October, 2012 Print
Richard Tanner, Head of AEW UK.
Inflation may not be, for the time being, a major issue for society at large, but for UK pension funds it is a priority issue. This is hardly surprising given that inflation is one of the key variables affecting the ability of pension funds to pay future benefits to members.
The extent of pension funds’ concerns is clear: in a recent AEW survey1, some 60% of pension industry professionals said the importance of inflation concerns in their day-to-day management of assets has grown over the last five years. Yet few are acting on these concerns. Over the past three years, just 7.3% of funds have substantially changed their portfolio mix in favour of explicit inflationhedging assets such as index-linked Gilts. One of the reasons for this could be the relative scarcity of linkers, which has pushed yields to historic lows.
The limited availability of inflationhedging assets does not however prevent investment committees from incorporating inflation hedges into their portfolios in other ways. Many local authority pension funds already have a significant allocation to property for instance, from which they expect net income streams that correlate with or exceed the rate of inflation.
We wonder how many of these property portfolios actually provide an efficient inflation hedge. Many allocations have high weightings to London commercial office space, which is fine in the kind of property bull market London has enjoyed in recent times. But as experience teaches us, capital values can also fall.
The high allocations to London office space stem from tradition and inertia: most property investors benchmark their assets to the Investment Property Databank (IPD) index, which tracks commercial property prices. As the oldest established investible index in the UK, IPD is employed almost universally. AEW Europe research indicates that over-weighting traditional segments and tracking broad IPD UK indices doesn’t really solve the problem of inflation hedging though. Yes, it has offered strong real net income growth, which can hedge inflation linked changes in pension fund liabilities. But the trade-off is a loss in real capital value.
Aside from the fact that real estate values fluctuate according to the prevailing economic conditions, buildings are depreciating assets. A lot of capital value is eroded over the usable life of a building and that impacts returns to pension funds. A fund can buy a city of London office site for, say, £200 per sq ft and create a building that is worth £800 per sq ft. However, 15 years later that same site could be worth £200 per sq ft again due to depreciation, the development of new competing buildings nearby, because the area has fallen out of favour, or for a variety of other reasons. Rising net income accompanied by capital loss is clearly not a sensible way to meet long-term liabilities.
Property funds that focus on inflation matching rather than total returns do exist. These funds have tended to invest in very long leases such as those taken out by supermarket chains. But market pricing for these kinds of leases has proved expensive, and many investors have ended up concerned about the performance prospects of some of these funds. Investing in the secure income of Retail Price Index (RPI)-linked leases in the traditional property sectors has come at the expense of yields that are substantially lower than for the IPD UK universe.
As well as the high pricing, investors are often surprised by the credit risk attached to these long leases. It is sometimes assumed that there is very little credit risk associated with long leases, and that they have a similar profile to investment grade bonds. Unfortunately, a lease is not a bond, and people can assign leases to weaker credits and dilute the covenant.
So it is clearly no simple matter to identify property segments and assets that both hedge against inflation and preserve capital in the long run. It would seem that there is always a trade-off. However, we believe it is possible to build property portfolios that achieve both aims. By changing the asset mix, it is possible to construct UK property portfolios with net income flows that have a correlation of nearly 90% with RPI, which can generate real returns well above inflation and also can provide long-term capital preservation.2
AEW Europe research has shown that by introducing a blend of nonmainstream and alternative property types into the mix, almost perfect correlation with inflation changes may be achieved. Real Estate Alternatives (REAs) cover a very broad range of assets including student accommodation, healthcare, leisure, pubs, restaurants and car parks. These properties often offer explicit RPIlinked leases, and are currently held in very small proportions by pension funds, if at all.
Although we categorise these assets as alternative, the stock is substantial. AEW Europe calculations show that the REA segment is almost as large as the traditional property universe. Whereas the IPD UK index of traditional property assets covers £139 billion of investible assets, there are also nearly £100 billion of REAs. This opportunity set is large and scalable from a fund perspective, increasing the investible universe by about 70%.
At the same time, data relating to historical income streams and prices of these assets is relatively poor. While there is good data on agriculture, forestry and some residential segments, for other assets – such as nursing homes – the data is far less rich. Investors considering allocating to alternative assets are likely to require an adviser or fund manager with significant niche expertise.
Pulling together the data is only the first step to creating a portfolio that not only matches inflation, but provides real income return potential to investors while also preserving capital. So assets are selected that have a high correlation of rental income growth with changes in inflation. To beat inflation requires assets with high real net income growth. This is a delicate balancing act: the more one aims to outperform inflation, the better the preservation of capital. But for very high performing assets, the real capital growth is negative.
An attractive going-in yield is also sought. Due to the credit-constrained nature of the current market and the dearth of bank debt, prices are currently depressed for many assets at the moment. Prices are also attractive because of the lack of competition from mainstream real estate funds, which tend to have the IPD UK index as their benchmark. The property market tends to be relatively slow to react to structural changes, and we expect attractive pricing to persist for a number of years before the inevitable appearance of me-too products.
AEW UK’s Real Return Property Fund has been set up to exploit these pricing anomalies. Based on the research and portfolio construction techniques described above, the assets it invests in look substantially different to the vast majority of property funds. It significantly underweights standard shops and restaurants, in-town shopping centres and standard office space, while significantly overweighting retail warehousing, department stores, supermarkets, industrial space, agricultural land, social housing and alternative segments such as pubs, wine bars, hotels, petrol stations, cinemas and student accommodation. Its target returns are different too: rather than aiming for relative returns, it aims to provide a real (after inflation) total return to investors of 5% a year.
Inflation matching property funds may well be an alien concept to many pension fund professionals. But if, as our survey suggests, they are really concerned about inflation, it makes sense to assess if the current asset mix actually addresses that concern. That assessment may reveal that asset allocation would be very different if the fund were to start investing again based on first principles.