Smart marinas and student digs, upscale hotels and doctors surgeries. They may not seem to have much in common at first blush but these are some of the new properties that investment managers are starting to offer to investors as property comes back into vogue. Consistent and strong returns, especially compared to low bond yields and erratic equity returns, and the use of property as a diversification tool are key to this renewed interest. Property fund managers are excitedly predicting that institutional allocations are going to triple to the asset class in coming years.
In the bad old days, propertys flaws as an asset class were obvious. Traditionally, investments were direct and dull. Large buildings were owned by Life Funds and stodgy institutional investors. Such direct investment was full of pitfalls. The lack of transparent pricing compared to equity and bonds was one. Illiquidity and the concentration of even a large portfolio on a small number of buildings another. These were compounded with high management charges. Overshadowing all those difficulties were generally weaker returns than equities. In the late 70s, the typical pension funds real estate allocation was about 20% but property failed to keep up with equities and investors neglected it so that it that had fallen to some 4% at the end of 2005, noted John Gellatly, head of indirect property and strategy at Merrill Lynch Investment Managers (MLIM). Many consultants are recommending pension funds take their exposure up to 10-15%, according to Gellatly.
Consultants are increasingly willing to recommend property, agreed Birmingham-based Greg Wright, head of property research at Mercer Investment Consulting. It comes as part of an asset-liability matching structure: property has long been viewed as sharing many characteristics of bonds, such as a reliable income stream and links to the inflation cycle, even though it is a riskier investment than government bonds because of the possible loss of capital. The low yields available on gilts and a shortage of supply of inflation-linked bonds, which are the best way to implement an asset-liability matching strategy, are helping the sea-change in how property is employed in portfolios, said Wright. And the move into property by institutions is big. Clients that invest in property for income are putting as much as one third of their bond allocation into this asset class, said Wright. He cautioned, however, that it will take time. The end of last year did not see massive new allocations to the asset class.
Better Palette of Offerings
Naturally, this interest in property has not gone unnoticed by investment managers and theres a scramble to offer investors more and better means of investing. They are refining unitised property funds to offer greater liquidity, long a bugbear of the industry, especially through offshoring Property Unit Trusts (PUTs) which are providing more tax efficient structures. There are new ways to offer greater diversification and the possibility of higher returns through manager of manager structures and overseas exposure. Finally, funds with strongly differentiated risk profiles are giving investors a more appealing menu of risk options.
Wright said that he sees great growth potential in the fund of funds route and sees it as an attractive way of gaining exposure to a broad range of styles and underlying properties. Providers include MLIM, ING and Schroders. Roughly 50% of clients who start property investments use fund of funds, typically allocating all their assets through this route, said Wright. You have to weigh the extra costs against reducing the hassle. Fund of funds provide better access, the ability to trade in the secondary market and access to funds that might otherwise be closed. There is more choice of underlying managers too now through more than 30 balanced pooled property funds, he added. That said, most of these are closed-end funds. The roughly £2.5bn Hampshire County Council Pension Fund, which is soon to double its target property allocation to 10%, is likely to move from a pure direct investment strategy to one that combines direct and unitised investments, said Winchester-based David Wilson, forward planning manager. This will give the fund greater access to areas such as shopping centres, he explained.
The changing profile of the market too is helping institutional investors increase exposure to property domestically. Until recently, the market was dominated by leveraged buyers that arbitraged the spread between financing rates and yields on property, explained Gellatly. The interest rate cycle and yield compression has squeezed the spread from between 200-300 basis points some three years ago to around 60 basis points now, making the trade much less profitable for this type of investor. That is forcing them out of the market and allowing institutional investors access, he said. The drawback is that many investors fear the spread compression may reflect a fairly fully valued market and there is a risk that after years of outperformance in the UK, property could be about to take a breather.
The fear that the UK market looks fully valued and the constant search for diversification is leading more and more institutions to consider overseas investments. The drive overseas is an international phenomenon, said Gellatly, pointing out that in the last 10 years there has been an explosion of new entrants into the UK market. Now, youve got Irish property companies, high leveraged clubs, Russian oligarchs and more lately Australians carrying out domestic IPOs to fund European property investments. Its a whole new scene.
Some pension funds are looking as far afield as Asia, but thats the exception and most UK institutions are sticking to Europe. Some of Hampshires new property allocation will be invested indirectly in Europe, said Wilson. On the surface, European markets seem attractive. They are two to three years behind the UK with the differential between borrowing rates and yields still high, noted Gellatly. But markets are less transparent and liquid than the UK. 70-80% of commercial property is on the corporate balance sheet in Europe and therefore unavailable to investors. That compares to 55-60% in the UK. Lower liquidity means that pension funds may not find it easy to withdraw money at short notice or when the market turns against them. That isnt stopping pension funds. In addition to Hampshire, Greater Manchester Pension Fund, which has close to £8 billion in assets is considering diversifying its 10% property exposure by investing overseas, said Nigel Frisby, investment officer for the fund. For now, the fund remains invested purely in the UK.
Geographical diversification is being matched with a greater willingness to offer investors products with diverse risk profiles. Managers are marketing income-biased, low risk funds investing in liquid commercial property at annuity funds and leveraged diversified portfolios at funds that are striving to get a more equity-style return.
This revolution in property offerings is about to be further enhanced with the introduction of Real Estate Investment Trusts (REITs) to the UK. For the most part, they are likely to be used for retail investment. Thats because offshore PUTs are flourishing and many have moved to the Channel Islands making themselves more tax efficient for tax exempt institutional investors, leaving little incentive to move over to REITs. That said, institutional investors that do not have exposure may well look at them as a possible option. The most significant drawback in using REITs is that as listed instruments, they are likely to share some of the volatility of equity markets, explained Wright. That volatility means they may prove difficult to sell to institutional investors as a proxy for bonds. Gellatly agreed that this might be an issue. Still, the increased visibility can only help push property to all kinds of investors. When you go into a mall in the US, often the first shop you come across is one that sells shares in the outlet itself, said Gellatly who envisages the big supermarkets selling and leasing back their outlets.
Property is shedding its unsexy image with a host of new products available to investors. And with the tailwind of good performance allocations are set to rise rapidly. And yet the question must remain: isnt the real boom in property returns already over?