Issued in July 2009 by Schroder Property Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1188240 England.
Authorised and regulated by the Financial Services Authority.
Schroders
Property and UK Pension Schemes
By Mark Humphreys, Strategic Solutions
and Mark Callender, Head of Property Research
Introduction
Although classified as an alternative asset, property is a relatively straightforward investment to understand and it has a long and respectable performance track record. Many of its performance characteristics stem from the simple fact that it is a physical asset, rather than a financial asset.
The aim of this paper is to consider the role of commercial property as an asset class for UK pension funds.
The paper covers UK commercial property’s key characteristics and considers the different ways by which investors can gain access.
Overview of property as an asset class for UK pension schemes
Property investment is generally classed as either commercial or residential. Put simply, whilst residential property is designed to house people, commercial property is designed to meet the needs of business. Within the commercial sector there are three broad types of property that meet the vast majority of business needs:
Types of commercial property
Industrial
The industrial sector consists of warehouses let to a wide range of occupiers from large third party logistics companies and major retailers, down to small printers and builders merchants. It excludes factories. The sector has tended to see quite low rental growth, but this has been compensated for by relatively high initial yields, (current rental income as a proportion of the value of the property).
Retail
This sector includes high street shops, shopping centres and out-of- town retail parks.
Planning controls on new retail development tend to be tighter than in the office and industrial markets and the sector has seen stronger rental growth over the long-term.
However, this advantage has been offset to some extent by relatively low initial yields.
Offices
The main occupiers of offices are financial and business services companies. The office sector has traditionally been the most cyclical of the three commercial markets and as a result, the timing of purchases and sales is particularly important.
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Institutional investors in the UK typically invest only in commercial property and have very little exposure to residential property. However, institutions in some other European countries such as Germany, the
Netherlands and Switzerland often have large scale holdings of residential property.
The reasons for this are complex. First, cultural factors play a part and in many large European cities renting an apartment is often the social norm and there is less emphasis on home ownership than in the UK.
Secondly, until the introduction of the Assured Shorthold Tenancy lease agreements in the UK, tenants had powerful rights of abode and it was extremely difficult to manage non-paying tenants, (in addition to the potential negative publicity associated with doing so). Third unless institutions can invest in blocks of apartments, it is often difficult to achieve the economies of scale in property management which can be achieved in the commercial sector.
The UK Government has launched various initiatives to encourage institutional investment into the UK private residential property sector although this has so far met with limited success.
Composition of the UK commercial property market
The chart below shows the breakdown of the UK commercial property market by the retail, office and industrial sectors as estimated by IPD (Investment Property Databank) at the end of 2008.
The IPD information for the UK property market is estimated to represent around 75% of the total combined value of the property assets held by UK institutions, trusts, partnerships and listed property companies. The IPD index bases its information on valuations of buildings by professional valuers and each building must be completed and available for letting for it to be included in the index. As at December 2008, the value of the UK property market tracked by the IPD indices was estimated to be around £129 billion.
Over time the proportion of the industrial sector of the UK property market has remained relatively stable. This is in contrast to the change in overall composition seen by the steady growth in the retail sector up until the late 1990s.
IPD UK annual index weightings, December 2008
Source: IPD
What drives returns from UK commercial property?
The total returns on property are composed of two main elements: the income return and the change in capital values. The income return on property is broadly similar to the dividend yield on equities. According to IPD it has traditionally been fairly stable at between 5-8% of the capital value and it has been responsible for the majority of total returns over the long term.
Most of the volatility in property performance over the short term has been due to swings in capital values.
Movements in property capital values are in turn a product of two main variables: open market rental values for occupier space and changes in the yields used by valuers.
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Shops Shopping Centres
Retail Warehouses Central London Offices
South East Offices Rest UK Offices
Industrial Other
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The open market rental value is the rent which a tenant would pay today to take space in a retail unit, office, or warehouse. Open market rental values are driven, on the one hand, by the demand for space from tenants and on the other hand, by the supply of new buildings. The rent is then fixed until the first rent review, typically in five years time, at which point it will increase if open market rental values have risen in the intervening period. If, alternatively, open market rental values have fallen, the upward only rent review provision which is standard in most UK leases, means that the rent cannot be adjusted downwards at review. This provides the landlord with a predictable cash flow until the end of the lease, provided the tenant avoids insolvency.
