The role of UK real estate in DC pensions

The roundtable – chaired by PP editor Jonathan Stapleton and held in association with Columbia Threadneedle Investments – asked if the investment case for real estate still stood for members of DC default funds.

It also discussed what is the most appropriate vehicle for accessing direct property as well as liquidity issues and ESG considerations for the asset class.

Real estate has been a mainstay asset in defined benefit (DB) for many years, but does that investment case still stand when it comes to DC?

Tim Giles: Strategically, it absolutely does. It is a fantastic real asset and can provide long-term real growth. Tactically, there are challenges that have come out of recent markets in terms of the changing property landscape and the desire for greater investment in private assets. Property was the original private asset; it now needs to be counterbalanced with private assets alongside it.

Alison Leslie: In private markets, real estate feeds into that ESG agenda and the net-zero journey, so you can have a massive impact in that area. There is also a housing crisis so investing in affordable housing can have a significant effect, particularly with the new government's manifesto promises on investing in the UK.

Martin Collins: People have always been fearful of the liquidity in real estate investments. Last year when we had to liquidate the assets of a multi-million-pound scheme for a buy-in transaction, the worst bit was the property, where we took a substantial haircut in the secondary market. Saying that, while there are dangers with illiquidity, that is not necessarily a reason why we should be reducing the return potential for DC members.

Additionally, it is not just about selling assets at the end when you want to crystallise and transfer, but it is about daily pricing, as well. With property, you do not really know what the price is. Over time, the price usually evens out, but that is something that, as a fiduciary, you have to be a bit wary of – how it is priced and how you allocate the units to members.

Lynne Stewart-Brindle: The opinion needs to move from that view that we had in the DB world, because that is being replaced by DC in the future. Almost any investment potentially could be viable if you have the right timeframe. If you have a longer timeframe, which we have with the DC world, you have younger members with a longer period to go. If we are pushing into consolidated markets, then you have that scale and the ability to feed real estate into default arrangements. It does not matter that it is illiquid because you have that timespan.

However, the macroeconomic environment that we are in at the moment is not doing anything to help the cause in real estate.

What level should allocations to real assets be at?

Tim Giles: If you are sub-5%, you are probably not actually doing anything meaningful in terms of allocations. But in terms of the ‘real' assets aspect of this, real assets are wider than just real estate. Property is one type of real asset, but renewables, infrastructure and all those types of things should be there, and they should be large elements, so thinking of it more widely around those types of assets, I would easily think there a case for an allocation of 10-20%.

Alan Pickering: Even within real estate there is space for diversification – there is residential, there is commercial and there are warehouses. Saying that, it is very difficult to say in today's environment whether total real estate allocations should be 5-10%, or how that 5-10% might be spread across different aspects of the real estate market.

To what extent are there still challenges with perceptions around illiquidity and costs?

Alison Leslie: I think where we have really been hurt with regards to real estate, and I think this is where the reticence from advisors as well as trustees comes from, is around the issue of people investing in real estate, perhaps as part of a self-select option, and then having huge problems getting out. As we have moved to private markets, however, we are now starting to ask whether we really need daily trading, and some of those barriers are starting to break down.

Lynne Stewart-Brindle: Yes, there is that fear of a manager closing the doors and you cannot get your money out.

It matters less, potentially, if you are looking at the master trust environment, where you are almost buying units of units and can afford to take those hits, or it can be absorbed. In the smaller schemes, and there are still many in the DC world, then you just cannot stomach that kind of inflexibility.

James Coke: What is troubling me is the potential for damage to the reputation of UK real estate funds around perceived illiquidity, or the perceived mismanagement of liquidity, due to the suspension of withdrawals on standard terms precisely when it was needed by some schemes.

While our monthly-dealt institutional fund has continued to meet all its redemptions on standard terms throughout the last two years, we accept that managers must learn from this experience to provide a liquidity structure that is appropriate for the DC market, to retain the confidence of consultants and trustees.

Martin Collins: The problem there is when managers try to change the product to address what they think the liquidity need is, and you end up only being able to buy a fund that is 60% property and 40% cash. 

Alan Pickering: Ordinary people in the street cannot sell their house at the drop of a hat. That is one of the easier investment conundrums to explain to people, that it does take time to liquidate property.

Tim Giles: I agree with that, Alan. Property is one of the best-understood asset classes by your average investor. They see it every day, day in and day out. You cannot help but walk past it all the time and understand the nature of it and illiquidity. I think coming back to the strategic case, if you want property, you should be willing to sacrifice liquidity. You should not, as a DC investor, ever be thinking, ‘I am going to sell all this on mass within the next three months at an unknown date.'

