Pension funds in Europe continue to increase their allocations to U.S. real estate, in an effort to diversify and hunt down yield that remains scarce domestically despite market concerns that the property cycle is in one of its later phases.
Sources said the U.S. real estate market is a more liquid and deeper option than Europe's. German and Swiss pension funds in particular have shown a particular taste for core residential and commercial real estate in the U.S. Since the beginning of this year, the European demand has helped to keep the prices of U.S. real estate assets high, sources said.
According to alternative assets research firm Preqin, the median allocation of Europe-based pension funds to North American real estate increased by 3 percentage points in the first four months of 2017 to 9%, compared with an average annual allocation in the previous three years of 6%. Specific U.S. data could not be obtained.
About one-fourth of all European pension funds had invested in closed-end real estate funds in North America for each year starting in 2013 and running through 2016. In the first four months of 2017, the proportion was already at that level, Preqin data show.
Reasons for increased allocations include underexposure to the market and the negative correlation of North American real estate with European assets.
“Most European institutional investors ... are increasing their real estate investments in reaction to the low-interest-rate environment,” said Alexander Tannenbaum, managing director at Universal-Investment-Gesellschaft in Frankfurt.
When Universal measured activity on its third-party administration platform, “the share of U.S. real estate (among) all real estate investments increased from 13% to 20% in the last three years,” he said.
Stephen D. McCarthy, head of North America at AXA Investment Managers - Real Assets in Atlanta, added: “We definitely see increased demand from foreign investors, which is helping to keep prices for core real estate high.”
“Cross-border flows from European pension funds into U.S. commercial real estate rose to $1.7 billion in the first quarter 2017, up 52% on the fourth quarter 2016 on a rolling 12-month basis and 133% year-on-year. In quarterly terms, volumes reached $584 million, a rise of 46% on the fourth quarter in 2016,” Mr. McCarthy said.
Despite recent political uncertainty and concerns of it being late in the property cycle, European investors have continued to be net investors into U.S. real estate, according to Andrew Angeli, senior director, Europe, Middle East and Africa and research team at CBRE Global Investors in London.
“Since the U.S. election last November, the Trump "reflation trade' has compelled investors to U.S. assets, with real estate having benefited. An improved economic outlook should support occupational (rental) markets, in what is admittedly a late-cycle economy,” Mr. Angeli said.
One factor fostering inflows to U.S. real estate is a 2015 amendment to the Foreign Investment in Real Property Tax Act. The amendment waived the tax imposed on foreign pension funds for their U.S. real estate investments, treating them the same as their U.S. peers.
The 36.5 billion Swiss franc ($36.2 billion) pension fund Publica, Bern, announced in mid-2016 a real estate strategy that included a new 4% allocation into non-Swiss real estate over the next three to five years. Because of Publica's existing allocation to real estate in Switzerland and other European countries, the pension fund's focus shifted to other markets, half of which is expected to be in the U.S.
Stefen Beier, Publica's head of asset management and deputy CEO, could not give further details of the plans to build this strategy by press time, stating the plan was in “a negotiation process.”
Although the tax exemption applies to direct investments or investments through partnerships and private equity funds, some sources downplayed the role the exemption played in the increased allocations.
Jon Zehner, global co-head of client capital at LaSalle Investment Management in London, said the more attractive spreads between fixed income and real estate yields in the U.S. is a bigger factor than the tax change. He said that is why Swiss pension funds have been quite keen on real estate in the country.
Demand also is being driven by strong spot performance. U.S. commercial real estate is yielding an 8% return, according to the NCREIF Property index, while residential U.S. real estate is returning about 7.3% year to date. That is well above what investors would get in European real estate or European government bonds. The MSCI IPD Pan-Europe Quarterly Property Fund index performance in the fourth quarter of 2016 was 2.3%; and as of April 27, 10-year Swiss bonds were yielding -0.17%, while 10-year German bunds yielded 0.29%.
Kevin White, head of investment strategy at Deutsche Asset Management U.S. in New York, said while the U.S. return to date is “below the 12% average of the previous five years, it was in line with historical averages. Vacancy rates in the U.S. apartment market are very low and demand remains robust, buoyed by demand from millennials who continue to eschew homeownership.”
However, he said, residential rental properties is the one sector with a meaningful level of supply, which has caused rental growth to stagnate in several cities, including New York and San Francisco. As a result, U.S. apartments slightly underperformed the commercial real estate index in 2016, with unleveraged total returns of 7.3%.
Max von Below, managing director-global investors group at USAA Realco-Europe in Amsterdam, added that U.S. residential and, more specifically, the multifamily market, provides very favorable risk-adjusted returns attributed to drivers such as healthy demographics, low homeownership and favorable supply-demand balance.
German pension fund BVK, Munich, with €82 billion ($87 billion) in assets, hired USAA Real Estate Co., Austin, Texas, to manage a new €750 million allocation in U.S. residential markets. BVK's real estate allocation is now 17% of its total portfolio.