Finding value in property

Written By: Matthew Craig LAPF Investments

Several different aspects of the property market are attracting attention from UK pension funds eager to find assets capable of matching liabilities without the extortionate cost of “safe” government bonds, or the volatility of equities.

Property has traditionally been a reliable asset for many pension funds, offering a reasonable income with the prospect of capital growth. Its reassuringly tangible qualities were reinforced after the global financial crisis, which ironically erupted after over-leveraged investments in the US sub-prime property market collapsed. Nevertheless, many pension funds are now diversifying from the bread and butter of UK commercial property and are looking at overseas property, or more niche areas such as residential, property debt and long leasehold property funds.

The London Pension Fund Authority (LPFA) is an example of how local authority pension fund attitudes to property are changing. Its chief executive, Mike Taylor, said: “We have a benchmark weighting to property of 4% on a £4 billion fund; we currently have £170 million in property. It is a global property brief and we have exposure to property in various forms. We invested in UK property until five or six years ago when, in line with the strategy in the rest of the portfolio, we decided to make our property exposure global. It is all commercial, and diversified between the various sectors, such as retail, industrial and office.” Taylor added: “We think it is a good diversifier, and provides a good yield, and it is less correlated with equities and other asset classes and has lower volatility.” One important factor for UK pension funds considering overseas property investments is their tax treatment and this can often be a sticking point. Taylor commented: “There are difficulties with overseas property exposure around avoiding tax traps, which meant it took us a long time to set up the right vehicle. Originally we were with ING, who sold their property business to CBRE. CBRE did a vehicle especially for us, as we could not find a suitable global vehicle. We have a number of regional vehicles, for different markets such as Europe, the USA and the Far East.” 

On the direction of property investment, Adrian Benedict, investment director, real estate, Fidelity Worldwide Investment, makes the point that London in particular is the focus of a lot of interest from overseas investors, who see it as a safe haven. Benedict said: “We have been taken aback by how much overseas capital is coming in. Up to 70-80% of the investment turnover in the City of London is underwritten by overseas investors rather than domestic investors. What is very interesting for us is that UK pension funds don’t seem to see the same opportunities here as overseas investors do. The latter see an attractive yield and reasonably attractive market fundamentals, a robust tenant base and supply at a low.”

It used to the case that if a UK pension fund was large enough and could allocate £100–£150 million to property, it would have its own segregated mandate with direct ownership of a portfolio of UK property assets. Now, as with LPFA, some funds may invest on a global scale, but there is also growing interest in specific niches of the UK market, normally through pooled vehicles. For example, Islington Council has invested £20 million of its £800 million fund in residential property, and is believed to be the first London borough council pension fund to have done this. Islington Council executive member for finance and performance, Cllr Richard Green, said: “Our decision to invest in residential property is based on careful analysis of the options. It reflects our view that investment in this sector will produce good long-term returns for local taxpayers and members of our pension fund.” He added: “We look forward to other pension funds joining the fund and starting a mass movement which will help to increase the supply of much needed housing in our country.” Islington is investing in the TM Hearthstone UK Residential Property Fund which holds a mix of new and recently built properties, half of which are in London and the South East, with a spread of private market and corporate tenants.

LPFA’s Taylor said his fund is also considering residential property as a new investment. “We have started to look at the potential for residential property. We haven’t invested yet, but we are looking at what options there are. We are particularly interested in the private rented sector, which we think could offer a better match for long-term liabilities; if rents go up in line with wage rises, it would be a good match. We are not interested in social housing as we are concerned about the governance aspects, for instance government interference in any investments.” Mayfair Capital Properties chief investment officer and co-founder, James Thornton, agreed that residential property now looks attractive, particularly in south-east England: “There is a large number of professionals who can’t afford mortgages, and there is not enough good-quality private rented accommodation for them.”

As well as residential property, Fidelity’s Benedict said there is interest from investors in long leasehold funds and in property debt. On long leasehold funds, he commented: “There is an opportunity with buying quality long lease-hold property which delivers a spread over government Gilts of 150 to 200 basis points. The challenge for property managers is that there are not that many long leasehold properties to invest in. Most funds are operating quite lengthy queues –pension funds have made allocations but have not yet got exposure. There can be a 12 to 24 month waiting period before money committed is actually invested.”

On property debt, Benedict said there are opportunities for investors in senior lending and mezzanine debt and added: “This area is of interest to pension funds looking for liability- matching assets. They are asset-backed but are really debt, not property.” Mayfair Capital’s James Thornton said it is seeing opportunities arising from the withdrawal of banks from lending. “Banks are not lending in the way they were. They might give 60% to 65% loan-to-value now, not 85%, so we are seeking to fill the gap. The developer’s capital is most at risk than our capital. Mezzanine providers might charge 25% a year if the developer is putting in 5-10%, but we will take a lower coupon of 15% a year though we want to share in the profits made by the developer. Local authority pension funds need to work with specialist managers to do this type of investment, which can complement UK property beta for investors, by ‘giving them alpha’”. Thornton added that Mayfair Capital’s core and core- plus strategies are also getting attention from local authority investors, as MCPUT (the Mayfair Capital Property Unit Trust) is investing on behalf of the Schroder multi-manager pension team. “For local authority pension funds allocating to a multi-manager fund, it is all about indirect investment. A big balanced property fund will deliver market returns, so a smaller fund like ours can deliver outperformance.” After 2008-09, many investors found it hard to withdraw cash from some property funds, which made investors wary about being gated – or trapped – when alarms bells are ringing. But this has not stopped an increase in indirect investment, as investors look to diversify overseas and into sectors such as long leasehold funds and residential property.

But according to Benedict, investors could be overlooking a well- established market sector in property. “There are some very attractive opportunities in the UK in second tier real estate. These are often high quality properties with strong tenants which are significantly mis-priced. The yield could be 500 to 600 bps over the long-term average; we are seeing 20 LAPF Investments April 2013 one of the best investment opportunities in the last 20 years. This kind of real estate used to be the normal preserve of UK pension funds, but many have left this segment of the market and, as a result of limited demand, prices drifted. Up to now, yields of 10-11% are possible, making it one of the few asset classes yielding more than before the global financial crisis. At the prime end of the market, yields are slightly lower than the long- term average. It is the second tier that hasn’t re-priced and it is very attractive for investors with discretion.”

Wherever investors choose to put their allocations within property, it is likely that they will pay more attention to environmental factors in the future, regardless of their overall view of the ESG (environmental, social and governance) agenda. One reason for this is that it is reckoned that carbon emissions from buildings are one of the biggest contributors to greenhouse gas levels. Hence, property managers can make a significant contribution to reducing carbon emissions through more energy- efficient buildings, and many are signing up to initiatives aimed at reducing unnecessary emissions. LPFA’s Taylor commented: “We have been involved in studies in relation to this issue and so we encourage our property managers to have ESG thoughts, but that is pretty obvious because it means that they are not wasting energy.”

In conclusion, property remains an important asset class for investors and could become more so in the future. One reason is that increasingly mature pension funds, which many local authority funds are, need assets that will match their liabilities and segments of the property market can claim to do this. Investors are also interested in opportunities which could offer good returns with low volatility. Areas such as residential property could offer this, and are likely to see growing attention as equity and bond markets look uncertain. And it is possible, as Adrian Benedict says, that some investors will pick up on opportunities in areas such as UK second tier commercial property. In any event, it is apparent that with careful scrutiny, the property universe offers a wide range of possibilities for the discerning investor.