In the post-financial crisis years, investors faced with historically low bond yields and volatile equity markets are shifting more toward real assets, including real estate and infrastructure, which can often provide a more stable source of income.
A BlackRock survey of institutional investors around the world conducted in late 2014 found 96% were invested in real estate, with close to half (46%) increasing their real asset allocations in the prior three years. And 48% said they plan to further increase their exposure to real estate in the following 18 months.
Prime real estate
What’s the big attraction? Janet Rabovsky, a consultant with Towers Watson, says real estate has a number of unique and desirable attributes for any investor looking for stable long-term returns.
“People like the income-producing characteristics,” she explains. “The other thing is that because leases are often tied to economic activity, generally, in times of high inflation when all sorts of other assets are getting hit, real estate tends to hold its value or at least hold its value better.”
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Phil Gillin, senior managing director and portfolio manager, Canadian property investments, with Sun Life Investment Management Inc., says real estate can provide a yield premium as much as 450 basis points higher than 10-year Canadian government bonds. “In a yield-starved environment, to get a 450-basis-point spread has got to be very attractive to institutional investors,” he says. On top of the yield premium, real estate offers potential for capital appreciation of 1% to 3% over the holding period of the asset, he adds.
In addition, Rabovsky notes that everyone has a mortgage or is a tenant, making real estate relatively simple to understand for investors. “It’s an easier asset for pension funds to invest in than, say, hedge funds, which are complex and opaque.”
Gillin points to other advantages, including diversification, as real estate generally has a low correlation to returns on other asset classes (such as stocks). “There’s a good spectrum of advantages, and I think that’s why you’re seeing so much interest in real estate over the last number of years.”
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In exchange for the higher income offered by real asset classes, investors accept one of the inherent disadvantages: what’s referred to as the “illiquidity premium,” David Mather, executive vice-president of Integrated Asset Management, explains. “You can decide to sell all your stocks today and go ahead and sell them. But if you own a building, you can’t realize the gains on a sale right away.” The sale process on a piece of real estate can take as long as six months, Gillin adds, noting real estate also requires professional management.
REITs to the rescue
But real estate investing today is more than private investors buying and selling properties. Third-party investment managers have come to the market, says Rabovsky, providing new services such as real estate investment trusts to pension plans. “You don’t have to buy a building; you can buy units in a fund now.”
That’s particularly important for smaller pension funds— especially those with less than $250 million in assets—which may not be able to invest directly in an expensive office building in a major market due to cost. They can invest indirectly through purchasing units in a REIT or other type of pooled fund.
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“So let’s say you are a $100-million plan. You can put 10% of your assets into real estate [using a pooled fund or REIT],” Rabovsky says, noting that the increase in pooled funds has widened the options for smaller plan sponsors. “It’s doable now; it didn’t used to be.”
Gillin agrees that while you get superior diversification with REITs—along with professional management—they are, in fact, not real estate but an investment in a security and are influenced by movement in capital markets. For smaller pension plans, a pooled fund might be a better solution, he says, providing the advantages of direct investment—without the market volatility.
Investors big and small
Allocations to real estate are on the rise, Rabovsky notes, particularly among the largest pension funds in the country, such as the Caisse de dépôt et placement du Québec and the Canada Pension Plan Investment Board. Those plans generally have higher allocations to assets such as real estate, infrastructure and private equity, she says—mainly because they’re public and not traded, and investors can get greater stability of return and lower volatility compared with equities. “Part of it is, they are just too big for their home market, so they have to go elsewhere,” she adds.
As of Dec. 31, 2014, the CPPIB had 16.5% of its investment asset mix dedicated to real estate and infrastructure, according to its most recent financial report. The CPPIB has been an aggressive buyer of real assets, recently investing $525 million in Australian infrastructure and $234 million in a new joint venture for a major mixed-use development project in Suzhou, Jiangsu Province, China.
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But these assets aren’t just for mega plans. “If you look at smaller plans—such as those under $250 million, and those between $250 million and $1 billion—their first foray [outside of bonds and equities] will likely be into real estate,” Rabovsky says. Their allocation could be anywhere from 1% or 2% up to 10%, she notes. But, on average, the real estate allocation of plans under $1 billion would not exceed 5% to 10%, Rabovsky adds.
Gillin says 10 years ago, pension funds were allocating around 5% to real estate. That allocation today is, on average, closer to 10%, with larger funds like OMERS and the Ontario Teachers’ Pension Plan clocking in at 10% to 20%.
Ted Willcocks, global head of asset management of Manulife Financial’s real estate division, agrees there’s a stronger appetite for real estate in pension plans. “If you look at long-term historic returns from real estate investments, in many cases, they exceed equities and corporate debt,” he says.
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Willcocks also points to the attractive fundamentals of real estate investing, such as the inflation hedge, income and capital growth. And North American commercial real estate markets have performed particularly well over the last 15 years, he notes.
Despite the overheated domestic housing situation in some major markets in Canada (i.e.,Vancouver and Toronto) office, and industrial properties have remained relatively stable and are “not related cyclically” to the residential housing industry, he says.
“The residential market is somewhat insulated from the commercial market,” Gillin adds. “All real estate is driven by economic growth. So there are similarities, but they are different players and different elements of the industry.”
Impact of rising rates
The BlackRock survey also suggests a significant rise in interest rates would cause many institutional investors to rethink their real estate allocations. Income-generating investments in real assets may be affected negatively if rising rates make bonds more attractive, the report says.
Pension plans have seen the effects of a low interest rate environment for the last number of years, but Willcocks feels rising rates are looming. “But there’s enough of a cushion that will allow for the softening of any major downturn in real estate,” he says. “It’s certainly something we study, and it gives us pause in certain asset classes and certain markets. But we do believe that rates—perhaps in 2015 or 2016—will be on the move.”
Mather agrees, noting six years ago, no one would have believed interest rates would still be at record lows in 2015. “The basic laws of economics have been suspended, but they haven’t been repealed. At some point, rates are going to start to go back up, but it’s difficult to predict when or by how much.”
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Despite possible movement in interest rates, there’s no doubt real estate has shifted from a fringe investment in the ’80s and early ’90s to a core investment today, with more sophisticated and better capitalized investors, says Gillin. “The stock and bond markets have been significantly more volatile over the last 10 or 15 years. That has driven a kind of flight to hard assets, from an investment point of view.”
“Real estate is no longer an alternative asset. It’s very well established as a core asset class for pension funds,” Mather adds.
Doug Watt is an Ottawa-based financial writer and editor.
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