Moving up the curve

What is the key challenge facing the European pension fund investing in real estate?

 

nstitutional investors around the world are facing similar challenges. Real estate has performed well over the last few years, but there is a lot of capital trying to get into a market where there is a finite number of investment opportunities. So the competition is fierce and returns have been under pressure. The real challenge from our perspective of giving advice and from the investor perspective of making decisions about deploying capital is what is happening on a risk-adjusted basis. Generally there has been a flattening of yields, so the real story is: how do I differentiate risk given that pricing doesn't necessarily do it?

 

Do pension funds understand the issue of risk differentiation?

 

think they understand it - I don't think it is a learning curve issue. The challenge is in the decision making process. One of the things I am consistently struck by when I meet institutional investors whether in Europe or Asia is that they all say they want to invest internationally to achieve diversification.

They would all generally feel better if they got a premium from a return point of view for investing internationally, which is logical. However what is happening is that local investors accept lower returns in their domestic market because they are comfortable with it, so the paradox is that money is moving across borders more than ever before. But in markets like South Korea for example, the European investor must either accept the lower returns which the local investor accepts or decide not to pursue that market. So investors cannot expect a premium for investing outside their home markets.

 

How do you view the role of the real estate investment trust (REIT)?

 

EITs is one area of real estate investing where the US has played a lead role - as you look at the evolution and arrival of REIT markets around the world there is a lot to be learned from the US. It will be interesting to see the rate of expansion of real estate markets in Europe once REITs have been introduced.

The US REIT market is shrinking because a lot of large public companies have chosen to go private. The same thing may happen in Europe somewhere
down the line - it took quite some time for it to happen in the US. I'm not sure I can explain why there is so much privatisation activity other than that there is a wall of capital that thinks that a private approach to owning real estate is better than a public approach from a valuation point of view. We can debate this extensively, but you can be sure that leverage has a lot to do with it.

I think that REIT activity in Europe and Asia will increase. One of the obvious benefits of the REIT is that it creates a very liquid and transparent way for global investors to get exposure to different markets and different sectors in those regions. In terms of private/unlisted investments Europe and Asia are certainly more opaque. I think institutional investors around the world are moving into global markets through REITs first because they are more transparent. The money seeking to invest in real estate is more than the market can absorb so the REIT market could be a lot bigger.

Do you believe that there are
cultural and local issues in the
different jurisdictions which may frustrate the functional development of real estate investing in Europe?

 

think that is absolutely true - it has been an impediment to the development of the REIT marketplace and will continue to be so. Europeans want to look at Europe in a homogenious fashion like they look at the US. But they shouldn't do so because as Europeans they know better than anybody that the Euro-zone is not a regional play because of cultural and local issues specific to the individual jurisdictions.

These factors cause dislocation, a certain amount of opaqueness and inefficiency in the market so we are enthusiastic about Europe as a private investment market. This is where the private fund investor can be tactical to generate performance in this confusing landscape. It seems that this will remain the case for the foreseeable future.

 

Is the European REIT a dream?

 

don't think so. I think that the scale and globalisation of capital which wants to be in real estate is going to push the European REIT because it provides an easy means of entry to the market. But it is going to be puzzle pieces: the UK and Germany are finally getting there, France has been there but has not seen much momentum. There has been lots of talk that the European REIT has to happen for a variety of reasons. Obviously there will be a lot of politics involved about the structure of the European REIT market; we are a long way off from Europe looking and acting like the US REIT market.

 

What is your view of the level of
education of pension funds?

 

think pension funds in Europe have similar challenges to those elsewhere - they tend to operate with small staffs with very big challenges in terms of the performance they need to generate. I think investing through funds is a good way to go for the majority of pension fund investors wishing to invest globally. However, many prefer separate account mandates, but these can be cumbersome and require a lot of involvement and expertise from staff. For the big guys this isn't a problem but for the average pension fund the separate account mandate is a very difficult way to invest. So I would advise this group that there are different strategies and risk profiles which can provide an efficient way get exposure to real estate - that would be an interesting dialogue.

 

How do you see pension fund
allocations to real estate developing?

 

llocations to real estate and alternatives will continue to increase because the performance opportunity in this space is becoming increasingly important to pension funds.