In common with UK gilts and other bonds, the capital value of a property is inversely related to the yield estimated by the valuer. Therefore a fall in property yields will lead to an increase in capital values, whereas a rise in property yields will lead to a decline in capital values. Property yields are derived from a mix of
influences including expectations for future rental growth, the level of short term interest rates, the yield on other assets and the availability of bank debt.
Total return of UK property and its components, 1988-2009
%
Source: IPD and Schroders, June 2009
Performance characteristics of a UK property investment
In the chart overleaf we display annualised performance for a range of different asset classes to the end of December 2008. Despite the recent downturn, UK commercial property has been one of the best performing growth assets in the UK over the last ten years. However, over the last two years UK property returns have shown higher correlations with equities than in the past, due in part to the lack of availability (and increase in the cost) of bank finance as a result of the credit crisis.
-40 -30 -20 -10 0 10 20 30 40
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Income Return Open market rental growth Yield impact Total Return Capital Value
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Historical asset class performance to December 2008
Annualised performance
Source: FTSE, IBOXX and IPD. UK corporate bond data started in 1997.
The IPD UK All Property Annual Index started in 1970 and the table below shows that property outperformed UK gilts, but underperformed UK equities over the last 38 years to the end of 2008. (Data for UK corporate bonds only began in 1997). This record reflects the expectation that property carries greater risk than gilts, but less risk than UK equities (see next section on volatility). Measures such as the Sharpe ratio which attempts to adjust the returns on assets for different levels of risk, suggest that UK property’s performance over the long term has been similar to that of UK equities and gilts.
UK commercial property and other asset total returns, % per annum
UK Property UK Equities
UK Gilts (All maturities)
UK Corporate Bonds (All maturities) 1998-2008
Total Returns 7.5 1.2 5.7 3.9
1970-2008
Total Returns 11.0 12.4 10.4 -
Total Returns - real terms1 4.2 5.5 3.6 -
Volatility in Total Returns2 15.0 19.1 11.2 -
Sharpe Ratio3 0.20 0.23 0.22 -
Source: FTSE, IBOXX, IPD, Schroders. Corporate bond total returns begin in 1997.
1. Total returns adjusted for inflation. Inflation averaged 6.5% per year 1970-2008 2. Property total returns are unsmoothed to remove valuation effects.
3. The Sharpe ratio is calculated as the fund return less the return from a risk free asset, divided by the annualised standard deviation of the fund.
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UK Property UK Equities UK Gilts (All Maturities) UK Corporate Bonds (All Maturities)
% Total return
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4.6%
7.5% 7.4%
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UK Property UK Equities UK Gilts (All Maturities) UK Corporate Bonds (All Maturities)
% Total return
N/a
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Volatility
Conventional measures of risk such as standard deviation and others based upon methods typically used to understand risk in an equity or gilt portfolio do not work as well in the context of a property portfolio. A typical risk number, calculated without any adjustments, will tend to show property is less volatile that either equities, or gilts. However, this is partly a distortion caused by property returns being based on valuations, whereas equity and bond returns are based upon prices. The reliance upon valuations reflects the fact that property is a physical asset and there are fewer transactions and prices compared with financial assets. If this valuation effect is removed using statistical techniques1, then it appears that the risk on a property investment is roughly half way between that of UK equities and bonds.
The implication that property carries more risk than gilts, but less risk than UK equities reflects the security of income. Gilts offer the best security because the income is guaranteed by the UK Government, while equities offer less security because dividends can be cancelled at the discretion of the company board. Property fits somewhere in between, given that tenants are contractually obliged to pay the rent, but there is a risk of tenant default. However, one of property’s redeeming features is that in the event of a tenant insolvency, the landlord may sooner, or later re-let the space. By contrast, the shareholder, or bondholder in an insolvent company may lose everything.
Diversification effects of property investment
Different assets within a pension scheme portfolio will perform differently at varying points of the economic cycle. A good diversifier will have a low correlation with other growth asset classes and its inclusion should therefore provide a degree of protection when other asset classes perform badly. The overall effect is to lower the volatility of the pension scheme portfolio’s returns.
As is shown in the table below, the historical correlation between UK equities and property is very low, around 0.29. Property is also very lowly correlated with gilts (around 0.02). The addition of a property holding to a portfolio consisting of gilts and equities should help reduce overall volatility.
