The decision by institutional investors on how much of the overall portfolio to allocate to real estate, commercial and residential, is driven by a balance of quantitative analysis and qualitative judgement underpinned by bespoke long-term liabilities. The “optimal allocation” to real estate for pension funds and insurance companies — and the average allocation of the two investor types varies — is the subject of an enormous body of academic research, with literally as many answers as there are investors.
There is no intrinsic right or wrong answer as to what proportion of assets an institutional investor should allocate to real estate. Instead, the role of real estate tends to be driven by investors’ underlying liabilities.
For example, a pension fund with a younger demographic membership may justify a higher risk asset allocation weighted toward longer-term, capital-growth strategies, while a fund with a high proportion of older members would be wise to target income and cash.
Typically, the risk/reward benefits of unlisted commercial real estate are such that traditional asset/liability models tend to throw up allocation targets of up to 50 percent to the asset class, regardless of volatility assumptions, explains Chris Andrews, head of client relationships at M&G Real Estate.
“It is conventional to add some judgement and industry convention to constrain the allocation to a lower number,” Andrews says, “a key consideration in the actual allocation being liquidity, or perceived liquidity, knowing that in extremis liquidity may be zero.”
The boundaries of global pension funds’ allocation to real estate are between 5 percent and 20 percent but the vast majority of funds tend to gravitate to an allocation of between 7 percent and 12 percent.
Within this spectrum, target allocations to real estate have modestly increased over recent years, up to 9.56 percent in 2015, according to the third annual real estate allocation survey from Hodes Weill & Associates LP and Cornell University’s Baker Program in Real Estate published earlier this year.
Survey respondents — comprising the real estate investment activities of 242 global, regional and national investors from 30 countries with a combined assets under management (AUM) of more than $11.2 trillion (€9.7 trillion) — indicated that target allocations would increase again in 2016, to just under 9.85 percent.
These incremental upticks will mask a more sizeable adjustment of between 1 and 3 percentage points of certain funds on a tactical basis. Regardless, the aggregate of these upward revisions to real estate — by US, European and Asian pension funds and insurance companies — reflects volume capital in the tens of billions.
Macro environment pushes up allocations
The cause of these institutional investor allocation increases can largely be explained by the macro environment. The global low interest rate environment has depressed bond yields, which in turn has reduced returns in investors’ more substantial fixed income allocations. This has forced investors up the risk curve into higher-yielding investments, such as real estate, in the enduring global hunt for yield.
More recently, this dynamic has been exacerbated further by the decision of central banks — such as the European Central Bank and the Bank of Japan — to cut interest rates into negative territory, which has further depressed bond yields, enhancing the perceived relative value of real estate in a multi–asset class portfolio.
This sustained low yield environment has led to “the need of many pension funds to pay out benefits that are too frequently in excess of net contributions,” Andrews explains.
Real estate’s “relative value” driver
The net effect has been to cement real estate’s importance, even in an environment where anticipated future investment returns from the sector are lower than delivered in the past two years.
Jason Oram, a partner at Europa Capital with responsibility for investment activity in southern Europe, comments: “Relative value is an important component of portfolio allocation, but the increased maturity of real estate as an asset class, in terms of transparency, access (both direct and indirect) and liquidity, has also enhanced its appeal to investors on a structural as well as cyclical basis.
“Real money investors have become more prominent participants in the real estate market since the global financial crisis due to their ability to invest on an equity-only basis and also on a time horizon with a longer-term period risk assessment of 10 to 20 years,” Oram says.
All uncertainty has an impact on asset allocation decisions, but institutions are not in a position of not allocating. Most institutions are experiencing an increase in inflows and the money has to go somewhere.
Paul Guest, lead real estate strategist at UBS Asset Management, Global Real Estate, explains: “In a more uncertain world, with low yields across asset classes, good-quality real estate makes sense as an attractive investment — it has considerable residual value and it generates an income stream, plus there is the possibility of future capital growth.”
