REAL ESTATE - Pension funds will increasingly target alternatives within the property sector, according to Arlington Securities.

In a research note published last week, the firm urged pension funds to diversify within Europe and across real estate sub-sectors in order to maximise returns within an acceptable risk framework.

According to Arlington UK research manager John Danes, this will mean investing in niche segments such as nursing homes, student accommodation, medical facilities and car showrooms.

Despite having little in common, three of these sub-sectors – nursing homes, hospitals and student halls – have demographics behind them. With an ageing population, the UK government has set a target of 40% by 2008 for medical procedures carried out by private providers for the state-funded National Health Service. It has also set a 50% minimum target for young people entering higher education.

In contrast, optimism over car showrooms is predicated on recent liberalisation of automotive distribution within the EU, industry consolidation, and a growth in sale-and-leaseback deals.

Danes said the appeal of these niche segments lies in their relative stability compared with office.

"New property sectors are developing that will mitigate the risk in property portfolios," he said. "They may not have the strong outperformance you get in central London office, but they’re stable, with fixed uplift."

Figures published by the firm last week indicated that office, despite expected returns on 12% this year, would continue to underperform retail and industrial.

As yield compression slows in the office market and capital growth ceases to be such a strong driver of total returns, investors should focus on rental growth to generate returns, the note said.