Breaking with tradition

Historically, French institutional investors’ idea of real estate was a direct holding in an office building in the middle of Paris. Today, many of the larger players are beginning to scout out opportunities across their borders as well as branching out into other segments such as retail, logistics and infrastructure projects.

According to Pierre Vaquier, chief executive of AXA Real Estate Investment Management, France, “There was a serious downturn in the property market in the 1990s and several long-term investors reduced their holdings. However, recently, we have seen insurance companies and retirement funds as well as new players come back into the market which is a reflection of the wider worldwide trend of an increased interest in real estate as an asset class.”

The reason is simple - diversification, according to Frédéric Pétiniot, managing director of Amadeis, a Paris-based consultancy firm. “As more French investors adopt a core/satellite structure to investing, real estate has become one of those satellites. The attraction is that the asset is not correlated with equities and bond markets but also the performance of the property markets has been excellent over the past five to eight years.”

Moreover, as Luc Berchem, global investment consultant of Hewitt Global Investment Consulting Practice, notes “Property also provides a natural hedge against inflation, which is attractive for investors facing real future liabilities.”

It is important to distinguish between the different types of investors and what they are looking for in terms of property investment, according to Mahdi Mokrane, head of research & strategy at IXIS AEW Europe, a European property investment manager. He notes that for example, life insurers seek stable cash flows to serve their unit holders. Non-life insurers, pension funds - there are not that many in France due to the structure of the country’s pension system - and retirement funds typically have a longer investment horizon.

While insurance companies have been more adventurous in their asset allocation, government-run pension schemes have been fairly wedded to a heavily fixed income approach where bonds represent about 70% of the overall portfolio, with equities comprising the rest. Although this is likely to remain the case for the foreseeable future, attitudes over the past two years have been slowly changing mainly due to yields on high-grade sovereign bonds falling to historic lows. This has forced institutions to expand their investment nets wider to look for performance.

A new study conducted by the French Association for Institutional Investors (AFIIi) and private consultants BIPE, which canvassed 65 French institutional investors with approximately €700bn of assets under management, reveals that they are increasingly switching money out of bonds and into shares, alternatives and structured products.

The recent policy decision by the Fonds de Réserve pour les Retraites (FRR) is a good example of the shifting winds. As of 1 June 2006, the state pension reserve fund’s portfolio had 56.3% invested in equities, 23.8% in bonds and 19.9% in the money market. This past summer, it undertook a policy review and announced it was allocating 10% of its €28.1bn of assets into alternatives. A third is to be invested in private equity with the remainder split between real estate funds, a passive commodity investment and public infrastructure funds. Hedge funds, for now, have been ruled out.

According to a FRR spokesperson, it is still early days and no hard and fast decisions have been made about the specifics of the real estate allocations.

Brenna O’Roarty, head of European strategic research at RREEF, the real estate and infrastructure investment management arm of Deutsche Asset Management, believes that FRR’s move could generate more interest in real estate as an asset class. She notes that although it will not happen overnight, further pension reform will ultimately be on the agenda and that could also generate more interest in the sector. “I think what is likely to happen is that there will be structural change in the system. The fiscal deficits in countries such as France and Germany will reach a tipping point, triggering pension reform and greater reliance on personal pension plans, in turn increasing further allocation to alternatives.”

In the meantime, large insurance companies and multi-retirement pension players like UMR Corem are likely to be the most active participants in the real estate market.

The insurance companies have been in the property game for several years, typically starting off by buying their own headquarters and other trophy buildings in Paris. It is a much newer investment for pension funds such as UMR Corem, who started three years ago and has gradually been building its real estate holding to just under 8% of total assets under management.

Vincent Ribuot, chief investment officer of UMR Corem, says, “We have stated before that our target is 10% and that has not changed. The aim is to find investments that if managed properly will help us meet our future liabilities. We are always in the process of looking for high yielding properties across the Euro-zone but at the moment they are difficult to find as the best products have become increasingly expensive due to fierce competition. For example, when we started investing, the yields in the Paris office market were between 6% to 7% but now they are below 5%. Our ideal yield is the 6% to 7% range. Anything below 5% is not worth it.”

Due to the complexities of the property market, UMR Corem invests through a special purpose vehicle run by IXIS AEW, which is responsible for sourcing the property across the Euro-zone and conducting the due diligence. Ribuot says, “We prefer investing in club deals with other institutional investors who share our long term objectives. The three main properties we are interested in are offices, commercial property and logistics. We are not looking for liquidity as much as good products and tenants.”

