Schemes should make space for global real estate

The UK real estate market is only around 5 per cent to 7 per cent of the investible global real estate market, which means many pension schemes are missing out on a much wider opportunity set while exposing themselves to UK-specific risks such as Brexit.

The UK property market has performed strongly in recent years, but to maintain high returns from real estate in the future, higher risk strategies will now need to be considered

Since 2000, correlations of global real estate with UK property have been positive, but low in local currency terms.

This situation is also set against a backdrop of expected subdued performance of UK core property over the short and medium terms, with returns driven by income rather than capital gain. We would expect a global core property allocation to produce enhanced returns over UK real estate for investors.

More global opportunities are now available...

There have been a number of barriers to investing in global real estate, but these barriers are lowering as new products are launched and regulations change.

Historically, the easiest and fastest way to gain exposure was via listed real estate, but this has several drawbacks including short-term dislocation with direct real estate returns and high correlations with equities.

Although this might still be the most appropriate way for some UK pension schemes to access global real estate, there are more opportunities to gain exposure either through a fund-of-funds or – if the investor is large enough – by investing in indirect funds directly, to create a bespoke portfolio. Only the very largest global institutional investors, such as sovereign wealth funds, would have the ability to build a directly owned global real estate portfolio.

While we believe that most UK pension schemes investing globally should focus on core and core plus strategies, since these are the bedrock of institutional property allocations, larger pension schemes with higher return requirements and risk tolerances could consider global value-add and opportunistic property funds.

The UK property market has performed strongly in recent years, but to maintain high returns from real estate in the future, higher risk strategies will now need to be considered. These strategies would be accessed via closed-ended funds with private equity structures, and fees would target low to high-teen net returns depending on the strategy.

... but unique risks remain

These strategies have a very different risk profile to core and core plus property. They will take on far greater property risk, such as speculative development and niche asset classes, and employ greater levels of leverage.

Large minimum investment sizes, greater complexity and greater risk mean these will not be suitable for all investors; pension schemes who do invest in these funds usually do so as part of a wider private market strategy.

There are unique risks associated with investing globally and other important non-investment considerations.

Currency movements, for example, are one of the main investment risks with property cash flows being notoriously hard to hedge. Currency hedged solutions are rare and investors will therefore need to accept the risk or incorporate hedging themselves through another manager – most likely a currency manager being used for other asset classes.

Other considerations include tax leakage when investing in other jurisdictions, valuation methodologies (which might be materially different to the UK) and regulatory risks, especially when investing in countries that are far less transparent than the UK.

Given the subdued outlook for the UK property market, as well as easier access and higher expected returns regarding overseas real estate – not to mention the potential risk-reducing benefits of diversification – there is a strong case for UK pension schemes to invest globally.

Oliver Hamilton is a real estate specialist at Aon