as stamp duty rules that make it less attractive for investors to buy multiple properties.
Activity on the part of the Homes and Communities Agency, which has been working with a number of interested institutional parties to provide new homes for the UK, has brought some publicity, and the growth (and performance) of investment funds specialising in student accommodation have certainly helped bring some momentum to the movement. Pereira Gray admits that creating a vibrant residential letting markets in the UK led by institutional owners is always going to be difficult. "But there is more momentum behind this today than perhaps at any other time I can recall. The objectivity and independence of the IPF gives it an important role in facilitating this debate," he suggests.
He adds: "We really ought to be able to find ways of bringing all the interested parties together and creating vehicles and having a legislative and regulatory framework within which they can invest and which will encourage them to do so."
But why champion a sector of real estate that has so many obstacles for institutional investors? First of all, Pereira Gray genuinely believes in the benefits of gaining exposure to residential properties. "My view is that residential is an investable asset class and the particular dynamics and characteristics of the return and risk delivery are attractive to institutional investors, particularly pension funds," he says.
Pereira Gray is not just a supporter of residential investment from a theoretical standpoint. He puts his money where his mouth is - or that of the Wellcome Trust, to be more accurate. The charity's report and accounts for 2009 show that the vast majority of the Wellcome Trust's property portfolio is invested in residential assets. That is £1.1bn to be precise, almost triple the £399m invested in commercial real estate.
Pereira Gray admits that the Wellcome Trust is "unusual, if not unique" among major institutional investors in Britain by having such a significant weighting to the residential sector. The charity's investments were already significantly weighted to residential, but in 2006 the investment division decided to reduce its commercial weighting further in anticipation of a correction in commercial capital values.
In hindsight, such a portfolio has served the institution well. Its residential investments have outperformed its commercial investments, on an ungeared basis, over three-year, five-year and 10-year periods. The residential investments also ensured that the Wellcome Trust's overall property portfolio saw a return -0.7% over the past three years, well ahead of IPD figures for pooled commercial property funds, which returned -15.6% over the same period.
"It has been a considerable contributor to returns," Pereira Gray says of residential. He admits that comparing the performance of the Wellcome Trust's real estate portfolio, which is overweight residential, with IPD numbers, which have a sub-1% exposure to residential, is like comparing apples with pears. The point of making the comparison is to show investors how useful, and appropriate, residential investments can be in an institutional property portfolio. "I would encourage people to look more broadly than they typically do - just office, retail and industrial - and to see this as a very viable asset, albeit one with obvious challenges."
The Wellcome Trust owns residential assets in different regions of the UK, but the vast majority of its holdings are located in London and the south east of England. It is here that Pereira Gray has identified what he describes as a "strong, constant demand" for housing that is not met by a constrained level of supply. It is this dynamic that will help underpin the favourable investment characteristics of the region.
It is close attention to the fundamentals driving real estate markets that prompted the Wellcome Trust to reduce its commercial property weighting prior to the credit crunch. Pereira Gray does not pretend to have anticipated the full force of the financial crisis and market downturn, but in the investment division at the charity there was particular concern at the cheapness and availability of debt financing in 2006. It was clear to them that it was generous lending conditions that were driving the rise in capital values more than fundamental economic drivers.
"It seemed an extraordinary juxtaposition for us that you had a very high amount of debt available at historically very high loan to value rates and extremely low interest rates. So was it a surprise that prices were climbing quite quickly? Not particularly. Although, like many things, I am not sure I foresaw the full scale of the correction," he says.
In contrast to his longer term optimism over residential, Pereira Gray has been quoted recently as being gloomy in his outlook for the commercial sectors. He is keen to dispel any notions of his being a commercial property market bear, citing that the charity has committed to purchase commercial real estate in the past few weeks, but he does have some serious questions. "Without wanting to come across as negative," he says, "I still think we are in an environment where tax is rising, the consumer is under pressure, we've got huge fiscal and budget deficits, increasing regulation and - especially in the UK - political uncertainty with an election due by 3 June 2010. Those issues would say to me that investors might rationally require additional risk premium today. It's therefore not yet entirely clear to me that the world has improved much since March 2009, though the worst of the crisis seems to have been averted."
When asked what lessons investors should take from the financial crisis, Pereira Gray says one is the recognition that there is a "huge merit" in looking "beyond the next quarterly earnings statement or the next prospective rental growth numbers, a little further into the future".
Looking into the future and grasping the ‘big picture' is never easy when economic and market environments are so uncertain. As stated previously, this is why industry bodies like the IPF are vital to investor communities. (IPF is itself a founding member of the UK's Property Industry Alliance, alongside organisations like the British Property Federation and the Royal Institution of Chartered Surveyors, which seeks to tackle major real estate issues in a more coordinated way.)
One item high up on Pereira Gray's agenda as chairman is the potential to widen the IPF's membership. He is proud of the IPF's resilience through 2009, citing membership numbers holding up well, but the board is currently reviewing its membership criteria to see if it is the right time to widen. It is one of the IPF's chief objectives to ensure the organisation has "a sustainable foundation going forward in what is a new world".