Despite the recent economic turmoil, real estate contributes a significant amount of returns for UK pension funds. Gail Moss reports
After a seismic loss of confidence, property investing by UK pension funds is now undergoing something of a renaissance.
"Property fell out of favour a few years ago, and the average allocation is still low," says Julian Smith, fund director at F&C REIT. "However, it is now starting to move back up and should reach 10% in the medium term."
Smith says there has also been a change in what pension funds expect from their property portfolios. "Diversification has always been the key thing, so in the past investors have gone for a mix of core funds and more opportunistic investments," he says. "But now property is getting more specialist and funds are demanding cash flows which match their liabilities. In future, the main driver for pension funds will be income, not capital appreciation."
This trend has also been noted by Andrew Jacobson, senior investment consultant at LCP. "Traditionally, property has been seen as part of the growth portfolio, as it helps to provide a return above inflation," he says. "That still works for many pension schemes, but as they become more mature they are likely to pay more attention to the bond-like characteristics of rental income streams. And as bonds are very expensive and yields are extremely low at present, property is being considered as a substitute."
Jacobson adds that while property should always be considered a long-term investment, pension funds have become more concerned about liquidity in recent years. "Exposure to the direct asset class is increasingly being taken through its most liquid form, i.e. large balanced property funds," he says. "This gives pension funds economies of scale and alignment with other investors, leading to better ongoing liquidity. Closed-ended funds where capital is locked away for several years are far less suitable."
Jacobson says this also underlines a further trend: a relatively risk-averse approach to investment, looking for high quality, secure properties to provide a safe haven investment.
Unsurprisingly, pension fund property portfolios still retain their strong domestic bias, thanks to familiarity with the market, and ease of access, particularly for those who want to hold property directly.
Resilient domestic market
And over the past year, the UK property market has provided solid returns. Total returns for commercial real estate for the whole of 2011 was 8.1%, according to Investment Property Databank (IPD). This was mainly attributed to income (6.8%), rather than capital growth (1.2%). Capital values actually fell in November and December 2011, and January 2012 by 0.2% during the latter. This fed through to the City office market, which experienced value declines for the first time in 27 months, by 0.1%.
"UK property has performed well over the past year," says Rod Ross, director, UK property funds, Aberdeen Asset Management. "Rental growth has been disappointing but, due to the level of income, total returns have been favourable compared with other asset classes. The most significant event has been the downturn in the middle of the year, which particularly affected demand for retail property."
The downturn prevented a greater element of capital uplift, with only prime retaining gains made since the start of the 2009-10 recovery. However, Ross says that income (around 6.7% of the return) has proved defensive. He notes that some pension funds that already invest have been reducing their allocations to other asset classes to put more money into property.
"They see property as a safer haven than equities and fixed income, which are both suffering from volatility," says Ross. "However, funds which haven't invested in property up till now continue to be cautious."
But even bricks and mortar have their downsides. "Our one concern is liquidity, and that raises issues because with the ongoing difficulty in obtaining debt, there's a continuing lack of activity," says Ross. "There aren't the buyers out there."
As other managers have noticed, safety-first has become a priority. "Pension funds are now prepared to sacrifice higher rents for income security, so demand is focused on the longer leases," he says.
And this is having an impact on the shorter-income end of the market. "There is very little demand for some parts of the office sector, especially secondary offices in premises where it's difficult to get longer leases," says Ross. "And multi-let industrial properties with unexpired leases of less than 10 years are also being affected because of a liquidity problem - investors are finding it difficult to get rid of them."
But supermarkets, with leases of over 20 years - albeit at relatively low yields - are becoming increasingly popular with investors.
There is, of course, another reason why supermarkets are flavour of the month, if not year, in comparison with other retailers. And that is the pressure the high street is experiencing, not only from out-of-town and online competition, but also from the growing consumer reluctance to spend, as job cuts continue to bite.
"Values have adjusted to reflect these changes, but we see the trend of fewer retailers able to trade successfully in the high street, continuing," says Ross. "Retailers will focus only on prime locations, so there will be less demand for all but the very best high streets. We may see the poorer secondary properties remain vacant for long periods of time."
And that is reflected in valuations across all commercial sectors. "Around 12 months ago, we expected secondary yields to have improved by about now," says Ross. "But the gap between prime and secondary has widened. In spite of the yield advantage to holding secondary property, there are very few signs of investors moving up the risk curve to get higher returns."
