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How should pension funds currently approach property investment when they are either looking to increase their property exposure or are intending to make their first foray into the market?
Before committing to property, funds should be certain about their investment needs and constraints. Property provides both a steady income stream and capital preservation. It is also counter cyclical, so it should help diversify a portfolio of equities and bonds.
Having decided it is the right asset class, and here I am going to assume we are discussing direct investment in UK property, the investment manager will seek a good mix of sectors and geographic spread. That said, some sectors will always offer better opportunities than others at any given time. Had you invested in West End offices a couple of years ago, for example, you would be opening the champagne right now.
Individual stock selection is another factor. The smaller the portfolio, the more crucial this becomes, because one property will represent a greater proportion of the whole investment. In practice smaller funds are virtually excluded from such sectors.
A report we commissioned from Property Funds Research, shows that investors wanting a specific return face an additional, unrewarded risk that costs a lot to minimise. Their portfolio modelling showed an investment over £500m is needed to achieve a 5 per cent tracking error across all types of commercial property. To reduce this to 2 per cent needs almost £4bn.
The cost also varies hugely from sector to sector: £100m investment buys a 2.5 per cent tracking error in standard shop units, but only 6.5 per cent in London offices. And whereas an investment of £28m gives a 5 per cent target tracking error in shops, £152m is required for London offices.
This is one area where indirect property can help. Indirect investments have become popular, in part to achieve that exposure and partly because they are perceived as being easy to trade but – and perhaps you would expect me to say this – switching completely to indirect rules out the possibility of exceptional gains from astute stock selection.
Would trustees be right for being cautious about investing in the UK property market following at a time that follows several years of strong performance and when yields are at historic lows?
I would certainly advise caution. As with any investment, timing is crucial. If you buy right now you will be doing so at – or very near - the top of the market. Rental yields are currently low and, if interest rates rise again, returns will be relatively less attractive compared with other asset classes.
Because there is little margin for further yield compression, we are focusing on properties that offer opportunities for rental growth. Currently the prospects are better for offices than in retail, for example.
Property should be regarded as a long term hold. This is reinforced by the fact that costs are high. Transactions are taxed at four per cent compared to 0.5 per cent for shares and it’s much harder and more expensive to look after bricks and mortar than an electronic share certificate! Then there are likely to be agent’s and solicitor’s fees, too.
The more short-term your thinking the better your stock selection and timing must be. Put another way, if your investment horizon stretches to decades you are likely to be less worried about annual fluctuations in value, but you should be able to benefit from good income returns.
What do you predict to be the biggest growth areas in property for institutional investors?
UK property is currently a hugely popular asset class and fully valued as a result. That has driven investors to seek pastures new, in Europe and countries like India, in large part using indirect vehicles as I mentioned earlier.
There are an increasing number of ways to invest in property. Some, like unit trusts, are attempts to address the perceived illiquidity of property. That, incidentally, is more perception than reality. Pension funds can accurately predict their need for distributable cash many years in advance and property assets are readily realisable over that length of time at their full value. Anyway, now we have REITs that are as tradable as any other shares. I believe it is likely, in the short term, that they will perform more in line with shares than direct property, thus losing the contra cyclical nature of the direct product. But it is far too soon to reach firm conclusions about their long-term performance characteristics.
Then there are derivatives. These are tactical tools typically used to manage the risk of over or under exposure to a particular asset class. In property terms they are still in their infancy and not for the inexperienced, but the market is certainly growing at a considerable pace.
We have also seen the launch of various specialist funds, such as health and leisure. Here you are buying a “business in a box” rather than just a property. You need to understand the business sector itself, not just the property market. And, if a specialist tenant like an hotelier closes down you could have a long term void on your hands because alternative tenants may be few. It may be wise to consider alternative uses before buying.
Getting back to direct property, some institutional investors have a growing appetite for properties where rents are tied to the Retail Price Index, which perform like an index-linked bond but with superior returns. That’s our one to watch.
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