A new survey by the Pensions Management Institute and Prupim offers some good news - UK pension funds are sticking with real estate despite the turmoil in their home market. But as Richard Lowe discovers, more surprising is what they want to see from their investment managers

As one property securities analyst said at a recent press conference in London, the real estate sector is short of friends at the moment. This was said, of course, in reference to short-term money that switches between asset classes, in particular the hedge fund community, which has been busy shorting the real estate sector.

Thankfully, the asset class does have ‘friends' in the form of long-term investors who place more importance on portfolio diversification and have the appetite to ride out cyclical downturns. Pension funds certainly fall into this category and anecdotal evidence suggests they will continue to allocate meaningful levels of capital to the asset class despite the onset of an increasingly negative outlook since early 2007.

A recent survey by the Pensions Management Institute in the UK and fund management house Prupim has added quantifiable evidence to this notion - at least for UK schemes. Having run interviews with 200 institutions in the UK, the survey revealed that three-quarters of respondents are either maintaining or increasing their current level of exposure to property.

You can see from figure 1 that 55.3% of pension schemes are maintaining their current level, while 21.3% are slightly increasing and 4.3% are significantly increasing their allocations over the next three years. This leaves a minority of those that are either undecided (10.6%), slightly decreasing (6.4%) or significantly decreasing (2.1%).

This is not entirely surprising given pension funds will generally set their target allocation every three years, but Paul McNamara, head of research at Prupim, says this is an "encouraging, comforting" confirmation that they are not in effect "running away from the asset class".

However, the turmoil and unprecedented volatility in the UK market cannot have unfolded without prompting the country's pension funds, many of which have large direct exposures to their domestic market, to question the benefits of investing in real estate. "They are a bit shocked at the speed at which things happened," McNamara admits.

But according to the survey results, the vast majority (73%) said recent developments had not altered the perceived benefits of investing in real estate. The majority of those whose views had changed (the proportion was higher among smaller schemes) pointed to poor short-term return prospects. But a number commented on the increased volatility exhibited by the UK market as a reason to look for ways to invest in real estate in which such volatility could be mitigated or avoided, including diversifying internationally.

If the recent turmoil in the UK market has not prompted the majority of pension funds to turn away from real estate, it has at least thrown up some questions about the characteristics of the asset class. Is real estate's reputation as a low-volatility asset class being challenged? And what implications does this have for its role in a multi-asset portfolio?

One survey respondent noted how pension funds had been attracted to real estate by its lower volatility relative to equities, coupled with higher return expectations compared with bonds, only to discover the level of volatility had possibly been underestimated. Another said: "Our perceptions of the benefits from real estate have changed - we are seeking lower volatility methods of owning real estate."However, by far the principal reason for investing in real estate, according to the survey, is not low volatility but rather the diversification benefits due to its low correlation with other asset classes (see figure 3).

In contrast, survey respondents were split down the middle on the question of whether real estate is an alternative or a mainstream investment class. It is likely that the larger pension funds with historic direct portfolios see real estate as mainstream, while smaller pension funds may place it together with their private equity and hedge fund investments. It is an important distinction, because it may go some way to explaining why a greater number of large pension funds have a preference for core investments than their smaller counterparts (see figure 2).

"For the larger funds this was a mainstream asset class and they tended to have larger allocations to it, whereas it was the smaller funds that saw it as an alternative asset class and that probably does mean it is in a bucket with other alternatives," McNamara says.Overseas investment, meanwhile, sees pension funds across the board targeting core-plus or higher (see figure 4).

"The way I read that is, if you are going to take more risk and get involved in markets you are not physically or mentally familiar with, then you are probably going to want to be better rewarded for doing it," McNamara adds.The most surprising finding for McNamara, in relation to overseas investments, is that almost half (44.4%) of survey respondents have some form of overseas real estate exposure. He is certain this figure would have been a lot lower a few years ago.

"That was a complete surprise to me," McNamara admits. "But the infrastructure to facilitate that has been building for a decade."The fund management industry will also be interested to learn that UK pension funds' top three characteristics of a successful real estate manager are, in order of importance: clear investment process; good operational risk controls; and, top quartile performance over the medium term (see figure 5).

"The natural expectation is to see top quartile performance right out there in front," says McNamara. "It is a clear message for [fund managers] like ourselves that we have to be able to articulate what it is we are doing and why."Another surprise was that pension funds placed ‘strong sustainability credentials' fourth in terms of importance.

"It finally scotches the notion that nobody cares about sustainability," says McNamara.
The finding is even more noteworthy when it is considered that the survey was mainly representative of corporate pension funds, with local authority schemes, which have been active in the sustainability space for some years, making up only 6% of the sample. "If it had been 96% local authorities it would not have been anywhere near as surprising," McNamara says.