Worldwide institutional investors are being seduced by real estate. Property has produced some impressive returns over almost any period during the last 15 years, and with bonds offering low returns and equity markets volatile, real estate is seen as an attractive alternative.
And for maturing pension funds with fewer contributors and higher payouts to pensioners, real estate looks attractive as a source of stable income in the form of rents.
“There has been a huge appetite for real estate over the past five years – it really will come to be seen as a ‘golden period’ for real estate,” says Peter Hobbs, global head of real estate and infrastructure research at
Deutche Bank subsidiary RREEF. “Over this time, real estate has performed really well, absolutely and in relation to other assets.”
But aside from returns, impressive though they are, it is as a diversifier that real estate really scores. Its returns are uncorrelated with either bonds or equities.
Research in October 2005 from JPMorgan put optimal weightings at 10 to 15 per cent for pension funds in Europe, but existing allocations vary widely from 0.2 per cent in Austria to 21.5 per cent in Italy, with the average at around 6.5 per cent. On the whole these are significantly higher than in the US or Japan where weightings average 3.4 per cent and 1 per cent respectively.
UK institutions are cranking up their allocations, but they are not yet at the levels that would give them the most favourable results. Robin Goodchild, head of European strategy at LaSalle Investment Management, comments: “In the UK typically pension fund allocation was typically 5 per cent , now 10 per cent is more likely to be the target for most, and some are pushing that to 15 per cent. In the Netherlands 15 per cent is not unusual.”
Historically US institutional allocations have tended to lag those of European counterparts, but here too allocations are rising. And the appeal of real estate is reaching out beyond traditional backers in larger public pension funds to smaller corporate funds.
In part this is due to the availability of vehicles that allow access to smaller funds. “Whereas in the past the corporate plans that are smaller in size would be precluded from investing in the asset class because they didn’t have $50m or $25m now they really can make an investment with as little as $1m, or with real estate investment trusts (REITs) they can invest with a much smaller amount,” says Allison Yager, principal at Mercer Investment Consulting.
Investors have tended to look first to domestic markets for their real estate investments, but the current tendency is to broaden horizons. The greater choice of vehicles for cross-border investments, coupled with greater availability of research and the need for diversification, have encouraged investors to look beyond their own borders. And in the last few years the eurozone has meant European investors regard the whole zone as their home market, with the disappearance of currency risk. A dearth of local investment opportunities is also driving investors to seek opportunities elsewhere.
In Switzerland where the focus has always been local, the current lack of suitable Swiss properties for investment means investors are beginning to look further afield, though as yet few institutions have acted.
More than 90 per cent of Swiss institutional property investments are domestic, according to Graziano Lusenti of Lusenti Partners. “It gets more and more difficult to find appropriate investments in the Swiss real estate market. That’s one of the reasons I expect international investments to increase.”
European attractions
 | Kiran Patel, Axa Real Estate IM |
For European investors who want to invest cross-border, the opportunities have increased. According to Kiran Patel, global head of research and strategy, Axa Real Estate Investment Managers, UK investors are now keen to invest in other European markets alongside a local partner. “A lot of work in the legal and tax area has been done to facilitate that,” he says. “You have greater information flow and more research.”
For UK investors another attraction of the European real estate market has been the lower borrowing costs. “UK institutions have got excited about continental Europe in the last couple of years because debt has been a lot cheaper in the eurozone and property yields are fairly similar, so generating leveraged cash you can get much higher numbers in continental Europe than you can for the UK,” says Mr Goodchild.
The taste for overseas investment is taking longer to take hold in the US, however. Ms Yager at Mercer says her US clients are not yet taking the plunge. “That partly relates to the fact we have some clients who are starting to build real estate portfolios and they have pretty conservative guidelines and are starting with more core strategies.”
Alternatives
Though usually considered an alternative asset class, for many investors real estate is actually part of the mainstream. Real estate may have been so long a part of the portfolios of many pension funds and insurance companies that they regard it as core.
From the angle of offering a risk return profile that is different from both equities and bonds, real estate obviously qualifies as alternative.
If it forms part of an allocation within an alternative portfolio, perhaps 2 per cent out of an alternative allocation of 6 or 8 per cent may be devoted to real estate, according to Mr Patel. One person in an investment team may be charged with dealing with alternatives as a whole, which can be an advantage. “It helps because the person who deals with alternatives tends to deal with private equity and hedge funds, and the indirect unquoted vehicles are similar in structure,” he says. Both real estate and private equity present investors with issues around valuations and liquidity.
Mercer in the US takes a different view. There real estate is regarded as a standalone asset class, separate both from alternatives and equities and bonds. Ms Yager comments: “We break it down between listed property and non-listed property which have different characteristics.
“From an asset allocation perspective it’s not lumped in with hedge funds and private equity. It has different characteristics from other alternatives and the more traditional asset classes.”
In building an optimal portfolio size matters. Large scale investors have wider scope for choice. With £1bn to invest, it is possible to build a portfolio by investing directly, using pooled vehicles, doing joint ventures or buying listed securities. It depends on the attitude to risk and liquidity, and the degree of control desired. Larger funds may well employ specialist real estate professionals, with the expertise that goes with that.
At the other end of the spectrum investors with less than £100m to invest are more limited. “Indirect vehicles are likely to be your main thrust, you may go for balanced funds if they exist,” says Mr Patel. “You may get a spread of managers – one office, one retail, one industrial - or give it to a fund of funds. That’s a new trend: funds of funds have started to take off a bit, though it means double fees.”
 Tyrrell: derivatives offer cheaper access to real esate rather than buying dirrectly | The level of underfunding or surplus also affects investment strategy. “If the scheme is underfunded they are going to be looking for very high returns, if comfortably funded they are probably going to be going for lower risk,” says Nick Tyrrell, director of research and strategy for JPMorgan Asset Management’s Real Estate’s European team. |
Derivatives
A new development has been the appearance of real estate derivatives. For the moment these are restricted to the UK market, in the form of swaps on the IPD index. The index’s annual return data for the UK going back to 1970 has recently been supplemented by quarterly data for use in derivative contracts.
In theory in the longer term derivatives could be a solution to one of the major downsides of property investment, its lack of liquidity. Currently one way of accessing real estate liquidity is to invest in listed property companies, but these are likely to reflect the performance of the stock market as much as the underlying assets, the properties themselves.
The advantage of derivatives is they are a cheap means of access to property buying, compared to buying properties. Mr Tyrrell estimates that the cost of selling one property and buying another at around 8 per cent in the UK, one of the cheaper markets for trading.
Derivatives may become an important addition to investors’ choice of vehicles for real estate investments, as they are for bonds and equities. But this may take time, as there are a few hurdles to be overcome.
Many commentators have serious reservations. For one thing there is a lack of intermediate liquidity with the consequent risk for an investor of being locked in to the investment.
“At the moment they have upfront liquidity,” says Ms Tyrrell. “If you want to take a derivative position you will probably find somebody in a short time willing to take a counter position and write a contract that will typically be for three years.
“The big question is: can you do something with your position in those three years? If you are locked into it for three years that is less liquid than property in a way.”
Valuations are also an issue, because there is no underlying market to give price transparency. Mr Tyrrell admits to feeling uncomfortable with not knowing whether derivatives are priced correctly or not.
Ms Yager agrees: “Derivatives work better when it’s an asset class that is traded on a market on a daily basis and you have a value every day.”
So it may be a while before derivatives take off as regular products for investing in real estate, and even then they may not be for everybody.
