Since 1980 pension fund weightings to direct property have fallen sharply. But recent performance has been strong and is now the time for council pension funds to hold property?
The WM Company suggests that property accounts for around 5% of total assets compared to over 20% in the early 1980s.
This reduction in weighting can be explained by a variety of factors:
-The universe of potential investments for pension funds widened following the abolition of exchange controls in 1979 - opening the way for international investment - and the introduction of index linked gilts in 1981. Property had to compete with other asset classes.
-Poor long-term investment performance, due largely to over-development following a boom/bust cycle of economic activity. The lower relative returns to property contributed to the fall in its weighting.
-Property's exclusion as a matching asset for minimum funding requirements has probably dampened enthusiasm for the asset.
Over the last three years, property has delivered a real return, after inflation, of around 10% per year, ahead of both UK equities and bonds.
Given the background of improved recent performance, it is timely to ask whether property is an appropriate asset class for pension funds given current prices. Property can play an important role in pension fund portfolios for a number of reasons.
First, property continues to offer a yield higher than other UK assets. Gilt yields, which stood in double figures in the early 1990s, have fallen dramatically. The 10 year benchmark gilt is currently at 4.9%. Equity yields have fallen and the FTSE All-Share yield is now at 2.2%, having been above 5% in 1990.
By contrast, the overall initial yield on the property market stands at around 6.5% - though most types of property trade between 5% and 9% depending on the type, location and other financial characteristics. Unlike other asset classes, property has been slow to respond to the lower inflation expectations that have benefited other asset classes. Many pension funds find property's higher yield beneficial as part of a total portfolio.
Second, property's yield means it is reasonably priced relative to other assets, compared to much of the 1970s and 1980s.
Several arguments support this outlook. The overall economic environment is generally more stable and less cyclical than for much of the post-war period.
Development activity remains relatively muted and investors are rightly much more demanding of their property investments. That is, property must be seen to contribute positively to overall portfolio returns and property prices seem to be more responsive to wider economic and financial market stimuli than during the 1970s and 1980s.
Returns are not expected to be as high as have been delivered over the last five years. But real returns in excess of 6% per year over the next five years or so are not unrealistic.
Third, property is often said to diversify portfolio risk - it is generally less volatile and poorly correlated with other assets. But comparing historic property returns with other asset classes can be problematic. Commercial property indices - unlike their residential counterparts - are based primarily on valuations rather than actual prices.
This means they are a 'smoothed' and lagged representation of prices. Observing past data can be misleading because absolute risk measures, such as the standard deviation of returns, and relative risk measures, such as the correlation with other asset classes, are understated. This can lead to an over-optimistic view of property in a multi-asset portfolio.
The conclusion is that, based on revised assumptions, property can play an important role in diversifying total portfolio risk efficiently.
So what are the best ways of gaining access to the market?
There are many practical considerations facing pension funds when considering property as part of a multi-asset portfolio:
-A segregated direct property portfolio must be large enough acquire properties that will deliver attractive returns
-The combination of property's indivisibility and its heterogeneity mean that returns in any year are often more widely dispersed than in other market - manager selection is critical
-With stamp duty at 4% for most commercial property transactions, entry into the market can be expensive and this will reduce returns in the short-term
-Some trustees have suggested property takes up a disproportionately large amount of their time.
There is no magic answer to the question of what is the minimum size of a segregated direct property portfolio. The obvious alternative is to purchase units in a pooled vehicle so investors get the effects of holding a larger portfolio than would otherwise be the case.
A recent trend has been towards a 'fund of funds' approach whereby a manager is appointed to invest in two or more vehicles. There are several advantages with such an approach:
-Investors can access a far greater spread of property than would otherwise be the case, even compared to investing in a single pooled vehicle. This helps provide better diversification, for example, Henderson Global Investors' model portfolio for fund of fund clients has an underlying exposure to some£2bn of property.
-The fund of fund approach helps to diversify overall manager risk by investing across different managers.
-The spread of units across different funds means exposure to any one vehicle can be kept to acceptable limits. The liquidity of units is improved.
-There can be the opportunity of entering and exiting the market on a matched bargain basis, whereby the costs are shared between the vendor and the purchaser.
Property continues to be attractive to council pension funds. Prospective real returns, while lower than experienced over the last five years, are nonetheless expected to be reasonable compared with other assets, and property helps to diversify overall risk efficiently. Many of the practical problems associated with smaller segregated property portfolios can be overcome through pooled and fund of fund approaches.
-Dr Guy Morrell, director of UK property, Henderson Global Investors.