The ability of property to perform more than one function within an investment portfolio could prove invaluable during slow market growth, says Mercer’s Paul Richards.

Property can play both these roles, and more in between. The full range includes:

  • diversification (traditional role of core property);

  • inflation and liability matching (long-lease funds and property debt);

  • secure income (long-lease funds and property debt);

  • high income and growth (some core funds);

  • high return (opportunistic and value-add property).

Not bad for a ‘single’ asset class. I will go through the assets in turn, moving up the risk-return spectrum.  

Secure and inflation-linked income funds

These funds invest in freehold land let on a ground lease, and also in buildings let for 20-plus years to high-quality tenants on long inflation-linked leases. These both contrast with the traditional five or 10-year UK lease with five-yearly rent reviews.

Traditional core open-ended funds have become less prominent in recent years in favour of more specialist property types, but they still provide a good mix of income and capital growth

Ground leases are arguably more secure than government bonds, as the entity paying the rent has so much to lose if they default that unpaid ground rents are virtually unheard of. 

Long-lease assets offer a spread over the tenant’s equivalent corporate bond, with better income security since rent comes ahead of everybody bar the taxman in the event of insolvency, and they also have a free building attached. 

These assets can provide a bedrock of secure, inflation-linked income in a portfolio, with a yield premium over investment-grade bonds of 150 basis points or more.

Property debt

In the UK, lending to property was for many years traditionally the province of banks. Bank lending was constrained after the global financial crisis and the gap was filled largely by third-party debt funds, which raised capital from pension funds. 

Capital security is high for senior debt and less so for junior debt, but both are protected by a cushion of borrower equity and both provide investors with regular income, senior loans of 150-350bp over Libor, mezzanine loans an internal rate of return of 10 per cent plus, and funds which mix the two – an IRR of around 7 per cent made up of interest, fees and profit share. 

These funds generally need capital to be locked up for five to 10 years.

Core funds

Traditional core open-ended funds have become less prominent in recent years in favour of more specialist property types, but they still provide a good mix of income and capital growth. 

There has been a move away from market benchmarks to longer-term nominal or real absolute return targets, since the former can lead managers to buy volatile assets that match the market in the short term, but that can underperform over the longer term. 

There has also been a move among some core funds to a barbell strategy, mixing long-lease assets with some higher-yielding value-add assets to provide a relatively high distribution stream with a bedrock of security. 

Long-term total return expectations are generally around 6 per cent, with more than half of this coming from income.

Value-add and opportunistic funds

These funds generally take risks on gaining planning permission, constructing or extending buildings, and letting space. 

They tend to perform best at times of economic expansion and their performance can therefore be highly cyclical.

A programme of smaller investments in several funds over a number of years can provide smoother returns than fewer investments in a limited number of funds. 

Most (but not all) of these funds are highly geared, up to 75-80 per cent loan-to-value, with target net returns in the mid-teens. 

The question should be, ‘What role can’t property play in a pension fund portfolio?’,  and the answer is, ‘Almost none’.

Paul Richards is head of European real estate at Mercer

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