UK and other European pension funds are going to have start taking property seriously again. It has taken some time but over the 10 years to 30 September 2001 property has at last overtaken the other main asset classes.
With UK equities returning 10.1 % per annum, overseas equities returning 9.6% and UK bonds providing a return of 9.9%, it was fascinating to see property returning 10.2% pa. Now it is a pity most pension funds have not taken property more seriously over the last 10 years.
However the last five years have seen the most startling turnaround. With property producing a return of 12.2% pa, it is difficult to understand now why funds have not invested more heavily in the sector.
After all in the same five year period UK equities have produced a return of 6.5% annualy and UK gilts have only returned 9.0% pa. With a strong pound over the same period overseas equities have only managed 6%. Not only has property performed well but its diversification characteristics have also reduced risk exposure along the way.
But what matters for pension funds are not the returns they have missed but the returns that might be expected to be earned over the next few years. It is in this regard that property really has some very attractive features. George Henshilwood of consultants Hymans Robertson has been a leading advocate for property and its diversification qualities for a number of years now.
He believes the optimal proportion of property in a pension fund portfolio is between 10 and 15%. Henshilwood’s figures indicate that a pension fund with a 10% exposure to property can expect a higher median return at a lower risk than a similar portfolio without property or even with private equity or hedge funds in place of property. The case is very persuasive.
So just what are property’s attractions? According to Stephen Pyne, deputy managing director at property advisers Baring Houston & Saunders, the case for property hinges on its yield advantage; its risk profile; the opportunities to add value as well as its low correlation or diversification characteristics.
It is difficult to understand just why such a high yield is available at the moment. With average equity returns having reduced so substantially it is really very reassuring to see such high yields available. Even if pressure starts to bring yields down, it should be quite a while before property’s yield advantage is eliminated. In the fullness of time the yield differential will reduce. However the adjustment should bring investors a very healthy capital gain in addition to the yield advantage.
One difficulty for a lot of pension funds is the actual investment itself. Many funds were put off property in the 1980’s because it was seen as a messy investment, time-consuming, expensive to administer and illiquid. Now many indirect opportunities are available giving access to investment sectors not otherwise available to the average pension fund.
Certainly giving access to sectors that have in the past tended to perform well. In addition, indirect investment gives access to specialist managers, gearing, liquidity, the opportunity to play in emerging sectors, in fact, according to David Hunter, chief executive of Aberdeen Property Asset Managers more or less the full range
of property investment options.
Jon Exley at consultants William M Mercer however, has an alternative view of property as an investment, he recommends considering property’s attractions as a match for a typical pension fund’s new maturity requirements.
His view is that whilst old valuation methods and the MFR encouraged equities, equities never matched liabilities, however they always looked good in quantitative models.
Although these models are still highly subjective, liabilities have changed, there is less discretion in the benefits provided, assets are now ‘marked to market’ and in the era of FRS17 the equity cult is being questioned. Recent market volatility has reinforced these questions so that high and safe yield is now more sort after than ever.
But where does property fit in? Most commentators have always considered that property is an alternative to equities. However during the equity bull market, property was at a big disadvantage in ALM studies, it suffered from prejudice in actuarial methods and was hindered by traditional property valuations. He asks therefore believes we may have focused on the wrong attributes of property. Instead we should focus on the fact that traditional institutional leases with investment grade tenants are as good as a corporate bond.
The starting point is to look for ‘high lease value’ properties where it is the value of the lease, not the yield that is crucial. Key characteristics of such a property are good tenants with long leases currently over rented and often in a poor location. Exley believes that by taking such properties at today’s yields with credit enhancement and insurance you can convert a lease into a bond with a very tax efficient structure.
Certainly property needs to be seen in the future in a new context, it has very desirable bond like attributes and with high yields, property seems bound to play a very important part in many pension fund’s asset structures. It will however be interesting to see just how many pension funds really appreciate the potential of this very versatile asset class.