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This article first appeared in PMI News, April 2007
By Nick Yeomans, Managing Director of Wilky Fund Management
EXECUTIVE SUMMARY
The case for investing in property
UK property has outperformed UK bonds and equities and diversifies risk
It offers both a higher income return and prospects of capital growth
Illiquidity is not the problem that some imagine
Real Estate remains an attractive investment – even at today’s prices.
Over the past 15 years property has been having one of the best runs since Lord Coe was a fresh-faced young Olympian. But now commentators are beginning to call the top of the market. So is this asset class about to stumble from gold medallist to also ran? In short, is it still worth a place on your starting line?
Recently there has been a shift in investment patterns away from equities and towards bonds. Whilst several factors have contributed to the popularity of bonds, including greater longevity, lower interest rates and tighter regulations, the fact that this shift followed the introduction of Financial Reporting Standard 17 is not entirely coincidental.
FRS17 requires annual disclosure of pension fund liabilities, which are calculated by reference to long-dated bond yields. Unintentionally, this has led to a vicious cycle.
Many funds switched to safer investment options, particularly long-dated and inflation linked bonds, as a way to match more closely the promises of inflation linked payments made to future pensioners. As demand increased, bond prices rose and yields fell. This meant deficits grew larger and funds were forced to buy more bonds.
Bond yields remain low and if pension funds continue to pursue an investment strategy of holding assets that are closely aligned to their debt-like liabilities, it is likely that long-dated yields will remain that way for some time. So might property offer a solution to pension fund deficits ?
The case for property
UK property has outperformed both UK bonds and UK equities over the last 3, 5 and 10 years.
Annualised Returns by Asset Class
10 Years 5 Years 3 Years 2006
UK Property (IPD Universe) 13.7% 14.9% 18.3% 18.5%
UK Equities (WM) 8.0% 8.5% 17.2% 16.8%
UK Bonds (WM) 7.8% 6.1% 5.7% 0.6%
UK Index Linked (WM) 7.7% 7.1% 6.7% 2.6%
Overseas Equities (WM) 7.3% 7.7% 15.2% 7.9%
Overseas Bonds (WM) 5.6% 5.0% 3.5% -4.3%
Retail Price Index 2.7% 3.1% 3.2% 4.4%
© Investment Property Databank Limited (IPD) 2007
Investing in property is well justified on performance grounds alone but it is also the only true hedge against the risk to equity performance. Property has consistently demonstrated a low degree of correlation with the returns from other asset classes and as such it is a true contrarian investment. It is a fallacy to believe that investment in bonds is able to “hold” overall investment performance in a multi-asset portfolio when equity markets are in decline and vice versa.
A meaningful exposure to property should, therefore, be seen as an essential component of investment strategy. This is particularly true for mature pension funds that have well defined current and future cash needs since property provides a steady income stream from rents, in addition to preserving capital. What is more, if your tenant goes to the wall, you would still have an asset to rent out again or sell, whereas shares in that same company probably would be consigned to the waste paper basket.
At its most simple, the “real cash” generated from property in the form of rent income helps to pay pensioners. In this sense, property let on long leases to tenants with strong financial covenants may be seen to have bond-like characteristics. But property can also demonstrate equity-style characteristics. For example, traditional lease structures in the UK typically allow for rents to be increased every five years. In this sense investment in direct property may be seen as a way of assisting funds to diversify their growth assets.
These reasons alone should mean that property has an important role to play in pension fund investment strategies. Property has demonstrated a long and sustained period of competitive returns when compared to other asset classes. Double–digit total returns for the last four years have been produced largely as a result of capital growth caused by yield compression rather than by rental growth.
Is the case still valid?
According to data from our research partner Property Funds Research property yields, as measured by IPD now stand at their lowest level since 1989 and the premium between property and bonds has diminished considerably over the last four years.
