![Sounding Board: Sovereigns turning to real estate amid challenging return environment](https://www.benefitscanada.com/wp-content/uploads/sites/7/2014/11/Real_estate_2-e1497015075304.jpg)
Like many institutional investors, sovereign players continue to face a challenging return environment, underperforming their targets by an average of two per cent over the past year, according to Invesco Ltd.’s fifth annual global sovereign asset management study.
The underperformance is partially attributable to low economic growth, which has also posed problems on the funding side. As economies slow, tax revenues are harder to come by and governments are less likely to allocate capital to sovereign investment funds. Indeed, new funding has declined to five per cent of assets under management in 2017 from eight per cent in 2015.
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Real assets that generate an income stream have become more important sources of funding. Infrastructure has long been a preferred asset, but there are limited opportunities in that space. There are a finite number of viable ports and airports, for example, and deploying capital into such assets can be excruciatingly slow. As a result, 71 per cent of sovereign investors have reported an underweight position in infrastructure, according to this year’s study.
Real estate represents a far more liquid alternative to infrastructure, and 46 per cent of sovereign investors expect to be overweight in global real estate this year. For domestic real estate, that overweight position is 38 per cent.
Sovereign investors cited a range of reasons for increasing their target real estate allocations, including the opportunity to capture liquidity alpha, the potential to generate income to match their mid- to long-term liabilities and the ability to manage their assets internally.
In addition, the increase in domestic allocations in general mirrors sovereigns’ appetite for income that allows them to match locally denominated liabilities.
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In many markets, domestic real estate has delivered higher yields than domestic bonds. As a result, rising real estate allocations have largely been due to reductions in fixed income.
Growth in international real estate allocations may reflect tactical factors such as restrictions in domestic markets or challenges in achieving target allocations in infrastructure or private equity. The study showed sovereign investors favour high-grade office and commercial real estate, where long-term leases provide greater predictability of returns, over industrial or residential categories that may offer greater development potential.
And finally, sovereign investors expect office and commercial properties to each comprise 40 per cent of respondents’ real estate holdings in the next three years, with the industrial and residential categories expected to make up 16 per cent and 28 per cent of their portfolios, respectively.
Michael Peck is senior vice-president and head of Canadian institutional investments at Invesco.