Although direct investing in real estate is still popular, institutions are also exploring other routes such as closed-end funds. Mokrane says, “The standard preference would be first direct investments mainly due to the control and understanding of the local market followed by listed properties for liquidity purposes.

“However, we are seeing an increase in the popularity of using closed-end funds because of diversification benefits and access to expert management for specific sectors and locations. In investing in funds though, the emphasis changes from choosing the best property to selecting the asset manager with the right skills and expertise.”

Investing outside France is a relatively new concept but due to escalating prices in their home market, French institutions have been forced to look outside their favourite stomping ground of Paris to regional cities such as Lille and Marseille and increasingly to their neighbours in the Euro-zone. This is partly due to a swell of foreign interest from countries such as the US, Middle East, Japan, UK, Germany and other European countries. They have pushed prices to new levels, especially in the office market, putting pressure on yields.

According to a report issued this past summer by global real estate advisers CB Richard Ellis, investors injected a record €12.7bn into the French commercial property market in the first half of 2006 as average rents across Paris stabilised. The market was not only driven by the volume of investments but the diverse nature of the players. French investors, ranging from real estate investment trusts to property companies accounted for just over half of all acquisitions and 41% of sales in that timeframe. The Spanish and Middle Eastern investors stood out as the most active buyers while the US were the most notable sellers.

Offices continued to be the favourite, accounting for a hefty 86% of all investments, thanks mainly to a 6% hike in prime rents since the start of the year in the popular Paris Centre West district. The surge in investor demand caused yields to slip by around 50bp in the first half of 2006, according to research from Invesco Real Estate. Although Invesco predicts further marginal yield reductions, it believes there is a clear risk of excessive short term yield compression due to the prospects of robust rental growth.

The increase in real estate prices is one reason why average asset allocation remains hovering around the 5% level. Another reason, according to Berchem, “is that some investors may be subject to limitations to real estate exposure or may have to ask for pre-approval by their control authorities such as the AGIRC-ARRCO funds, (the supplementary pension schemes association).”

Moreover, assets under management are escalating at such a rate that asset managers cannot keep up the pace in terms of slotting the money into different pots. As Vaquier of AXA points out, “There has been a great deal of talk about increasing the exposure to 7% to 8% but I do not see that happening in the near future, except perhaps for the insurance companies who have been in the property markets for years and have the experience. One of the problems we are seeing is that due to the rapid growth in AUM, institutions are struggling to allocate the money as quickly as required.”

Take life insurers. The study conducted by AFIIi and BIPE revealed that the explosion in demand for life insurance in France over the past 10 years has prompted a rapid expansion among the country’s institutional investors. Between 1995 and 2004, money invested by such institutions in France grew by 11% a year, compared with 8% in Germany, 6% in the UK and the US and just 1% in Japan.

Looking forward, market participants believe that new investment vehicles such as the Organismes de Placement Collectif Immobilier (OPCI) will generate more interest and activity in the real estate sector. OPCIs, which are slated to make their debut sometime in the first quarter of 2007, will allow individuals as well as institutions to invest in open-ended, tax transparent funds. A minimum of 60% of an OPCI’s portfolio must be invested in property and they will have to maintain a 10% level of liquidity. The vehicles will be allowed gearing, but the limits are yet to be decided.

Although, the new funds are loosely modelled on the German open-ended funds, the French regulators are insistent that they will not repeat the same mistakes. The German funds suffered when valuation questions led to thousands of investors pulling out, causing a liquidity crunch. One of the main differences to the French vehicles is that the OPCI will have their assets regularly valued by independent experts, ensuring they represent fair value, according to industry experts. Moreover, investors will not be able to buy and sell the funds from day-to-day, as in Germany, but will instead be subject to a delay of several weeks before selling.

Pierre Bollon, director general of Association Française de la Gestion financière (AFG), the French association of investment funds, says, “We have the advantage of hindsight and have learnt the lessons from the experience in Germany. The investment funds are similar to UCITs and mutual funds and they must be managed by an asset manager which has been duly authorised by AMF, the French regulator. One advantage of the OPCI is that unlike investing directly, they offer investors a slice of a broader and more diversified property portfolio.”

The problem, as with real estate investment trusts (REITs), is that the tax advantage is only applicable when investing in France. As a result, closed funds will continue to be the preferable route for those who want to gain exposure to other geographical jurisdictions.