As published in Professional Pensions on 26 June 2008:

Following an incredibly strong run of positive returns, UK property markets suffered a significant set-back over the last year.  This has led many UK pension funds to re-examine their property allocations.  Even before the recent weakness, many UK property managers had proposed diversifying into European property.  After all, broader diversification has always been a mantra of investment management.  We feel it’s appropriate to consider this question from first principles as it applies to property.

UK pension funds have historically invested in real estate in order to achieve diversification away from their equity investments while obtaining some broad inflation protection for their liabilities.  UK property had performed well in achieving these goals until the last 12 months: returns over the last five and ten years have been comfortably ahead of gilt returns, and the yield offered by property investments ensures that the characteristics of property remain somewhere between that of equities and gilts.  The problem for trustees and consultants is to determine the rationale for investing outside the UK, introducing currency risk and where the returns bear no specific relation to UK based liabilities.

This problem has two possible answers: overseas property investments could be treated the same as the existing UK property allocation, or as an alternative investment with its merits assessed on that basis.

As part of a core allocation to property, we need to determine what makes overseas property investments different from the UK and, where they are different, why this is attractive.  Investing in overseas property does not have the same benefits in terms of reflecting prevailing UK bond yields.  Property yields will depend on specific regional factors; there may be less clarity over the level of agency costs in some regions which depress the yield that is ultimately returned to the investor.  We believe investing outside the UK provides broad diversification, but there is insufficient information about the characteristics of returns, the impact of currency movements, the yields that can be achieved and the level of leakage in the returns.  On this basis it could be argued that overseas property may not be any better than a UK only approach.

There could be an advantage from capitalising on the independent cycles of different property markets to shift allocation from market to market.  Nevertheless, trading property is expensive and may outweigh the benefits of any successful market allocation decisions.  In addition, if trustees are looking to invest beyond the UK, it would seem to make sense to give a manager scope to use the widest opportunity set available. This has not generally been the case to date.

At present, much of the activity from managers has been to offer a European solution, rather than investing globally.  We believe this is partly the result of the current structure of some UK property firms.  A number of firms with a core UK business already operate in Europe or have recently developed their European capabilities. The perceived opportunity that has come from the recent downturn in the UK market has provided an effective way of increasing the funds managed by these European teams.  While the European offering may be credible, re-allocating funds from an existing property allocation may not add meaningful diversification.  If trustees are prepared to look outside the UK, why restrict the search to Europe?

If we treat global property investing as a non-property allocation (i.e. not sourced from an existing property allocation), we can consider the benefits of diversification and return enhancement relative to other alternative assets.  For the expected return to be enhanced, the proposition needs to be globally attractive, i.e. accessing markets when prices are depressed or where investors can expect strong levels of top line growth.  We believe that the emerging market economies, where the populations are growing and economic growth continues to be strong, are likely to be the markets that see the greatest potential for high sustained levels of property returns.  However, the risks in these regions are also likely to be the greatest (as are the costs).  It is crucial that any property manager selected has the ability to manage value and growth opportunities on a global basis.

We do not believe that including a European allocation, the most frequently proposed change to an existing UK property mandate, is the most effective route.  We believe that overseas property investment should be considered a fully global basis and as an investment in its own right.  The UK-based houses that trustees have traditionally employed may not be the most appropriate choices for this approach.  Trustees should investigate a wider range of managers.  We expect more managers to offer clients global property solutions in future.  Developments such as IPD’s ongoing work to develop a global property index should ensure that there is some degree of accountability for returns, and will help trustees assess the full benefits of investing globally.