Pension funds are now much more capable property investors than they were but how far will prevailing market conditions stretch their capabilities? Richard Lowe reports

The global real estate investment market has developed hugely over recent years, in terms of scope, capitalisation and sophistication, but it still remains less mature and sophisticated when compared to equity or fixed income markets.

Can the same be argued for real estate pension fund governance in relation to real estate investments? Real estate is by no means a new asset class for a large number of European pension funds and is more likely today to be viewed as a mainstream category rather than an ‘alternative'. However, many pension funds have only entered into property in recent years.

As Pam Alsterlind, partner and co-head of private real estate investment management at Partners Group, explains, it really does "depend on the pension fund". Alsterlind cites the €250bn (€169.5bn) California Public Employees' Retirement System (CalPERS) as a prime example of a highly sophisticated institutional real estate investor. CalPERS has been investing in the asset class for at the best part of three decades.

"You wouldn't see any big difference between their real estate investments and others, in terms of procedures, policies, what their staff can do and in the style in which they invest across the whole risk spectrum," she says.

In contrast, other Partners Group clients, which include European pension funds as well as US institutions, are recent entrants to the real estate markets.

"For them you are taking baby steps along the way," Alsterlind explains. "One client, a US-based fund, would only invest in core or value-added US real estate and we are now going back and educating them on the benefits of investing offshore and in higher risk categories."

How far up the risk spectrum pension fund investors are able to go depends on an institution's "experience level", she adds. "The more experience you have, the more you are going to be willing to potentially move up the risk spectrum. People usually start with core real estate and direct investment - buying an office building or buying into a fund that has direct ownership of real estate. But as they get comfortable, there are a lot of other opportunities. It might be buying into a fund that turns around real estate companies, so the investment is then in a company that owns real estate. That is riskier and more complicated to understand."

Stephen Holt, head of UK and Ireland institutional sales at Principal Global Investors, has a lot of experience in working with trustees of UK pension funds and has not found governance in the area of real estate to be "notably lagging relative to equities or bonds, for example".

Holt points out that a number of UK pension funds had sizeable direct real estate investments reaching back to the 1980s, many of which were "wound down" as the downturn of the early 1990s hit home. Real estate is also a subject that trustees are going to have a natural familiarity with, given the culture of residential property ownership in the UK.

"If somebody can grasp the concept behind property investment, they can understand that returns are generated by a combination of capital appreciation and the income yield the property achieves," Holt says. "They can understand the differences between the geographical and sector effects within portfolios that the fund manager will try to capture."

The current uncertainty and anticipated downturn in global real estate markets does have the potential to pose more of a challenge to pension fund governance than periods of unbroken growth as we have seen in recent years, both in terms of weathering the storm and taking advantage of opportunities that actually arise in times of dislocation.

Holt believes that today's uncertainty will pose a challenge, because it is coinciding with the move by many UK funds to diversify their real estate investments on a pan-European or pan-global basis, as well as some of the most sophisticated UK funds looking to commit capital to specialist satellite vehicles that focus on particular sectors or geographies.

The end of the bull market in real estate "begins to make people think about downside protection", Holt says, including the use of derivatives, swaps and other synthetic instruments."That introduces an added level of complexity that trustees are not used to coping with," he says. "That is going to be challenging."

But at least pension funds have not panicked at the first signs of a crisis in the real estate markets, says Greg Wright, principal at Mercer. "Pretty much uniformly across the client base, we haven't seen any panic, which I think has been quite heartening," he says.Wright contrasts the ability of trustees to assess the situation soberly with the early 1990s when the market downturn spurred an institutional exit from the asset class. "At the first sign of bad news, people wanted to get their money out. Forewarned is forearmed this time around."

As Wright adds, some pension funds are comfortable continuing to invest in real estate in the current market environment, reasoning that "things have gone down, I'll capture those better yields that are now available". Others may be delaying their investments to the middle of 2008, but none of Wright's clients are "completely turning the tap off".

Pension funds will therefore be in a position to take advantage of opportunities that arise in a bottoming market. As Alsterlind says, "you can come in now as a new investor in these markets and buy low. That is what is great about private real estate - there are inefficiencies in the market and we look to capitalise on those opportunities.
In the past, when everything was healthy, it was easy to invest, but now these will separate those who can really read markets and see where the inefficiencies are."

Pension funds, of course, need the sufficient sophistication and governance provisions in order to be in a position to capitalise on these opportunities.

"It requires more education," Alsterlind admits. "Some may shy away from it."

Nick Duff, head of property at investment consultant Hewitt Associates, admits there are "some educational requirements in terms of performance reporting and such like", but maintains that real estate does not pose more of a challenge to trustees and pension fund governance than other asset classes.

