Real estate allocations up as investors seek security

Institutional investors are using real estate as yet another proxy to bonds, to effectively manage volatility and protect against rising inflation.

In Europe and the U.K. particularly, real estate allocations remain on the rise. The number of European investors allocating to real estate has increased 4% since November 2015 and, on average, those investors are allocating 40 basis points more, to 10.9%, as compared to a year earlier, according to data from London-based research firm Preqin.

With average gilt yields of 0.5%, and the 10-year U.S. Treasury offering 2.3%, asset owners aren't shying away from taking on the illiquidity of real estate. Investors have accepted they need to be innovative in finding yield and they are becoming more sophisticated at it, sources said.

David Engel, portfolio manager at the Swiss Federal Pension Fund PUBLICA, based in Bern, said the board of the 36.5 billion Swiss franc ($39.9 billion) fund approved a new strategic asset allocation of 4% to open-end real estate funds at the beginning of 2016, which includes non-Swiss real estate.

“We will be building up this allocation at the expense of foreign government bonds. We are currently implementing this strategy, which will span three to five years,” he said.

Mike Walsh, head of institutional distribution, Legal & General Investment Management based in London, said, “With 50% of the FTSE 350 pension plans cash-flow negative, clients are investing in these assets from both a yield (perspective) and as part of a wider cash-flow matching strategy.”

In the U.K., where the June Brexit vote was said to have slowed the pace of real estate inflows because of uncertainty connected to London's position as a key European finance hub, the demand for the asset class picked up in the third quarter.

“Our clients have a continued healthy appetite for long-term, inflation-linked contractual income and the demand for low risk real estate has certainly ticked up since the Brexit vote,” said Matthew Abbott, principal at Mercer's real estate research boutique based in London.

Real estate has not lost its appeal to U.S. pension funds either, according to consultants at NEPC LLC. The “majority of our clients are thinking about sourcing an opportunity in the U.K. because of the weak sterling ... these conversations are vivid, but no deals in dollar terms have been concluded,” said Sean Gill, NEPC partner based in Boston.

Justin Curlow, investment strategist at AXA Investment Managers' real assets unit in London, agreed that “international investors have taken the Brexit opportunity to take advantage of the precipitous decline in sterling to seek out prime U.K. property at a discount.” These deals have accounted for the vast majority of purchases post-Brexit and signified that global investors clearly took a longer-term view., he added.

For PUBLICA's Mr. Engel, although he views the U.K. as still an interesting market, the risks increased due to Brexit.

According to data from Standard Life Investments Ltd. as of Aug. 31, long-term real estate offered 330 basis points over five-year U.K. gilts and 4.2% yield, while commercial real estate offered 440 basis points and 5% yield.

Long-term lease strategies in the U.K. have been increasing since 2015 at the expense of short-term lease strategies, said Paul Jayasingha, senior investment consultant at Willis Towers Watson PLC based in London. Based on 2015 figures, commitments to long-term leases exceed £1 billion.

European real estate is attractive because it offers investors both strong terms and returns.

Richard Marshall, head of secure real estate at Standard Life based in London, agreed with Mr. Jayasingha, saying it is possible for investors to acquire properties leased for more than 20 years with strong financial covenants where rental payments increase each year in line with inflation subject to a cap and collar arrangement.

In Germany, too, pension funds — which are more heavily invested in fixed income compared to their U.K. counterparts — are diversifying from negatively yielding bunds into real estate. As a result, property accounted for €6 billion ($6.5 billion), or 2.9% of portfolios through Sept. 30, compared with 1% at the start of 2012, said Markus Neubauer, managing director at Universal Investment, Frankfurt. Alternatives, excluding real estate, constituted 7.7% in the same period.

Universal Investment conducted a client poll, according to Mr. Neubauer, which found “40% of our surveyed clients had said they intended to reach alternative investment allocations of 9% to 12% within the next two years, while some 10% have a prospective quota of 12% or higher.”

Real estate attracts the attention of pension funds globally. Since the Brexit vote, three U.S. pension funds — the $299.5 billion California Public Employees' Retirement System, the $9.5 billion Public School Teachers' Pension & Retirement Fund of Chicago and the $15.5 billion Illinois State Board of Investment — as well as the £2.9 billion Norfolk Council Pension Fund, Norwich, England; and the $90 billion Korea Post Savings, Sejong, announced searches for real estate managers, according to P&I reports.

Nevertheless, “An investor needs to realize that because of the illiquidity, these assets will remain on the balance sheet for a very long time and an exit in difficult times is almost impossible (and not reasonable),” Mr. Engel said.