Total return correlation coefficients, 1970-2008
Property UK Equities UK Gilts
UK Property 1.00
UK Equities 0.29 1.00
UK Gilts 0.02 0.59 1.00
Source: FTSE, IPD, Schroders
The main reason why property has been a good diversifier of equity risk in the past is that property returns have usually been driven by the rental cycle. Rents are largely a function of the current health of the UK economy which partially drives occupier demand. Thus, traditionally property has been a coincident indicator of the economic cycle. Conversely, equities are usually driven by expectations for future economic growth and profitability and they tend to act as a lead indicator of the economic cycle. A feature of the last five years is that property values and total returns have been driven primarily by changes in investor sentiment and the availability of bank debt, rather than by the demands of the occupier market.
This, in part, explains why property has provided less of a diversification benefit in recent years. However the long term characteristics of property are unlikely to have fundamentally changed.
1Index Smoothing and the Volatility of UK Commercial Property, Investment Property Forum, 2007
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Income growth
The growth in income from property shows a reasonable link to UK inflation over the long term. In part this attribute simply reflects the tendency of open market rents to rise broadly in line with the prices of other goods and services over the long term. Probably the most significant factor which might break the relationship would be a major relaxation of planning policy and a big increase in new building.
However, in addition, the long term growth in income also reflects UK lease terms. In particular upward only rent review provisions protect the income in existing leases from falls in open market rental values. Open market rental values usually fall because there is an increase in vacant space. They would probably also decline if there was a widespread fall in prices across the economy (i.e. deflation). While the degree of protection offered by the upward only provision has lessened over the last 20 years, (as leases have got shorter and the annual number of leases coming up for renewal has increased), it is still beneficial. (It is important to note that although the income from property may respond to long term inflation, the same does not necessarily apply to property values and total returns, because they are also sensitive to changes in interest rates).
Property income versus inflation
Property Income Growth p.a.
UK Equity Dividend Growth p.a.
Average UK Earnings p.a.
Inflation (RPI) p.a.
2003-2008 4.1 7.7 4.0 3.0
1998-2008 4.6 2.4 4.1 2.6
1980-2008 6.3 6.3 5.8 4.1
Source: FTSE, IPD, ONS, Schroders
Illiquidity
The physical nature of property means that the time and cost associated with transactions are greater than for financial assets. Professional fees typically amount to 1-1.5% on both purchases and sales. Add to this Stamp Duty of 4% on the purchase price, and the round trip cost of buying and selling property amounts to around 7%. In normal markets, this deters most investors from frequent transactions and results in a relatively illiquid asset class. Liquidity may also vary during the property market cycle with investor sentiment and financing terms. The last twelve months have reminded investors of the liquidity constraints (even in pooled funds) of property.
However, investors typically expect to be rewarded for accepting illiquidity: this is known as the illiquidity premium. The strategic implication is that investors should hold property for the long term to minimise transaction costs and benefit from the illiquidity premium. Pension schemes are almost unique among investors in their ability to capture an illiquidity premium due to their long term investments.
Potential to enhance UK property returns
While investors in financial assets like equities and bonds have little or no opportunity to influence the returns from individual holdings, property is a physical asset where investors can enhance its performance through active management of the physical asset itself. Professional management can add value in a variety of different ways such as upgrading obsolete properties (e.g. to become more energy efficient), or by changing their planning use or by extending the length of the current lease.
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Of course, it should not be forgotten that some of these opportunities arise because property is a physical asset and it is subject to obsolescence. While tenants are usually liable for routine repairs and maintenance, they are not responsible for major improvements to accommodate new technology, or to meet changing environmental, or building standards. Research by the Investment Property Forum2 suggests that historically spending on occasional improvements has averaged 0.7% of capital value per year. While this investment will usually result in an immediate increase in value, over the long term a property will gradually depreciate, in the sense that its value will fall relative to the value of a brand new property.
Furthermore, development and major refurbishment schemes may carry a much higher level of risk than investing in existing let properties. Winning planning permission for a new development, or a change of use can take several years. How much development is appropriate will vary from investor to investor, depending upon their target return, investment timescale and their appetite for risk.
UK property and the economic cycle
With its mixture of medium/long term (and relatively predictable) cashflows together with its link to economic growth, property is often considered a hybrid asset, part way between equities and bonds in nature. In reality, property behaves in different ways at different points in the economic cycle as illustrated by the schematic diagram below.
