Although confidence in non-listed funds has suffered in the wake of the downturn, increasing international diversification should help to revive interest in these funds, says Paul Mitchell

New research has explored how UK institutional investors' real estate strategies are likely to evolve following on from the unexpectedly sharp downturn. The research, undertaken jointly for INREV and the Investment Property Forum , sought the opinions of pension funds, insurance company life funds and charities whose £447bn (€515bn) of total assets represented about two-fifths of the total universe's capital. The INREV report also presents detailed estimates of the size and composition of UK institutional real estate universe.

Not surprisingly, there was a range of real estate strategies being followed by these investors. Most invested predominantly through direct real estate. This reflected both the dominance of big investors in the UK institutional universe and a strong preference, wherever practicable, for the control and influence a direct portfolio provides. Interestingly, few were able to invest in REITs and listed companies as part of their real estate allocation; traditionally, such investments were part of the equity allocation where the skills and expertise were perceived to be more appropriate.

There were polarised strategies amongst these big investors towards non-listed real estate funds. Some had embraced these enthusiastically, diversification being the primary objective. In this respect, non-listed funds were used primarily to enhance their UK real estate portfolios by providing access to out-of-reach or specialist sectors, and to lower the risk of the multi-asset portfolio by providing an exposure to international real estate. Superior returns were a less widespread motivation; within this group, a small number were using non-listed funds very selectively with the aim of getting alpha from carefully chosen managers.

Almost half invest outside the UK, on average putting about 15% of their real estate there. Figure 1 shows that non-listed funds were also the main route by which investors in the research got their international real estate exposure; for example, large pension funds (total assets >£2.5bn) investing in international real estate had 79% of this exposure in non-listed funds. Overall, this dominance leads to UK institutions investing around £8bn in international non-listed funds. Direct was difficult to implement for all but the very largest investors and did not provide sufficient diversification; most saw little alternative to using non-listed funds.

Figure 1 also reveals how cross-border investing in UK institutions is heavily intertwined with attitudes to non-listed funds. Those investing internationally generally have a higher exposure to non-listed funds than those restricting their real estate investments to the UK. For example, those big pension funds investing in international real estate had 25% of their UK real estate in non-listed funds compared with only 8% in those big pension funds investing only in the UK.

Those investors with negligible exposures to non-listed funds and not investing internationally had fundamentally different investment philosophies to the majority for which a well-diversified exposure was central.

They either saw no need for enhanced diversification from investing internationally and using non-listed funds (the rationale being that it could be attained more efficiently elsewhere, such as through hedge funds), felt that the returns were not worth it given risk, illiquidity, and governance issues, or had a very specific return requirement for real estate which, in their eyes, would be corrupted by a non-listed and cross-border exposure. They represented a significant minority of UK institutions.

There were also those who avoided specialist funds because they preferred to get access to out-of-reach or specialist sectors through joint ventures, which were perceived to offer superior control and alignment of interest. For this group, joint ventures were very much an alternative to non-listed funds, a view backed up by the observation across the survey that those with low exposures to non-listed funds had relatively high exposures to joint ventures.

The smaller institutional investors, which had insufficient capital and management resources to have their own direct segregated fund, also had varying strategies towards real estate. Overall, most of these small investors gain their real estate exposure through a UK balanced non-listed fund. This exposure and the investments by the bigger pension funds in UK specialist funds lead to non-listed funds accounting for about 22% of institutions' exposure to UK real estate, in total around £16bn of investment.

There were, however, also examples of smaller pension funds with much higher exposures to international real estate than their larger counterparts - in some cases representing 50% of their real estate compared with the typical 10-20% in the larger institutions. Their strategies involved either appending an exposure to a separate UK balanced fund or taking an integrated pan-European or global approach. The latter, according to some investment consultants, is becoming the norm in new mandates.

Looking forward, a number of themes emerge from the research. First, the proportion of their capital which UK institutions commit to real estate is poised to increase. This applies particularly to pension funds, mostly the smaller ones that at present are least likely to invest in real estate.

Second, international investing is set to increase relatively quickly. While most investors were attaching short-term priority to the UK and a few were planning to shrink their international exposures, the majority were committed in the longer term to an international real estate strategy. Increased exposures would occur as allocations which were not invested during the downturn were committed, as allocations were made for the first time, or raised to the levels attained by the pioneering investors. A particularly notable observation is that those completely new to real estate invest more outside the UK than their more experienced (and larger) counterparts.

This second development should lead to an increased focus on non-listed funds. Increased international investment was particularly the case among the 16% of investors planning to increase their exposure to non-listed funds.

Finally, and by contrast, many were also now reconsidering their use of non-listed funds, having faced unfulfilled liquidity, lack of control, and misaligned interests both with fund managers and co-investors. A significant minority were planning to reduce the proportion of non-listed funds in their real estate portfolios.

The focus of such reductions was typically UK specialist funds. Counterbalancing this was an increased desire to invest directly in sectors previously perceived to be out of reach or where the expertise to invest directly had been thought to be lacking. Such investors were happy to compromise the diversification benefits that had originally justified the non-listed approach.

The growth in real estate investment generally, and in particular investment outside the UK, should lead to UK institutions' exposure to non-listed real estate increasing by almost 25% from £23bn to over £28bn over the next few years. Figure 2 indicates declines among life funds will be outweighed by higher pension fund exposures. Overall, non-listed is expected to increase from 2% to 2.5% of institutions' multi-asset portfolios.
In conclusion, dependence on UK specialist funds is likely to fall as insurance company life funds (the heaviest users of specialist funds) reduce their UK real estate exposures and as the big investors in general shift towards direct investments and joint ventures. By contrast, higher strategic allocations to international real estate should - when market conditions permit - lead to greater investment in funds focusing on international markets.

At the same time, the indications are that a significant minority will continue to eschew investments in non-listed funds and international real estate, focusing instead on a core UK direct exposure and looking in other asset classes for diversification and superior returns and risk.

Paul Mitchell, Paul Mitchell Real Estate Consultancy