An increasing number of pension funds and other institutional investors are looking to increase their strategic weighting to real estate and as part of that process to diversify internationally. The reasons are well known: property investment can generally deliver steady and relatively high income combined with the potential for long-term capital appreciation. Its relatively low correlation to equities and bonds also make it an excellent diversifier. While rents offered by property are less secure than the income streams generated by bonds, they still represent a contractual call on a company’s income and therefore have to be paid ahead of dividends, regardless of the corporate tenant’s circumstances. Even when a tenant goes bankrupt, the effect on the value of the asset is limited to loss of rental income and therefore mostly of a temporary nature. A diversified property portfolio will also derive a sizeable percentage of its income from non-corporate tenants such as governments, local authorities and semi-public agencies, which are less exposed to the economic cycle and provide strong covenants and income.

Our internal research also shows that property can offer some protection against price and wage inflation surprises, particularly because in many European markets rents are linked to the inflation index. In addition, as rents are generally only subject to upward revision, property can also act as a limited hedge against deflation.

The most obvious drawback of property is its lack of liquidity. For long-term investors such as pension funds, who need a regular and fairly steady income stream to cover their liabilities, this lack of liquidity should be less of a concern. It also means that they can exploit the compensating higher expected returns.

Based on our internal research, we suggest that long-term investors with inflation-linked liabilities and without major liquidity constraints should contemplate investing up to 10 per cent to 15 per cent of their assets into a highly diversified property portfolio.

Diversification is the key

Regardless of the size of the allocation, it is essential that the property portfolio is diversified across sectors and property types and contains sufficient holdings to deliver a balanced return. In practice, this means that the portfolio will comprise holdings in the retail, office and industrial sectors with tenants from both the private and the public sector. However, the level of diversification offered by relatively small-scale, illiquid domestic markets (e. g. Germany, where the investable market is a small proportion of total stock) is inevitably limited. Hence a growing number of institutional investors are looking to invest in other European markets and take advantage of the low correlation between national property markets. Property investors have traditionally been reluctant to invest outside the domestic market due to a relative lack of transparency in these markets. However, there is now a growing recognition that the European Union and by extension the European Economic Area (Norway, Iceland and Liechtenstein) is becoming the real domestic market. The advent of the euro has further facilitated a more European investment approach. Other than the UK, most of the larger property markets are linked to the eurozone, while several of the new EU member states have indicated their intention of adopting the single currency in the years to come.

While there is growing economic convergence among the EU member states, each of the property markets still has specific characteristics (for example, in terms of planning controls), thus offering significant diversification opportunities. The nature of property (a tangible asset with a bond-like income stream) means that its cycle is more closely linked to the state of the real domestic economy than is the case for equities or bonds. By diversifying into European property, Nordic investors become less vulnerable to the ups and downs of their own economies and the individual property sectors. Despite the growing economic interdependence in Europe, there remain considerable differences between the economic performance and cycles of the individual economies, even within the euro-zone.

Direct or indirect investing?

The large lot size and indivisibility of individual property assets and the high transaction and management costs associated with buying and selling property makes direct investment particularly capital-intensive. Direct investment also requires considerable management time in terms of maintaining and managing the property. In practice, only the largest investors have the necessary capital and in-house expertise to build a diversified portfolio via direct investment. Most investors will instead opt for a pooled approach, whereby a professional management team takes care of selecting and managing a diversified portfolio of property holdings.

Growing investor demand across Europe, including significant demand emanating from Nordic pension funds, has resulted in a significant increase in the number of pooled solutions within the European markets. Growth in the indirect fund market has been particularly strong in the last five years, as property has demonstrated its diversification benefits against equities. According to the European Association for Investors in Non-listed Real Estate Vehicles (INREV), excluding the German open-ended funds targeted at retail investors, there are now 460 funds investing in Europe with a combined gross asset value of €297bn.

The sheer number of funds reflects the scale and fragmented nature of the European property market. For all but the most experienced institutional investors, investing directly into non-domestic European markets is a potential minefield. Indirect funds can overcome this hurdle. However, the size of the European market is such that investors have to build a portfolio comprising a wide range of property funds to achieve a meaningful diversification. This in effect bars medium-sized investors who have only a limited property allocation. In response, several of the larger specialist teams have now launched fund of funds solutions. The key is to find a fund of funds solution that is truly pan-European but which at the same time is underpinned by a rigorous country-based research in terms of both economic and real estate prospects.

Long-term prospects

The potential offered by investment into the European property market is considerable. Many European property markets are still immature and are likely to see significant development over the coming decades. We are also witnessing a long-run increase in the strategic property weightings held in Nordic pension funds and insurers’ portfolios. Danish and Swedish investors have so far led the way. However, there is evidence of investors in the other Nordic markets increasingly evaluating a diversified approach to the asset class. So far it is estimated (Mercer Investment Consulting Survey 2003) that the total value of all assets held by European pension funds is around $3.1trillion, of which property is $204bn, representing a weighting of around 6.5 per cent. If we accept that on average the appropriate property allocation of long-term investors
such as pension funds should be around 10 per cent, the value of European institutional property holding, has the potential to rise by $100bn to $304bn.

In response to this demand, the transparency, liquidity and scale of the property market is in turn undergoing a fundamental increase driven by both public and private investment vehicles looking to match growing investor appetite with suitable solutions.

The recent performance of European property against bonds and equities, underscores this shift. This is why we believe this momentum is not just a temporary phenomenon, fuelled by low interest rates and excess liquidity, but rather a more permanent repositioning of property as an asset class within the European institutional investors’ universe.

While some segments of the market may suffer from a short-term setback in the event of a rapid rise in interest rates, we believe that this will not halt the fundamental re-appraisal of property that is currently under way as pension funds and other types of long-term investors diversify their portfolios into assets that can generate relatively secure income streams over the long run. A diversified indirect European portfolio allows institutional investors to achieve that while also ensuring exposure to the capital appreciation of European property. This is a message of which most large Nordic institutions appear to be particularly cognisant.

In co-operation with:
Merrill Lynch Investment Managers

Contact
Anthony Biddulph,
Merrill Lynch Investment Managers,
33 King William Street,
London, EC4R 9AS
Tel: + 44 207 743 4656
Email: anthony_biddulph@ml.com

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