But all on the retail front is not gloomy. Besides supermarkets, Aberdeen likes retail parks and prime shopping areas, such as central London and traditional cathedral towns, where the ability to build shopping centres is constrained.
"Some retailers are being very successful and continuing to grow market share, and in a lot of cases, tenants are prepared to accept RPI [retail price index] or fixed rental uplifts," says Ross. "We think rental growth in these areas will keep pace with RPI growth."
Smith adds: "In retail, there's a flight to quality, so it's the prime shopping areas such as York - where we've been buying for clients - and Chichester which are more robust." He believes that shrewd manipulation of both tenancies and the properties themselves will be the key determinant in returns.
"The days of investing in property and just waiting for the value to go up are long gone," he says. "The difference between the winners and losers over the next 12 months will be asset management skills."
Within the UK, the London market continues to be seen as a safe haven for both British and international investors, attracting £32.5bn (€38.9) in investment during 2011, according to CBRE. This was down on the total for 2010 (£35.8bn), but the strength of the market in the fourth quarter of 2011 - during which it saw £8.3bn of investment - suggests continuing appeal for investors. This flight to quality is particularly relevant to London, which accounted for £8.4bn of the UK's total for 2011.
"I expect that situation to be maintained," says Jacobson. "Central London offices are less likely to be exposed than the rest of the UK to the government's austerity measures. Throughout the UK as a whole, about 20% of employment is reliant on the public sector, whereas in London it's only 10%. So it should be less affected by government cuts."
In addition, London is still a world financial centre and will be more resilient in terms of demand from global financial institutions for office space, says Jacobson. "There is also lack of new space because of cutbacks in bank financing for new office developments," he says. "Also, in terms of London retail, extra tourists brought in by the Olympics should help boost spending."
As ever, there are pockets of stability in the regions, and Smith says he has seen some office markets improving there. "We have seen occupancy increase in Manchester, Glasgow and Bristol," he says. "However, there is still an oversupply of secondary quality offices."
One concern a year ago was how quickly the large property portfolios held by the banks would be released onto the market. But the feared flood of properties has not materialised, says Ross. "The banks have sold the good quality properties, but retained those of poorer quality," he says. "I anticipate we'll see them looking for other solutions for disposal - such as joint ventures with fund managers."
However, rather than seeking sales of secondary assets at heavily discounted prices, lenders are preferring, where possible, to trade on the loans. "That's good, because it will further delay the negative impact of more secondary properties being brought to market, and thus help to preserve value," says Ross.
Global diversification on hold?
In spite of a renewed interest in property investing, there is a mixed picture in terms of diversifying abroad.
"Before the crisis, there was an appetite to go further afield, because returns in the UK were lower and it was a more competitive market," says Smith. "Pension funds expanded into Europe, then Eastern Europe, and then the US and Asia. But since 2008, there has been very little new investment abroad, reflecting greater risk aversion and more attractive pricing of UK property."
Smith adds: "There are now some new opportunities in Europe, but few pension funds are taking advantage. Even though UK investors are more optimistic about the future of the euro than they were a few months ago, they are not confident about the overall economic outlook for the next six months."
But Ross says increased appetite for property has caused more pension funds to consider diversifying abroad. Where funds do invest, Ross says, the stronger European economies such as Germany and the Nordics are still attractive, and are usually tapped via multi-country funds. "There are concerns about currency weakness and a potential fall in consumer demand, but these are seen as short-term issues," he says.
Further afield, he says that Asian markets remain attractive, with very strong potential growth. "However, people are now very selective, and carrying out more due diligence," says Ross. "They are concerned about the level of gearing, and also about the total cost of investing in the fund and the impact on performance."
Jacobson is also concerned about the structural aspects of buying abroad: "At the moment, funds that access European and international markets are less suitable for UK pension schemes than those in the UK."
First, he says it is more difficult to get to know the markets properly. And a higher level of ongoing governance is needed than for the UK. "Second, overseas vehicles typically rely on higher levels of debt financing," he says. "Most UK balanced funds have leverage of between nil and 10%, whereas some European funds being marketed to UK pension schemes have 40-50% leverage." He says this could be significant, because debt financing from the banks is more limited than it was before the credit crisis of 2008.
"There are also the regulatory changes in Europe, with Basel II and III placing more capital constraints on banks," Jacobson adds. "That will make debt less available and more expensive than it used to be."
He is also concerned about how ongoing uncertainty about the euro might affect the property market. "The potential for the break-up of the single currency will have a significant negative effect on property on the continent, irrespective of other issues," he warns.