Second-tier wins out against core property investments

Now the economy is gradually climbing out of recession, the future for property and infrastructure investments is looking more solid. But pension scheme trustees are still wary of these types of illiquid investments.

Evidence that the market is experiencing rosier times is demonstrated by property index provider IPD showing that pension funds significantly increased property investment last year.

This included putting more than £400m into alternative areas of commercial property and showing strong interest in index-linked leases backed by strong covenants. In 2012 £74m was invested in alternative areas, while in 2011 only £9m went to this area in the property market.

When second is best

Trustees are often slightly concerned about large property allocations because they worry about liquidity constraints. “Over recent years, property has been discussed and perhaps discarded by many boards,” says Steve Delo, independent trustee at Pan Trustees. But in the past year experts have seen a lot more attention focused on the asset class.

One of the main areas of focus is the secondary market, since the price of prime quality property in the UK has soared. “Trustees are very wary of the primary market, which is pretty overpriced,” Delo adds.

During the financial crisis, schemes were looking for the safest investments they could find, says Andrew Jacobson, investment consultant at LCP.

“At the time, they felt that high quality prime London-based properties were a very safe investment, so we saw a lot of money flow into those kinds of assets between 2010 and 2013. That meant that the yield on those properties was reduced quite significantly.

“Looking at it today, it doesn’t offer a very attractive return opportunity,” he says.

One of the reasons tier-one property has become so expensive is due to international investors sweeping up high-profile properties.

For the full The Specialist report on property and real assets, click here for the PDF.

In the past 12 months, more and more UK scheme investors have sought refuge in the secondary property market. These good-quality properties are less expensive than the prime assets found in central London and parts of the southeast.

“The yields available in this sector of the market are well above historic norms,” Jacobson says.

In 2000 and even up to 2010, investors were getting a yield of about 2 per cent above gilts. “But today, even though yields have compressed a little bit over the last six months, it is still 6 per cent per annum above gilts,” he says. “This is a significant reward to justify the extra risk schemes are taking because they are opting for the second best.”

Bubble concerns

This does not mean investors can rest on their laurels – the secondary property market is also subject to possible over-pricing. However, Greg Wright, head of property research in KPMG’s investment advisory practice, is still positive about the sub-asset class.

The relatively low-risk, income-driven approach of long-lease has experienced increasing popularity over the past year, and the universe of options is expanding now that more funds have come into this space.

“Funds are still trying to find properties that include a tenant on a long lease, an inflation-proofed income and obviously a good-quality tenant. Increasingly, more managers are finding different sorts of assets that fulfil those criteria,” Wright says.

A few years ago, the main focus was supermarkets. Now managers are also looking at other sectors such as hotels, car parks, GP surgeries and marinas.

“The only cloud on the horizon is whether the pricing of some of those assets is starting to become quite high, particularly some of the supermarkets,” says Wright. “There are still a number of managers buying the Tescos and Sainsbury’s of this world, but the yield on those is getting lower and lower.”

He warns that yield is probably getting to the point where if it gets much lower, investors may question whether they are going to achieve outperformance targets.

Upping the game

Pan’s Delo says consultants have stepped up to the plate by thinking more deeply about property and trying to be less generic in their advice.

“Consultants are more specific about the sort of areas in property that trustees should focus on,” he says.

Wright argues that managers also have to work harder to get the desired results. When managers cannot turn to buying supermarkets but must find alternative assets, they need to be skilled enough to identify those sorts of assets.

And even when they do, the waiting period for schemes from when they decide to invest and the moment they actually allocate the money can build up to a few years.

“When managers are struggling to find the assets, you could find that the pipeline gets longer and longer. That would be a disappointment to pension funds. When they sign up in 2013, they don’t want to be handing over the money in 2015,” Wright says.

For the full The Specialist report on property and real assets, click here for the PDF.

He adds that managers will have to work a bit harder to source good investments.

According to LCP’s Jacobson, time is of the essence. He urges his pension scheme clients to move quickly to avoid missing out on a large part of potential returns.

“At the moment it is an attractive investment, but in the past six to 12 months we have seen an increasing number of investors looking to allocate their money to this kind of best-secondary property investment. The impact of that is of course that it pushes up the prices and reduces the yield,” he says.

Making an impact?

Some fund managers have seen a trend among schemes, especially council funds, to contribute to the local economy by making impact investments.

Last year, the £13.4bn Strathclyde Pension Fund established a property fund to make investments of less than £10m in local commercial real estate.

Strathclyde’s pension fund committee agreed to establish a £50m Clydebuilt Property Fund with Ediston Properties that will invest in the region’s commercial sector. The fund will form part of the scheme’s New Opportunities Portfolio.

“Market information suggests commercial property in the west of Scotland is increasingly seen as a recovery opportunity in an under-researched market,” stated the committee meeting minutes.

The investment is hoped to provide a boost to the local economy, said chair of
Strathclyde Pension Fund and Glasgow city treasurer, councillor Paul Rooney.

“I’m positive about seeing more of their money being invested in the communities in which they work and live – supporting native businesses and jobs,” he said in a statement.

Strathclyde said the main focus is expected to be commercial property. “Opportunities in residential property and other areas that fit the fund’s criteria will be considered,” the scheme stated.

In April this year, fund manager Hearthstone Investments reeled in a mandate from the £1.5bn Falkirk Council Pension Fund to invest £30m in social and affordable housing in Scotland.

The investment adds to the supply of new homes and supports local economies, and investors simultaneously benefit from stable, long-term returns.

Christopher Down, chief executive at Hearthstone, says it is a sign that institutional investors are becoming more interested in residential property. “It is a very big asset class – £5trn – but until recently institutions haven’t invested in it. It is more management-intensive than a commercial property,” he says.

“This has given institutions some worries about investing, but with fund managers now beginning to offer investments to pension schemes it means they don’t take on that management burden. It is much easier for pension schemes to invest in residential now, and they are beginning to react to that.”

For the full The Specialist report on property and real assets, click here for the PDF.

Michael Barrie, director at fund manager Legal & General Property, says his team is working on adding new skills to provide intelligence in these markets. “We think there is the need for greater private investments in social housing and health care.

“We have an ageing population and there is still an underprovision of healthcare and care homes across the UK, and potentially more demand for ethical funds. These [are] areas [where] we will push hard.”

Barrie adds that social housing corporations do not necessarily go to banks anymore for their funding. “They are looking more and more at private investors and want those investors to be stable providers, so pension funds make an obvious match when it comes to meeting those needs. Real estate is a very physical and obvious way in which you can see that you are making a difference. But it is not something you can do overnight,” he says.

Creating a movement

The London Borough of Islington Pension Fund was the first in 2012 to invest 2.5 per cent of the fund’s assets into residential housing. The scheme urged other pension funds to follow their lead and join the fund, even talking about a “mass movement to help create the supply of housing that is much needed in the UK”. But the appetite among other schemes seems to be lacking.

Mark Gayler, investment manager at Devon Pension Fund, says it is “not really appropriate” for schemes to invest in social housing simply because the local authority that the scheme is run for wants this to benefit the wider community.

Devon has built up its property assets to 10 per cent in the past few years, but is not planning to get involved in the residential market.

“As a fund we have always taken a strong line that we need to maintain our fiduciary duty to make returns for the members of the scheme.