"It is very difficult to monitor the progress of non-listed real estate - there are issues on pricing, short-term performance - but the key message is to be sure the trustees are fully cognisant of those sorts of shortfalls."You get that with other asset classes as well - it is not necessarily just real estate. Today's trustee or investment committee is a lot more tuned into the different investment types than they were five or 10 years ago."

Global real estate investment markets have made massive strides in recent years in terms of their sophistication, but they are still less developed than the equity counterparts. For example, while the advent of property derivatives demonstrates the speed and extent to which real estate is progressing, the fact that such instruments have only made it onto the scene relatively recently when equity derivatives have been firmly established for years is equally notable.

This is certainly one way of looking at the development of the real estate investment market in context, and one that has implications for pension fund governance. Pension fund investors invariably allocate to the asset class for its diversification benefits - essentially its low correlation with equities - and its potential for strong returns.

However, one theoretical cost of committing capital to real estate, as opposed to equities or bonds, is that the former will not necessarily be able to offer the same level of transparency.Nick Brugman, global product specialist property at ABN AMRO Asset Management, believes that the problem is "basically inherent" to the asset class.
While improvements can be made to the market, and regulations and rules can be tightened, "you cannot have the transparency that you have with equity markets", he says.

Brugman cites the recent fraud scandal surrounding the Philips pension fund as the kind of incident that boards can never be "100% sure" they will be able to avoid. The risk management framework being set up by the Dutch Association of Institutional Property Investors (IVBN) in response to the fraud will no doubt help prevent similar cases in the future, but it is impossible to completely immunise against such problems when the asset class in question is always going to offer a limited level of transparency.

Of course, investing in unlisted real estate and thereby outsourcing the transactions and processes to a third-party means a pension fund is further removed from instances like the Philips debacle."It still can happen," Brugman says. "But if you believe the asset manager you are giving your money to is a reliable party, you make a big step."

Listed real estate, and real estate investment trusts (REITs) in particular, can offer yet more transparency due to the reporting obligations they are subject to. This, of course, varies from region to region, depending on the local reporting regimes in place.
Brugman therefore believes the growing popularity of listed real estate "will help make the whole asset class more transparent".

The largest pension funds in the Netherlands have certainly embraced listed real estate; many have invested in the sector for several years and the largest, ABP, currently assigns more than half of its real estate allocation to listed investments.
Patrick Kanters, managing director, real estate, Europe and Asia Pacific at ABP Investments, explains that the pension fund aims to take a "broad view on what is happening" in both the listed and unlisted sectors, but that the fund is currently favouring the former.

"Our portfolio strategy really comprises of these two categories and currently we are generally more in favour of building up more exposure to listed real estate," he says.
With some of the larger institutions, like ABP, embracing listed real estate, many smaller schemes with fewer research and analysis resources will have considered following their lead."For some smaller pension funds that provides some comfort,"
Brugman says. "If they are very positive on listed property, then there should be some truth in that story. That triggered for a lot of pension funds and institutional investors the question whether they should invest part of the asset allocation in listed property."

However, any potential clamour for listed real estate among pension funds has been somewhat subdued by the dramatic volatility seen in property stocks since the early part of 2007. Brugman admits that this high volatility - something which many investors have sought to avoid by committing capital to real estate in the first place - has undoubtedly put many pension funds off the sector."Looking at what happened last year in listed property markets, a lot of investors are currently reassessing the ability to invest in listed property markets, because if they make an investment in property they don't like volatility," Brugman says."They invest in properties to be away from the volatility in their equity portfolios, so the whole trend to global listed property is a bit delayed."But Brugman believes that investors need to have "the nerve" and a long-term perspective to allocate to listed real estate, in spite of the volatility it demonstrates.

"Luckily," he says, "there are a lot of investors who do have the nerve and the long-term view to see the benefits of what is currently happening in the listed markets and see the benefits of listed property as a serious alternative for property assets.

"If you invest in property, you don't do it with an investment horizon of one or two months. If you buy an office building, you do it because you expect that over the next three or five years, or even longer, you will get an interesting return. Basically, that is what you do in listed property, because if you buy a listed property company or a portfolio of listed companies, what you buy is a vehicle that gives you access to different direct property markets. And because the price of your assets is quoted every second, you have volatility. But if you do that with the same investment horizon as you would have investing in direct property, what you get is a return which is close to a return of direct property assets."

But Rainer Jakubowski, chief executive at the €19bn German pension fund BVV, has fundamental concerns about investing in property securities, because arguably they do not represent ‘pure' real estate and will be correlated to equity markets.
"When I buy equity exposure it should be pure equity and when we are taking on real estate risks they should be pure real estate ones," he says. "I don't like this kind of mixture, because it is always difficult for your risk management."