Aon Hewitt Retirement and Investment Constructing Your Property Portfolio Risk. Reinsurance. Human Resources.
Executive Summary While most pension schemes invest in property through UK core commercial property funds there are a number of other investment opportunities within the property asset class which pension schemes may want to consider. These strategies could help enhance return, improve income or complement existing LDI portfolios. In our view, pension schemes would benefit from diversifying and/or expanding their allocation within property to take advantage of these opportunities by establishing a property portfolio which is less focused on UK core commercial property and tailored to their specific needs. Introduction Property allocations form a key component of pension scheme portfolios and this allocation is typically in the form of UK core commercial property, either by way of investing in commingled funds or as a segregated arrangement. In recent years there has been an increase in the investable opportunity set within the property asset class. Funds that focus on property debt, long term inflation linked cash flows, value add or opportunistic property and even the private rented sector are now easily accessible for pension schemes. These opportunities offer a range of attractive risk adjusted returns and can help pension schemes navigate a world where the yield and expected return on traditional asset classes remain low compared to historical standards (see our previous paper Re-thinking Income). While most, if not all, UK pension schemes continue to invest in property through UK core commercial property funds we think pension schemes would benefit from having a more diversified property allocation (see our previous papers Bankers Lose Interest and Private Rented Sectors). In this paper we highlight how allocations to property could be expanded and tailored to meet specific objectives for pension schemes. Aon Hewitt Constructing Your Property Portfolio 2
Background The level of diversification and sophistication in pension scheme portfolios has been increasing over the past few years. Where schemes once held mostly UK equities and bonds they now have global equity and bond strategies. Liability driven investment strategies (LDI) are used to manage interest rate and inflation risk. The likes of diversified growth funds, hedge funds and other alternative and illiquid strategies have been added to portfolios in order to improve the overall risk and return profile. However, in general pension schemes have been slower in developing their approach to property and diversifying their portfolios, with schemes traditionally only invested in UK core commercial property funds. The allocation to UK commercial property has been very beneficial to pension schemes over recent years, delivering strong returns of around 9% p.a. since the end of 2008 split fairly evenly between income and capital appreciation. IPD All Property Index cumulative return IPD All Property Index 180 Cumulative return 160 140 120 100 80 60 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17 Source: IPD, Aon Hewitt While the UK commercial property market felt some impact from the referendum result last year it is showing signs of resilience. We still have a positive view on UK commercial property, but returns are likely to be driven by income rather than capital appreciation and we expect them to be in the low to mid-single digits over the next few years. From a diversification perspective we believe pension schemes would benefit from reshaping their property exposure and reducing the reliance on UK commercial property. In addition we think pension schemes should consider higher overall allocations to property as relative to equities and bonds the opportunities within property are very compelling. Aon Hewitt Constructing Your Property Portfolio 3
Property opportunity set There are a number of alternative property opportunities that exist which pension schemes are starting to take advantage of. The table below sets out the key characteristics of some of these strategies. These opportunities exist not only in the UK but globally. Pension schemes can access funds which focus primarily on the UK, Europe or even global strategies. Characteristics of alternative property investments UK core UK private rented sector Value add / opportunistic UK high lease value Manager long-term expected returns (p.a.) 4% - 6% 3% - 11% 6% - 9% - 15% 5% - 7% Coupon (income distribution) 3-4.5% 3- Circa 4% Unlikely 2.5-4% Inflation linkage Partial, implicit No Partial, implicit Partial, implicit Yes, explicit (but typically capped) Risk Moderate Low to high Moderate High Moderate to low Correlation with UK core n/a Very low, greater linkage with other credit opportunities Moderate Higher correlation, unless non-uk Yes, but explicit inflation and long leases reduce volatility Primary return focus Income and capital appreciation Income Income Mostly capital appreciation Income Property types Commercial Commercial and residential Residential Commercial + speciality (including residential) Commercial and residential (ground rents) Primary vehicles Open-ended Closed-ended Open-ended Closed-ended Open-ended Vehicle term Perpetual 7-10 years Perpetual 8-10 years Perpetual Liquidity Moderate Low Low Low Moderate Minimum investment 1m 5-10m 5-10m 5-10m 1m Annual management fees (p.a.) 0.6% - 0.8% 0.5% - 1.5% + profit share for higher risk strategies 0.9% - 1.3% 1.0% - 2.0% + profit share arrangement 0.4% - 0.6% Source: IPD, Aon Hewitt Aon Hewitt Constructing Your Property Portfolio 4