Behaviour of UK property as an asset class through the economic cycle
Source: Schroders, for illustration only
During a recession when rental values are falling and there is little prospect for income growth, property is essentially like a bond and property yields may be quite sensitive to changes in bond yields, albeit with a slight lag. The same is also true in the early recovery phases of an economic recovery when the rents paid by tenants on existing leases are still likely to be above open market rental values (this is known as over-renting).
By contrast, after a sustained period of economic growth, when there is little vacant space and open market rental values are rising, then property behaves more like equity and may deliver significant income growth.
Role of leverage
Some property investors may seek to enhance long term total returns by using leverage (also known as gearing). Leverage is the use of borrowed funds to increase exposure to property, and INREV’s database (the European Association for Investors in Non-Listed Real Estate Vehicles) shows that the majority of unlisted pooled property funds have the ability to employ leverage.
2Depreciation in Commercial Property Markets. Investment Property Forum, 2005 Recovery
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Leverage is commonly used by property investors for three reasons. Many commercial properties have high values and often the only way for some investors to buy them is to use debt within the financing structure.
Secondly, UK lease terms have a relatively long duration (IPD research shows the average lease term is around nine years) and typically incorporate upward only rent reviews clauses. Provided the tenant remains in business, the future income stream may be perceived to be an attractive asset against which banks are willing to lend. Finally, UK property investment has sometimes been effectively self-financing, and this has been seen as a way for investors to improve their return on equity invested. The chart below shows a proxy for the cost of finance (5 year swap rate plus a margin) and the All Property Initial Yield. Where the initial yield is above the finance cost, a property investment may at this point be self financing.
Initial yield from a UK property investment versus the cost of finance
Source: IPD, Datastream (5 year LIBOR swap rate plus a margin), May 2009
The effect of leverage on total returns is to magnify returns – positively or negatively – depending on
performance relative to the cost of finance. Where total returns exceed the cost of debt, an investors’ return on equity will be increased. The reverse is true when returns fall below the cost of debt. Compared with a property portfolio which is ungeared, a leveraged property portfolio will have greater volatility and in some periods may result in losses. Around 2005-2006 the cost of finance exceeded the average initial yield.
Effectively some investors were hoping for continued strong rental growth (and hence capital appreciation) to deliver during this period.
Accessing property
Many investors do not have sufficient time or resources to be able to purchase and manage a well diversified portfolio of directly owned property. For these investors, there are number of ways of accessing property indirectly. This includes property securities (including Real Estate Investment Trusts or REITs), unlisted pooled property funds and fund of funds. The advantages and disadvantages of each are discussed below.
Unlisted pooled property funds
Unlisted property funds come in many different guises and range from diversified balanced funds to sector specialist and opportunity funds. For the generalist investor seeking a return profile which is similar to the IPD UK property market index, diversified balanced pooled funds would usually provide a broad UK exposure.
These are typically open ended funds which provide diversified exposure to all UK property sectors. They may have the ability to use leverage, but often this will be limited. Investors will usually be able to buy and sell units monthly or quarterly, or more frequently if the manager operates an efficient secondary market.
The advantage of these vehicles is that they may provide a much better proxy for the direct property market than listed property securities. The relatively low level of volatility compared to listed property securities and diversified market exposure make unlisted property funds an attractive vehicle for institutional investors who are seeking portfolio returns similar to the UK property market, (measured by indices such as IPD’s). In addition, they are attractive to investors who wish to exploit a long term illiquidity premium from UK property.
Compared with the direct property market, unlisted funds with low or no gearing may provide better liquidity, although this can be tested in extreme market conditions such as 2008. Liquidity may be lower than for listed property companies.
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2001 2002 2003 2004 2005 2006 2007 2008 2009
All Property Initial Yield 5 Year Swap Rate Finance Cost including banks' margin
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Property fund of funds
An alternative to unlisted property funds held individually is the property fund of funds. Over the past ten years the number of unlisted funds and range of property investments has increased substantially. For professional fund of fund investment managers, this provides opportunities to select from a variety of fund strategies including specialist sectors and the ability to focus allocations on certain market sectors.
The advantages of fund of funds are that they provide investors with further diversification of manager and asset risk. As with any fund of funds, however, the main disadvantage is that these benefits come with an additional layer of fees.
