Real estate allocations – what to think about in 2024

Timeframe is key

Defined benefit (DB) schemes with short timeframes should think carefully about investing in real estate, because of its illiquid nature – and this is particularly important in today’s market conditions.

Speaking on her outlook for 2024, Rachel Titchen, charities and investment director at Broadstone, said: “While real estate investments provide steady income and potential capital appreciation, their inherent illiquidity makes them less suitable for UK DB pension schemes with shorter-term timeframes.

“This is particularly relevant in the current environment, with interest rates on the rise and corresponding market liabilities reducing. However, for pension schemes with longer-term timeframes, real estate can still serve as a tangible hedge against inflation and contribute to portfolio diversification when managed effectively.”

A similar sentiment was expressed by Pieter Heijboer, head of investment strategy at Van Lanschot Kempen, who said: “Pension funds are long-term real estate investors who tend to prefer non-listed real estate (over listed real estate) as it offers similar long-term returns, better return diversification versus listed equities, a large opportunity set, and a lower regulatory capital charge.

“Within non-listed real estate, we have a positive long-term stance towards the European logistics and residential sector, while we have a negative view on older offices as these are challenged by secular trends such as working from home and required energy efficiency improvements.”

“Energy efficiency is also a key issue that will affect demand for property assets given the ongoing focus of UK pension schemes on ESG risks.”

Think climate

The illiquid nature of real estate is just one of many challenges for UK pension funds, according to Peter Hall, partner for Momentum Investment Solutions & Consulting. He added that energy efficiency is also a key issue as UK pension schemes focus on climate risks.

He said: “The real estate market faces similar challenges from UK pension schemes as those highlighted above as property is effectively an illiquid asset. However, the real estate market faces additional challenges. The office sector in particular will be challenged by changes in working habits and there is likely to be greater focus on the quality and location of the assets.  

“Energy efficiency is also a key issue that will affect demand for property assets given the ongoing focus of UK pension schemes on climate risks and environmental, social and governance (ESG) risks generally.

“Alternative parts of the property market such as the residential sector – for example, social and affordable housing – have become an increasing allocation in portfolios to diversify away from some of the challenges in commercial property markets.  We expect this trend to continue.”

He added that these challenges mean that pension investors are not well rewarded in real estate markets. 

He added: “Whilst there has been a material re-pricing of property assets, the yield available over and above risk free yields is less than it has been in the past and the prospects for capital appreciation are likely to be more limited.  In general, we don’t believe that investors are sufficiently well rewarded for the risks and illiquidity in real estate markets currently and investors are likely to find more compelling opportunities in alternatives.”

“Unless there is replacement capital for the huge exodus of DB money, we are going to see fewer transactions, leading to further value decline, particularly in the regions where domestic institutional investment is needed to support the levelling up agenda.”

The changing of the guard is causing issues

PATRIZIA’s Mischa Davis said many DB schemes are moving out of real estate holdings in preparation for buyout.

The managing director and senior fund manager at asset management firm PATRIZIA said: “The impact of heightened interest rates on the real estate transaction market is well documented: as the Bank of England hiked rates to a 15-year high in August 2023, it was reported that UK commercial real estate investment for the first half amounted to £18.5 billion, less than half the volume compared to the same period last year.

“Far less discussed is the impact rates have had on capital allocations to real estate and the changing of the guard from DB to defined contribution (DC) as the primary pension scheme investor into the sector. 

“This change has been accelerated by increasing interest rates that have driven liabilities down faster than asset values, leading many DB schemes to be fully funded, move to a buyout strategy and exit real estate holdings. 

“Unlike many factors that impact real estate investment, this is not cyclical; once this capital has gone, it has gone. The problem here is that the DB capital leaving the market is significantly outpacing the DC capital that is coming into it.

“DC schemes are controlled and managed very differently to DB schemes, which means this capital is not finding its way to private market real estate on the scale needed and when it is, there is very little transparency around how it is allocated.”

The changes mean there may be fewer transactions, leading to a decline in value.

Davis added: “What this means for the year ahead is that, unless there is replacement capital for the huge exodus of DB money, we are going to see fewer transactions, leading to further value decline, particularly in the regions where domestic institutional investment is needed to support the levelling up agenda. 

“Whilst the impact on real estate markets and the investment management industry is important, more so is the impact of this on DC members and the value of their pensions. It is not good governance for pension portfolios to be either under-allocated to private market real estate or restricted to in-house funds when better performing managers and funds exist.

“We see the positive impact this kind of healthy competition has on the superannuation funds in countries such as Australia and could learn a valuable lesson in the benefits of genuine diversification. Greater transparency around DC pension fund capital allocation and increased diversification of managers would only benefit DC pension member outcomes.”

 “For the majority of institutional investors who have a real estate allocation, 2024 looks set to be a more attractive year than they likely would have found 2023.”

In uncertain times, property could be a good diversifier

However, it may not be all doom and gloom, according to some experts. Pensions funds are likely to ‘double down’ on portfolio diversification, which could be beneficial for pockets of the real estate market.

Indraneel Karlekar, global head of research and portfolio strategies at Principal Asset Management, said: “The global economic outlook for 2024 looks cloudy, as the threat of economic slowdowns may be exacerbated by major headwinds such as the US dollar, oil prices, and higher interest rates. In the face of increasing market uncertainties, investors and pension funds are likely to double down on portfolio diversification for risk-adjusted returns – a move that could be beneficial for pockets of real estate.  

“In fact, real estate assets are often beneficiaries of investor rotation into long duration, as pension funds direct their focus on reliable sectors aimed at delivering long term returns to help members achieve their goals through consistent and secure growth opportunities.”

He added there are still various challenges the real estate market faces next year. 

Karlekar said: “Like most sectors of the market, real estate is also subject to various challenges in 2024. However, subsectors with resilient and structurally driven demand will dominate in meeting the needs of a changing economy and society while offering attractive long-term growth. These areas should be the principal focus of schemes focused on reliable and consistent growth.”

Opportunities for the selective

The majority of institutional investors who have a real estate allocation will enjoy an ‘attractive year’ compared to 2023, according to Barings’ Paul Stewart.

The head of Europe and Asia Pacific real estate research and strategy, said: 

“For the majority of institutional investors who have a real estate allocation, 2024 looks set to be a more attractive year than they likely would have found 2023. While it will depend on the individual investor’s circumstances and type, there are opportunities to be had both in equity and debt.

“We believe that logistics and retail have reached the trough in the property cycle, although prime offices may have slightly further to go before pricing expectations between vendor and purchaser meet. And, when it comes to residential rentals – in their many guises from build-to-rent to purpose-built student accommodation – the fundamentals remain compelling. 

“That being said, pension funds’ investment managers ought also to take a strategic and long-term view. Some of the best opportunities include core equity investments that benefit from long-term structural factors, such as demographics, technology, and excellent ESG credentials. It’s why we remain bullish around central London prime offices, proving they tick-off the sustainability box.”

Stewart added that pension funds should look at real estate debt. “We believe pension funds need to be seriously considering real estate debt – now more than ever. With reduced transactional activity, the market is focused on refinancings. The combination of higher underlying rates, increased margins and property valuation decline has created an opportunity for whole loan and mezzanine providers.

“In the next few quarters, we’d expect mainland European prime property yields to continue heading north of five percent - and at least six percent in the UK. After that, there could be some compression once interest rates ease and the economic and property cycles move into an upswing from around mid-2024. 

“There are opportunities to be had for pension funds as the cycle resets. But caution and longer-term thinking will need to be the order of the day.”