Even though its medium term prospects look far more modest than in recent years, expected returns from property are still likely to exceed those from bonds. So surely there should be a greater role for property in pension fund investment strategies than existing asset allocations might suggest?
The bond-like characteristics of UK commercial property – secure long-term income streams – are undoubtedly a good match for pension fund liabilities. Property portfolios with their ability to produce regular real cash returns from rental income could be constructed with the particular aim of generating cash flows to pay pension liabilities. But property offers a two-fold advantage over bonds in this liability matching approach. Firstly, it offers a higher income return and secondly it is an asset class with genuine growth capability. Given these advantages there is a strong case for pension funds to allocate a meaningful proportion of their assets to property. Whilst recognising the attraction that bonds have for pension funds seeking to more closely match their scheme liabilities, we do not believe that bonds alone offer the most effective solution. In the long-term a combination of bonds and property is likely to be more effective.
A problem of perception
Despite property’s evident advantages some funds remain cautious because they regard property as illiquid. Whilst it is true that an office block takes longer to sell than a parcel of shares, is that really a huge problem?
Property should be used as a long term strategic asset to match long term liabilities, rather than a tactical tool capable of capturing the benefits of market fluctuations. Another reason for treating it as a long term hold is because transaction costs are high. Stamp Duty is four per cent compared to 0.5 per cent for shares and there are likely to be agent’s and solicitor’s fees, too.
These issues may help explain the recent popularity of indirect property investments; that is investing in property funds rather than owning property directly. But although indirect property may provide that tactical element missing from real estate investment, it also divorces the pension fund from the possibility of benefiting from the stock selection skills of a direct property manager. Acquiring the right property at the right time can provide the touch of stardust that enables the portfolio to outperform its benchmarks.
Even smaller funds can participate successfully in the property market. By investing in market segments with smaller lot sizes, for example high street shops, industrial units and provincial offices, it is entirely feasible to build a well-diversified portfolio. If exposure to larger lot sizes, such as retail warehouses or larger London offices is required, then indirect investments can provide the solution.
Illiquidity only becomes an issue if the owner is faced with large and unforeseen cash requirements. However, given that most funds are able – indeed are required to – predict their cash requirements many years in advance, does it really matter that real estate sales take a few months?
Not only are a pension fund’s needs predictable, they are often long term. As active membership dwindles, mature pension schemes can be faced with a net outflow of funds into pensioners’ bank accounts for periods of 20 years or more. Given this sort of notice, it would be a poor property manager indeed who could not a set up a properly considered disposal programme to deliver a matching income stream.
Given this sort of requirement, the returns generated by property and its diversification benefits should make it an asset class of choice, rather than one to be shunned.
Pension fund allocations to the property sector have certainly increased in recent years but still only represent about 7% of overall assets. This seems extraordinarily low given its long track record of performance. It is also at odds with the fact that for property to have meaningful diversification benefits it would probably need to form at least 10% of a multi-asset class portfolio.
Shall we wait for next time?
This lack of exposure will certainly have hindered overall returns but is it now too late to consider acquiring property for the first time or to increase exposure to the sector?
We would certainly advise caution. As with any form of investment the timing of investment decisions is crucial to performance. Buying now, we believe, means buying at or close to the top of the current cycle of performance. UK commercial property is fully priced. Yields are certainly very low when viewed historically and there is not much scope for further yield compression.
However, at ING Real Estate’s recent seminar, managing director and chief investment officer Stephen Page said the majority of investors were seeking an average return of 7 – 8% p.a.
We expect total returns from property of around 9% this year and an average of around 8% for the next three years. Whilst we anticipate a period of much lower returns, property will continue to offer very respectable performance. Demand for UK commercial property will remain strong and should keep yields stable. Rising rents, particularly in the office sector, will continue to offer the opportunity for growth.
In conclusion, property, even at today’s prices, remains attractive. Property is a marathon, not a sprint, so there is time to recover from the occasional stumble.
Ends
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