It is well known that property returns are linked to the real economy through rental income which tends to increase over time in line with economic growth.  Thus property can be termed a “real” asset.  The relationship with underlying economic forces provides a somewhat tenuous link to pension liabilities since active members’ liabilities increase in general with average earnings.

Property performance tends to be more volatile than that of bonds but is significantly less volatile than equities.  In addition, property has a very low (or negative) correlation with other asset classes.  This means that property is highly effective at reducing overall risk within a pension fund portfolio.  In this sense it is sometimes regarded as an ‘alternative’ to equities.

A directly held portfolio of property investment is really only viable for large pension schemes with Eur200m or more to invest; smaller schemes typically use pooled funds.  It is not practical for pooled funds to track a specified benchmark because of liquidity.

In our view, a property exposure of under approximately Eur200m makes investment via a pooled investment vehicle the most appropriate approach.  One option is to purchase units in a specific pooled property fund.  This can be expensive.  The cost of buying and selling units, which reflects the cost of buying and selling the underlying properties, can easily amount to 7% or more.  The spread between offer price (the price at which units can be purchased in the primary market) and mid price (the value which will appear in the investors’ statements) would be half of this difference (3.5% in this example). 

There can be opportunities to gain exposure via the secondary market where bargains are matched between holders wishing to sell and potential buyers.  Costs incurred are typically 0.2% to arrange the deal plus (in the UK) 0.5% stamp duty reserve tax.  However, this avenue is not open to some pension arrangements, e.g. Defined Contribution Schemes, who need to identify a Fund which will accept modest contributions on an ongoing basis.  Also, it should be remembered that, property is an illiquid investment and managers of pooled property funds often require advance notification of redemptions.  Typically this can take up to three months.

An alternative to investing in a single property fund is to invest in a “Fund of Funds”.  Managers of pooled property funds cannot always obtain exposure to certain sectors or locations of the property market often because of liquidity and timing constraints.  A solution to this, which as well as increasing the range of investment opportunity also diversifies risk, is to invest with a property manager who, as well as investing in their own property fund, invests in other property funds.  There is an “additional” fee for this, typically 0.2%, but the fee for investing in the manager’s own property fund is generally reduced or waived. 

Larger property funds enjoy some advantages as there are a number of sub-sectors within the asset class, such as retail parks and city offices, where exposure can only be gained through large lot sizes.  On the other hand, smaller funds should be able to be more nimble in making sector allocation changes to counteract any size related constraints on their overall investment strategy.

In the UK, we have already begun to see the beginnings of international property investing with an increasing number of managers tentatively raising funds for investment in developed Europe and a small number of pension funds investing in these vehicles. We also see, primarily in a research capacity, more international funds aimed at the listed property markets.

It is frequently argued that international property investing creates opportunities for diversification, as international property markets are not well correlated with each other, and for superior returns through a broader opportunity set.
Investing in property markets abroad for diversification reasons seems relatively unattractive when property is only around 10% of the total pension fund. It is anticipated, however, that the arguments in respect of listed property will be reversed. Listed property is neither closely correlated to equity markets nor to property markets but seem to fall between the two. 

Looking forward, pension fund investors will need to decide where listed property investing fits:

• 
  Is it part of the equity portfolio? Possibly not. Managers are structuring themselves to see listed property equity as part of property not quoted equity.
• Should listed property market securities be thought of as a separate asset class  or at least a distinct sub set of property and,
• If so, can it be used to justify a further allocation to property?
• If listed property securities are part of the property asset class what would be the relative proportions of listed to direct property equity in a balanced or evolving property portfolio?
• If listed equity is part of the overall property portfolio is this where the property portfolio gets the bulk of its global diversification, thus reinforcing the argument that overseas investing should be largely confined to opportunity type funds?

Irrespective of the approach adopted, the degree to which the property allocation within pension funds has grown over recent years would suggest that it has come of age and, on balance, ‘mainstream’ rather than ‘alternative’ seems more fitting.

 Brian Henderson, Investment Consultant