How to protect property investment value against rate rises

In such an environment, property clearly presents an attractive option for pension funds. Not only is it able to offer the streams of income that schemes are searching for, property also helps to diversify portfolio risk, as it tends to be uncorrelated to the broader market.

But it is important that pension funds recognise the current climate is subject to change.

In a recent speech David Miles, a member of the Bank of England Monetary Policy Committee, argues that long-term interest rates will stay at around 3 per cent – rather than their 320-year average of 5 per cent since the founding of the Bank of England – as investors have come to appreciate the attractions of safe assets, the risk remains that the historical average re-establishes itself.

Schemes therefore need to be aware how they should adapt their property investments to cope with the rising bond yields that may result from future interest rate rises.

Getting value 

In the period from 2007 to present day, the real estate market has become polarised between long secure inflation-leased assets and the rest. Most notably, a number of new 'secure income' style funds have been developed.

These funds, which were almost nonexistent prior to the crisis, have grown significantly. Consultancy KPMG recently reported that £8 out of every £10 being allocated to the property sector over the past few years has gone into these types of strategies.

Unsurprisingly, the weight of money chasing secure, preferably inflation-linked income streams has crushed the yields available on these assets, while the absence of investment in other real estate outside central London has had the opposite result.

There is therefore a risk that with the forces of the past six years reducing, and potentially reversing, some of the pricing effects observed between shorter and longer-term income profiles could similarly be reduced or reversed.

While a number of existing core property funds have moved towards their relatively new secure income competitor funds in terms of risk profile and hence distribution yield, there are a number of recently launched core property funds that are more exposed to the shorter income assets that have been the biggest real estate casualty of the global financial crisis.

Managers of these funds have often been able to achieve double digit yields on these assets in the market, which makes income returns attractive. This is especially appealing for pension funds, as these returns can be achieved without loss of capital. Furthermore, it is likely to be these managers that benefit from an improving economy, compared with their competitors.

These managers are also able to take advantage of other real estate assets that are presenting opportunities, such as those secondary assets that are well located, with strong tenant demand and depth and variety of tenant demand through cycles.

Another interesting strategy the core property market is revealing can be found in smaller lot sizes. Buying smaller lot sizes of less than £10m allows investors to take advantage of the significant yield advantage by exploiting current pricing inefficiencies in smaller assets relative to long-term pricing.

Yields on lower value properties tend to be higher across all real estate segments.

Richard Tanner is managing director at property investment manager AEW UK