Property securities
Real Estate Investment Trusts (REITs) and other property securities are listed companies whose shares are tradable on the stock exchange. Property companies structured as REITs are required to hold individual properties for a minimum of three years and distribute 90% of income (among other requirements) to benefit from exemption from income, capital gains and corporation taxes. REITs can therefore be regarded as property investment companies. Non-REITs do not have to abide by these rules and can be managed with greater flexibility. Non-REIT property companies include developers, fund managers and trading companies.
The advantage of property securities over direct or unlisted property funds is liquidity. Daily trading volumes of the largest REITs is significant, and for investors for whom liquidity is important, they offer a means of
accessing property company portfolios through the stock market.
Set against this, there are two principal drawbacks. Being listed, property securities are subject to equity market volatility. This contrasts with direct property or unlisted property funds, where valuations and pricing are less frequent. The additional short term volatility therefore negates some of the benefits of diversification that often attract investors to UK property as an asset. Over the long term, however, the performance of property securities is likely to be more correlated to direct property. Secondly, REITs and property securities typically employ higher levels of debt within their capital structure than unlisted property funds. This too can add to volatility.
UK property market expectations
Schroders currently do not expect to see a meaningful UK economic recovery until 2011. On a positive note, the combination of very low interest rates, quantitative easing and sterling’s depreciation appears to have slowed the sharp decline in economic output which began last Autumn. However, on the downside, the process of consumers and companies paying down debt and repairing their balance sheets still has some way to go. This is likely to act as a drag on UK consumer spending and business investment through 2010.
The weaker outlook for the UK economy has in turn fed through to Schroders’ UK property forecasts and we now expect open market rental values to fall by around 25% from their peak in mid-2008 to their expected trough in 2011. Offices are likely to suffer the biggest decline, with a cumulative fall in open market rental values of 35-40% from peak to trough, compared with a total decline of around 20% in both the retail and industrial sectors.
Yet, while the fall in rental values will gather momentum this year, the decline in capital values may slow down in 2009 for two reasons. Firstly, not all of the fall in rental values will immediately impact upon capital values.
In part this is because some leases are reversionary – in other words the current rent paid by tenants is below the open market value. In addition, the specific features of UK leases and in particular, the upward only rent review clause, mean that the rental income on existing leases is insulated in the short-term from falls in open market rental values. While the majority of existing leases will probably become over-rented during the next 2- 3 years (i.e. the open market rental value will fall below the current rent), it will only be when those leases expire, or a tenant becomes insolvent, that landlords will suffer a drop in rent. Although UK leases have gradually shortened over the last two decades, the average unexpired term at the end of 2008 was still nine years3. The flipside of this favourable income protection is that when rental values eventually recover, property capital values and total returns will not immediately feel the full benefit.
The second reason we believe the fall in capital values may stabilise in 2009 is that the rise in property yields may begin to moderate as rental value falls are priced in by investors.
3 Source: Investment Property Databank
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Recent investment activity
We have seen some investors who are not reliant upon debt returning to the UK commercial property market this year. In addition overseas buyers have been encouraged not only by the correction in UK property values, but also by the depreciation of sterling. The main focus of investor attention has been on high quality
properties let to blue chip tenants on long leases at a price up to £50 million. The chart below shows the number of deals for 2009 breaking through the six month average, indicating renewed interest in UK commercial property.
Transaction volumes – signs of life?
Number of deals
Source: Property Databank, Schroders, March 2009
Conclusion
Property has been an attractive growth asset class for pension schemes over the longer term, as well as a potential investment to capture an illiquidity premium through long holding periods. Property also offers diversification benefits when added to equity and bond portfolios.
It is possible to enhance property returns over time through skilled active management of the physical assets.
There are a variety of means of access to UK property. Pooled and unlisted vehicles can provide the lower volatility and investment diversification UK pension funds require, provided the vehicles are not highly geared.
Following its recent weak performance, UK property capital values may be beginning to show some signs of stabilisation. Given its long term attractions as an asset class, pension scheme investors may wish to reconsider the role of property in their long term strategy.
0 20 40 60 80 100 120 140 160
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Important Information
For professional investors and advisors only. This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Property Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that
Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no
responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors.
Issued in June 2009 by Schroder Property Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration no. 1188240 England. Authorised and regulated by the Financial Services Authority.
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