However, it is getting more difficult to generate reasonable returns on the core side of the spectrum and by their nature pension funds are not expected to pursue risk too aggressively. If we look at the core side we see very low returns relative to historic levels so that pension funds looking for higher returns will be pushed out on the risk spectrum towards opportunistic initiatives. But do they really want to take that much risk?

Interest in core has cooled in the minds of most pension funds - they like the quality and predictability but the returns have got so low that pension funds are wrestling with the issue of pushing the risk profile. The fact that they will not necessarily be compensated for that extra risk will be a limiting factor on how much institutional money goes into real estate.

My observation regarding pension fund allocations to real estate is that in most markets they have moved from the traditional 5-7% into the 10%-plus range. We will tend to see more of a shift from core to opportunistic than additional allocations - at least for now. Sometimes it is difficult to tell the difference because you also see core properties being acquired with aggressive leverage because of the low cost of debt, and this makes them more opportunistic.

I think investors are moving away from core investments and we expect to see some upward movement in the yields on core because of that. Yields are so low that we wonder whether they are sustainable. Investors have done well with core portfolios over the last five to 10 years because they have got so much performance from capital appreciation, with less coming from the income side. This has all come from the compression of cap rates and the underlying values going up dramatically. Now that cap rates are as low as they are that game is over. So it is very hard to justify a 4-5% cash flow yield if you don't have the capital appreciation as well.

 

What is your view of investor

attitudes to gearing?

 

uropean institutional investors are wary of gearing, but to achieve the returns that they need will they have to take the plunge? They have done so elsewhere and I think European investors will have to do the same. I don't think they will rush to - nor should they rush to - high leveraged strategies with say 60-80% leverage.

Most pension fund investors, certainly those in the US, have become comfortable in a core strategy using 40-50% leverage to get better returns. Some pension funds are moving to a higher level of gearing through their allocations to opportunity funds where they are clearly buying in to a high leverage strategy. European pension funds will have to deal with leverage proactively if they want to benefit from exposure to the asset class.

 

What other potential dangers do investors face?

 

ne concern is that institutional investors move large blocks of capital based on where they see the market opportunities. My sense is that the level of sophistication of larger pension funds in Europe is very high, and medium-sized pension funds are putting a lot of effort into moving up the curve. In this kind of environment it is very easy for the supply-side to fall into the trap of promising higher returns because that is what the pension funds want but then taking on more risk to get there which is not what the pension funds want.

The interest rate environment is benign but with yields being as low as they are it won't take much in the interest rate change to change the valuation dynamic. This is a short-term risk.

Some people talk about the impact of a shock but markets have recovered from shocks almost without exception. The shock risk almost seems to suggest some catastrophic shock. In the case of the London bombings the market corrected for a short period of time but bounced right back. If you look at 9/11 there was several months of downtime but again the market rebounded. I think the financial markets have started to accept the fact that that's the way things are now.

What might take some air out of the real estate markets is if alternative investments of some kind present themselves and become attractive. But right now there is nothing there to move momentum out of the market and I think the money will stay in the sector for the foreseeable future.

 

What areas of real estate investing present the most risk?

 

sia is an interesting place that can be a bit risky in terms of the likely volatility. There is no question about the demand side of those markets. But whether it's India, China, or other parts of Asia there is a lot of money chasing a small number of opportunities so there could be an imbalance in the risk/return relationship where investors could misprice the risk pretty dramatically and not factor in the volatility.

One of the unusual things about real estate is that some investors are very good at understanding the asset class and some generalise about it. It is a very difficult asset class to generalise about because of transparency issues, dislocation and inefficiencies that occur on a micro market level. For example, if you generalise about the US residential market being overpriced you would be right about a market like Florida but absolutely not in the Upper East Side of Manhattan. The US market is more homogenious than it has ever been but it is still very diverse.

So I think it will boil down to the specific bets that people make. Investors have to be willing to do their homework and the grass roots research around the asset class. It is not an asset class where you say ‘I'm going into real estate so I'm going to sleep well at night'. That is a fairly boring answer but that is the reality.

Five to seven years ago investors didn't need to be so precise and could make a general bet on real estate, and most of those bets have paid off. Today the market is very different - there will be bets that will pay off and others that won't because of where we are in the cycle.