With equity markets and valuations at or near all-time highs, bond yields remaining near historical low levels, the additional income and return potential available from the range of property opportunities is very compelling. 14% Property opportunities 12% 8% Returns 6% 4% 2% 0% UK equi es Global equi es UK gilts UK ILG UK corporate bonds (IG) Hedge funds RPI infla on (forecast) ARBS (Libor +2%) DGF (Libor +4%) UK core property : senior loans : whole loans : Mezz loans Private rented sectors Value add High lease value Source: Aon Hewitt Capital Market Assumptions 31 March 2017 and our buy rated manager s targeted returns We think pension schemes would benefit from diversifying and/or expanding their allocation within property for the following reasons: Alternative property strategies offer better income and return potential than more traditional asset classes/strategies Diversified property portfolio reduces reliance on UK commercial property Portfolio can be tailored to meet specific needs (income, return, inflation linkage) Aon Hewitt Constructing Your Property Portfolio 5
Tailoring the property portfolio There are a wide range of investment opportunities within the property universe. For pension schemes which are trying to tackle the challenges of today s market conditions while investing in lower risk strategies then the opportunities within property may be worth considering. Having a more robust property portfolio by using the full opportunity set within the asset class would allow pension schemes to tailor the portfolio to suit their specific needs. For example; Income generation Return seeking Inflation linkage Diversification The charts below show illustrative property portfolios, these could be achieved from either increasing the overall allocation to property or adjusting the current allocation to core property. Income generation Return seeking whole loans 20% Private rented sector Value add/opp senior loans Core 70% mezzanine 15% Core 50% whole loans 15% Targeted return: 5.6% p.a. Targeted return: 7.2% p.a. Inflation linkage Diversified Core 25% Value add/opp 5% High lease value 15% High lease value 50% Private rented sector Core 50% Private rented sector 25% 20% Targeted return: 5.9% p.a. Targeted return: 6.3% p.a. Source: Aon Hewitt Capital Market Assumptions 31 March 2017 and our buy rated manager s targeted returns Aon Hewitt Constructing Your Property Portfolio 6
What are the risks? Property is an illiquid asset class and many of the opportunities mentioned in this paper are accessed via closed ended funds with up to a 10 year lives. These funds are impossible to exit unless an investor s interest is sold on the secondary market at an uncertain price today. Even open ended property funds will have the ability to take action to protect the interests of redeeming and remaining investors if required, such as deferring redemption requests or increasing dilution levies. We therefore recommend that schemes review their liquidity requirements before increasing their allocation to property. However, in our experience, most pension schemes already have sufficient liquidity within their portfolios. Property is also susceptible to more general risks such as a slowing economy and uncertainty around Brexit, however the best fund managers will assess these risks when making investment decisions and take into account downside scenarios. While we continue to favour property as a long term investment these potential near term risks should not be discounted and they will play an important role when deciding which strategies to allocate to. For example in today s income return driven environment investing in property debt and long lease property is looking attractive compared to core property. Overall we believe that a well-diversified property portfolio across different strategies and regions rather than being focussed solely on UK core commercial property will help pension schemes meet their wider investment and funding objectives. Contact Implementation practicalities These property strategies are not risk free and the main risks and considerations prior to implementing them are transactional costs and liquidity, however we believe these are mitigated for the following reasons: Transaction costs (not relevant to property debt): The transaction costs will vary, depending if the investment is funded from core property (which would have higher transaction costs, c2% on the way out), equities or bonds. This may not be an insignificant sum and acts as an initial drag on performance. However, we see this cost mitigated for the following reasons; Realising very strong performance generated over the past few years from assets in order to fund these investments. Disinvesting from assets which have a lower expected future return compared to the new investments. The improvement in expected return will offset transaction costs. Reducing risk by further diversifying portfolio. Liquidity risk: Some of these funds involve committing capital up to 10 years. Most pension schemes have adequate liquidity in their portfolio and can benefit from capturing the illiquidity premium from these strategies. In addition the term of these strategies, c10 years, fits within the recovery period for most pension schemes. Governance: Additional funds or strategies may increase the governance burden for trustees. However, trustees can expand into these alternative property strategies in a manner which suits them and fits within their governance framework. Jeffrey Malluck, Senior Investment Consultant +44 (0)131 456 3841 jeffrey.malluck@aonhewitt.com About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative human capital solutions. We advise and design a wide range of solutions that enable our clients success. Our teams of experts help clients navigate the risks and opportunities to optimise financial security; redefine health solutions for greater choice, affordability, and wellbeing; and achieve sustainable growth by driving business performance through people performance. We serve more than 20,000 clients through our 15,000 professionals located in 50 countries around the world. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: http://aon.mediaroom.com/index.php?s=58 Aon Hewitt Constructing Your Property Portfolio 7
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