The UK’s largest insurance group, the Prudential is a ‘born again’ property investor, but with a hardnosed approach to real estate that would probably make earlier generations of property experts within the group turn in their graves.
“We are extremely dispassionate,” says Martin Moore, managing director of the property division, now located within Prudential Portfolio Managers, the investment management operation of the £140bn group. “If we reached the stage, where we felt property was unlikely to perform significantly less well than other investment opportunities around the world, then we would exit property.”
As it is the Prudential is reckoned to be the UK’s largest institutional property investor with a portfolio of £9.5bn. “We manage the property element of the life fund, which was £7bn at the end of last year, as well as a number of internal unit-linked funds, the smallest of which is £30m. The focus is on the UK market place, where it invests across all sections and sectors of the UK market.”
The first plank is a belief that the prospective returns from the real estate market as a whole are broadly comparable to those from equity markets. “We set out to achieve a return from real estate of 5.5% per annum. But we look at this on a risk adjusted basis, so the returns must be commensurately higher with higher risk investments. But if we look back over the years, it has produced nothing like that in real terms.”
Looking forward, however, he believes that the market is now more refined than in the past, and that as an asset class property has low correlation with equities and bonds, “so having real estate in a portfolio reduces uncertainty to returns”. and the actuaries like property, as with income returns of 6.5 to 7% on average from UK property it helps increase cash flows to the life funds. “Our overriding objective is to deliver consistently above average performance, with the emphasis on ‘consistently’. We are not going to take extraordinary risks in case that one year we perform extraordinarily well, if there is every chance next year we do less well.” The portfolios are measured against market benchmarks, but as the funds have different characteristics, subsets of the main IPD universe are used. “So, for example, we judge the Prudential staff pension scheme against the IPD occupational scheme data.”
The division runs itself as self-contained property investment management company serving only the Prudential, but with the aim of making a contribution to the group shareholders’ profits. “We negotiate our fees and tariffs with our internal clients from time to time and these are often much tougher discussions than you might have with normal outside third party providers.”
Moore sees research as the key to everything his operation does. “We describe ourselves as a research-led organisation. But our property research team does not sit with us, but within the central research function within PPM, looking at property from a global investment perspective. This means that the basic elements in our modelling are entirely consistent when modelling and making decisions around other asset classes.”
He adds: “The team has an important role too in the asset allocation process. They will be contribute to that process their developing views on the long-run returns from property, the year-on-year variability of those returns, and the correlation between property and other markets.” From this can be derived a long run range in which they want the property exposure to be maintained, typically a range of 10 and 15%. “That is the strategic asset allocation over a five year view, within which a tactical short term view is taken,” he says. “Currently our exposure would be around 12.5 to 13%.”
Specific five-year forecasts are prepared by the research team as to how the market in the UK will perform. “We look at the 13 statistical regions of the UK, and at the three main sectors of retail, commercial and industrial, as well as some sub-sectors.
“We also look at some 50 or 60 of the main cities and towns. Every quarter we up-date these five year forecasts.” This forms part of the input when the property fund managers are defining strategy for their various funds.
“What we do not want to do is, by default, to take extreme positions against the aggregate of our competitor funds, because that implicitly brings a greater degree of risk to portfolios and therefore increasing the propability of generating radically different returns compared to the competition. Some people would call that the herd instinct, but we feel it is an important part of property portfolio construction and risk management.” This does not mean that the managers are not prepared to take long or short positions, but just that they like to do this with eyes wide open, he says.
The correlations of assets within the property market itself by sector and region are monitored, as historically different markets in vtarying parts of the country perform differently, varying over time. “So as part of controlling risk, we look at the correlations between these different sectors and regional combinations, which inform how we shape our portfolios.”
Moore says that over the past seven years the division has built up a unique modelling and appraisal methodology. “This gives us a very important framework and point of reference to help us make decisions as to whether markets or properties look cheap or dear. What we are trying to do is to focus on those properties we think the market is mispricing.”
Each year the portfolios are examined and a positive decision is taken about whether or not to continue holding each individual property. “In the past properties tended to be bought and locked away. Now each year every property has to re-earn its place in the portfolio. If properties are delivering returns below those we require, that helps us inform our sales decision.” As a consequence, the division is quite active is selling assets. Moore reckons the turnover has been around £1bn a year, including what is spent on development, disposals and acquisitions.
“I cannot stress sufficiently the importance of stock selection, “ he says. “ From the attribution work we have done with IPD’s help, it is very clear that by a big margin the single biggest component of our outperformance is the decision around individual stock selection.”
The division is about 300 people strong and embraces all the property skills needed to construct and manage portfolios of real estate. The decision was to run a full inhouse team, he says. “In other organisations, there has been a tendency to outsource, which is something we considered on many occasions, but we decided to follow a different approach.”
Having a highly integrated team is one of the main reasons for their success, Moore reckons. “Our combination of an intellectual and pragmatic approach, since our research is actually informed by the people out there buying and selling property.” He describes it as a two-way process that has developed over time. Up to five years ago the division had operated as discrete teams, based around professional specialisations, such as leasing and investment. “We then decided to re-engineer and re-design the business and formed a multi-disciplinary teams, which sit together. That has helped us make much better informed decisions, and led to a much better motivated workforce, all of which has helped us achieve better results during the 1990s.” It is essential that everyone understand what they contribute and to get skills and objectives aligned as far as possible.
For the future, Moore believes that area of information management will play a critical role in the development of the division. In particular, they are looking at systems to help provide information in a more structured format. “We want to get people to share information as perfectly as we can. We reward people for challenging convention, so if they come up with suggestions for improvements and doing things differently, they are rewarded if their ideas prove valuable and work.”
The overall results have been impressive, both on the output and input sides. The huge £7bn life fund has shown a 2% per annum outperformance against the relevant IPD benchmark. “We think this is an enviable record, which has meant an amount of the order of £120m to £140m of additional value each year to shareholders, against the average of the competition. On the input side, Moore says the costs are below those of the competitors judging by the data from the IPD cost management survey.
But one thing PPM’s property division is cautious about is entering the third party segregated business. “We must be careful not to do anything which diverts our focus away from managing our existing portfolios. The returns for running such mandates are often very low, as they are very competitively fought for.”
But constant change is the way forward. “Even though our results are good, we have to keep re-inventing ourselves. While things are changing very fast, I am certain that for every threat we face, there are a greater number of opportunities.”
This is based on a talk to the IPD/Global Property Research Conference held in Wiesbaden