Of course, real estate is also relatively illiquid and requires expert management, so it should be approached with the correct expertise. Capital market volatility has typically been followed by a review of the overall portfolio risk level.
“The biggest casualty,” says Andrews, “is usually equities, being the primary source of capital risk.
“Allocations to asset classes with lower volatility have been the primary beneficiary, turbo-charged since 2012 by the declining yields available from fixed income — and growing convexity risk — and the realisation that we are in a period of ‘lower for longer’.”
A normal and natural state
Uncertainty and volatility feels like a fixed part of the investment landscape these days. In the United Kingdom, the country’s EU referendum vote on 23 June could have enormous implications for foreign and UK pension fund and insurance company asset allocation. The scope and depth of those issues are too far-reaching to explore here, and anyway much depends on the outcome of the vote.
In broad terms, risk and uncertainty is a normal and natural state of markets and economies. As Andrews says: “The current risks are likely no greater than prior risks in other market cycles — they are simply in a unique combination that we have not seen before. Is Brexit any bigger a risk than when Britain joined the EU 40 years ago?”
For many investors, real estate investment is a medium- to long-term venture and risks should be evaluated on this basis, rather than scenario planning individual political events or the probability of “black swan” moments.
“A degree of uncertainty in any market, and the reflective analysis that it brings, is not always a bad thing, particularly in real estate, which can at times be prone to cyclical over-exuberance,” argues Oram.
“Many of the macro influences on the market have been positive for real estate. For example, falling commodity prices have led to a significant improvement in household confidence and spending — energy bills fell by 30 percent in Spain in 2015 — which has been a positive influence on retail turnover and residential values.”
In addition, the continued low interest rate environment sustained by the ECB has improved commercial occupier confidence and continued to ensure that the yield spread offered by real estate, when compared to sovereign bonds, remains high by historic standards and continues to draw interest from global investors. Moreover, in the years post–global financial crisis, institutional investors have become increasingly sophisticated.
Investor sophistication on the rise
This sophistication has manifested itself in defining allocations within real estate differently, using risk and volatility assumptions relative to the type of investment; whether it is core versus development, debt versus equity or senior versus mezzanine debt.
The outturn of this more modern process tends to be that it is “not immediately necessary to liquidate an overallocated, illiquid asset class like real estate,” says Guest.
“For a typical institution looking to match long-term assets to long-term liabilities, then core, income-driven real estate investment makes sense,” Guest continues. “At a time of low inflation, low interest rates and low growth, plus volatility in more liquid asset classes, a larger allocation to real, income-generating assets like real estate is sensible.”
By comparison, sovereign wealth funds and endowments, which are typically seeking generational wealth preservation, are less yield-driven in their real estate investments, and would allocate to the asset class differently.
Andrews says: “Increasingly, investors are seeing the world split between financial securities and real assets, so real estate may also have to compete on a risk, return and liquidity matrix with other real assets — infrastructure, private equity, timber, etc.”
Investors are more open to sector-specific funds since the global financial crisis, says Martina Malone, senior vice president at Prologis. “They value the deep expertise and data-driven insights that a singular focus can bring and recognise the benefits of accessing smart, long-term investment decisions.
“We are noticing that investors are working with fewer GPs and larger ticket sizes, focusing on well-known name brands with significant track records,” Malone adds. “Many investors seem to be resource-constrained and lack a sophisticated structure to assess real estate investments, particularly in the face of fairly intensive due diligence processes.
“For investors seeking direct investments, there may be an underallocation due to a lack of available investing opportunities,” Malone points out. “Even substantially-sized funds with experience of investing in real estate are finding it difficult to fully allocate at the moment.”
Real estate generally provides an “anchor to windward” — but there remain variations in risks and opportunities between and within European countries, as well as between the forms of investment. As the cycle continues, so too, no doubt, will the ever-increasing sophistication of the end-investor.