Put Property Back Into Pension Funds

Pension funds are always under pressure to limit liabilities and increase income. Today, in an environment where political and policy turbulence makes it hard to predict where the economy and markets are heading, the pressure is even more intense.

Over time, pension funds’ allocation of investment toward property has fallen, but the time has come to reverse this trend. A report from Cluttons Investment Management sets out the argument for how, if pension funds are seeking long-term steady income, the answer lies in real estate.

“Given where we are in terms of global uncertainty — Brexit, U.S. trade tariffs and general political unrest — property assets have the potential to deliver what other investment classes might not: strong returns, low volatility and high income,” Cluttons Investment Management's Matthew Peake said. “With equities’ volatility and gilts’ low income, this is an opportunity that funds can ignore no longer.”

Property’s Fall From Grace

Pension funds’ love affair with real estate has been cooling for the last 40 years. Back in the late 1970s and early 1980s, 15% to 20% of a pension fund’s allocation would generally be real estate. Today, the real estate allocation typically stands at about 5%.

The rapid rise in equity valuations during the 1980s and 1990s, until the dot-com crash in the early 2000s, pushed property out of popularity. When equities similarly started to drop out of fashion due to their volatility, index-linked gilts took their place.

Pension funds continue to manage enormous amounts of capital. According to Cluttons Investment Management, they make up 44% of the £6.9 trillion of assets managed in the UK. However, poor investment returns and demographic changes have created sizeable funding gaps for defined benefit pension schemes. There is a growing need for these funds to hold assets that behave in a similar way to their liabilities, which is leading to a general reassessment of investment strategies.

In recent months, the expected yields of index-linked gilts have been affected significantly by the economic uncertainty surrounding Brexit and this has shrunk growth forecasts. Though they are still a tempting option for the more risk-averse investor, with a low expected return, pension funds need to find an alternative.

“The typical yield differential between property and gilts is historically 2%,” Peake said. “At the moment it is 5-6%, assuming a 15-year lease term and an index-linked gilt of the same duration. Does this mean that property looks cheap or gilts look expensive?

“Whichever way the argument falls, with the growth outlook for gilts, we think there is a meaningful argument for pension funds to increase weighting towards index-linked property. Gilts give a very risk-averse opportunity, but funds need income to meet liabilities, which property provides.”

Where The Opportunities Lie

According to the analysis by Cluttons Investment Management, property has continually outperformed other asset classes during the last 20 years in many regards. Its low volatility is largely due to the high percentage of returns that comes from income, while longer-term leases provide much less risk than short-term ones.

The ideal real estate asset for a pension fund is a long-dated income opportunity, ideally a lease of more than 15 years. Preferably it will be index-linked, providing the security and stability that pension funds crave. There is stiff competition for this type of asset, however.

“Long-income property funds managed by the likes of M&G, Aviva and L&G are also looking at core real estate assets that provide lower risk and volatility,” Peake said. “Some opportunities will come to market, but generally these investments have to be created rather than managers waiting for them to appear. You’ve got to be proactive.”

One way to be proactive is to actively speak to owner occupiers of property about sale and long-term leasebacks. Or to look at ground rent opportunities that could provide the duration of income the fund is looking for. While some investors focus on core real estate in central London, opportunities can be found in less obvious places.

“If you’re adopting a long-income strategy, you can buy across sectors and in all geographies of the UK, particularly if the fund doesn't have a relative return performance objective that requires measurement against a market average. Alternatives such as student accommodation and healthcare are very interesting at the moment, often providing the long-term income that pension funds crave. You can still find long-term leases in more conventional sectors, of course, but competition is stiffer.”

The performance of the property sector is always linked to the country’s overall economic performance. Although the UK is currently facing a high level of political turbulence, the sector continues to perform better than other asset classes. If pension funds become more willing to up their allocation to property, they could uncover the risk/return balance they are seeking in today’s climate.

This feature was produced by Bisnow Branded Content in collaboration with Cluttons. Bisnow news staff was not involved in the production of this content.