As published in Professional Pensions, 19 November 2009: In the third quarter of 2009, UK property produced its first positive returns since mid 2007, with the IPD Monthly index returning 3.3%. Prices fell by around 45% over the two year decline prior to this. Even the modest rally in quarter three looks disappointing when compared with equity market returns in excess of 20%. However, property yields appear to have peaked around 8% in the summer and have fallen back modestly as investor activity has picked up.
Our manager research team are currently working on a record number of property searches, falling into two main categories – re-building allocations to strategic weight and first time investors looking for diversification. The significant amounts pension funds have to invest will add to the wall of money expected from UK retail investors and from overseas investors attracted by the additional value created by the weakness of the pound. There is also an expectation that the UK property market will be among the first to recover, having been among the earliest to go into the downturn.
What types of approaches are clients taking? Many of the schemes looking to acquire property for the first time are focusing largely on UK pooled vehicles, including fund of funds. Even for those building back to a target allocation, there has generally been an initial preference for UK assets. We might expect to see a pick-up in interest for global mandates as we move further through the recovery cycle.
We are starting to see queues developing for some of the higher quality property funds - in stark contrast to the queues for disinvestment witnessed only a year or so ago, the legacy of which continues in some funds today. Most funds are now trading at Net Asset Value (NAV), with some even trading at a premium. Property managers have been planning their response to a recovery for some time, with in excess of 50 new UK Recovery funds currently attempting to raise capital. We believe that the majority of these will fail to gain sufficient funding, but this clearly demonstrates the appetite for product development amongst the property managers.
While investor demand for property has increased, we must not lose sight of the fact that the occupier market remains weak; the poor state of the economy has put pressure on the affordability of rents along with a high level of voids. In terms of supply, many banks are still awash with property they have “inherited” through business failures. We are likely to see a good proportion of this hitting the market when valuations look more attractive, possibly capping price appreciation in the medium term. Further, most private sector defined benefit schemes are now closed, with de-risking plans already in place or being planned. For schemes in this situation, the past two years have been a salutary lesson that “property really is a long term investment”; we may well see some schemes start to actively include property sales in their de-risking plans over the next couple of years.
Current market conditions provide some very exciting opportunities for property fund managers. A number of established managers are updating terms and conditions in their contracts to allow them more flexibility than was originally given when these were agreed in the 1970s or 1980s. This includes a broadening of the asset class into more specialist sectors (along the lines of student accommodation and healthcare which have already made inroads), as managers seek additional diversification. A question mark remains as to whether there is a place for residential property in institutional portfolios and, more importantly, whether vehicles will be available to allow institutional investors to easily access this area of the market. Given the experience of the past two years, and with the increasing likelihood of mortgage defaults due to the rising rate of unemployment, the jury remains firmly out.
The property derivatives market started to develop in the UK several years ago, but remains a relatively illiquid market. Pension schemes should, however, continue to monitor developments in this area.
One lesson that investors have learned throughout the downturn is the impact of gearing. Investors should take a sensible approach to gearing and its impact on volatility. Over recent months, we have seen an increasing divergence between the best and worst performing funds. With some of the poorer performing funds remaining forced sellers, this divergence may continue for some time.
In summary, there are a number of competing factors which will influence the property market over the foreseeable future. The enthusiasm of new investors will provide some upside but over the year is likely to be balanced by assets brought to the market by banks. We might not be quite out of the woods yet but we believe that the worst is probably now over.
Linda McKay, Manager Research Property Analyst