Andrew Brown: Ideal allocations to real assets, including direct property, through master trusts have been somewhat hamstrung by commercial considerations, that have seen them competing on cost. That has been to the detriment of innovation, sophistication of investment strategies and asset class diversification. Indeed, having engaged with master trusts over the last five to ten years, there has been a clear message (with exceptions) that they cannot do what they want to do in terms of portfolio construction, with cost considerations potentially proving less optimal for member outcome. This has not helped the case for real estate, which is a more expensive asset class.

Alan Pickering: The problem is some intermediaries think cost is more important than value.

Tim Giles: That is the ongoing problem. Everybody can see fees, but they cannot see future returns. It is always the problem. It is a very hard concept to get across and to get people to buy into.

Alison Leslie: The conversation on this is definitely changing. There is much more discussion around value, but you can promote that as much as you want, the person signing the cheque still has to buy it. That is the difficulty of it. 

The change in the macroeconomic landscape is going to help with that, because we have come from an environment where passive investments have dominated, and we are now getting active management through in private markets. The culture around DC is changing, so that shift in terms of whether we can do something that is maybe a bit more hybrid will come, and people will start to accept asset classes that are more expensive.

What is the view around the table as to the most appropriate vehicle for real estate for DC? Is it long-term asset funds (LTAFs) or is it something else?

Alison Leslie: I am pretty vehicle agnostic. If the truth be told, I don't think it really matters, and I think the discussion has become quite distorted because of LTAFs. People have been allocating to private markets for a long time in different forms. You do not need an LTAF to do it.

Alan Pickering: Vehicles will come and go – it is the asset class that is important. Market conditions, tax regimes, and regulatory regimes have an influence on the vehicle, but it is the asset class that we are trying to get access to.

James Coke: The interesting debate around LTAFs is the relative merit of single or multi-asset strategies. For small and mid-size schemes that want a one-stop shop, you could combine private assets within an LTAF, and effectively, you have a solution that you buy off-the-shelf. But we question whether this is this a transition solution, as we hear more and more that schemes want exposure to the best underlying funds, rather than the wrapper. If it is not going to be here in five to ten years' time, that does not incentivise the marketing or the tech people to go and design a product that is ultimately not the long-term solution.

Lynne Stewart-Brindle: Managers that have grasped the LTAFs have realised it is about scale and trying to build a unitised type of product that is going to appeal to many clients to make it viable. But that is not to say it does not provide good value. Ultimately, it does not matter what you call it or how you put it together, as long as people have access to the asset class they want.

Alison Leslie: The LTAFs that we have seen are actually very different. I expected them to all look quite similar, and they are actually quite varied. You have some that are single sleeve, you have some that are single manager but multi-asset, and then you have some that are multi-asset and multi-manager.

The challenge will be the platforms, because some of the platforms may only be able accommodate so many due to operational constraints. You cannot just launch 20 LTAFs and expect them all to work on a practical basis.

Andrew Brown: I think we need to understand the benefit of any investment proposition and how it contributes to members' investment strategies in terms of diversifying risk and enhancing returns. LTAFs are not an asset class, they are a vehicle. They may play a helpful role in enabling private market investments within DC default funds, though it won't be the most efficient structure for all providers.

Asset class exposure in DC is increasingly global in nature, particularly when it comes to equities. Should this be the case for real estate as well?

James Coke: First of all, everyone has a fiduciary duty to maximise returns, so if we are going to make the case for the UK real estate, it needs to stack up against global real estate. Traditionally, it has. Right now, there is probably the best argument for UK real estate as an asset class than there has been for a long time.

Secondly, there are environmental and social considerations that real estate can contribute positively towards, and investing more domestically may have a broader appeal to scheme members. Ultimately, you are investing in the bricks and mortar of local communities where the scheme members work and live.

Andrew Brown: Unlike public market equities and bonds, real estate is an imperfect market where information is not readily available. It requires local people who understand the market environment, the town, city and occupational market of where you are transacting. Buying directly on a global scale seems quite difficult. Of course, there may be diversification benefits, particularly at a macro level, but property is not an equity or bond type purchase where information is easily accessible.

Tim Giles: Diversification will push you towards globalisation, without a doubt. You want to pick the greatest opportunities there. Strategically, though, I think there is a stronger case for real estate that is more linked to the local economy – with people using these returns to pay for things linked to local prices, particularly property-related costs.

Martin Collins: Real estate is very different from equities, where you can decide value is better in another country and move assets there very quickly. With real estate you have to make a long-term decision so you cannot just make shorter-term value plays. Then there is the issue about expense and loss of control and governance. The expenses are a major issue – you need a very large scheme to invest in overseas properties – it is quite unlike other asset classes where there is a diversification case for it, but there are a lot more costs, so you have to be really large to do it and commit to it long term.

There are opportunities for diversification in real estate beyond globalisation, such as investing in different parts of the property market. Which sectors should DC schemes potentially be looking at?

James Coke: We fundamentally believe in the diversified model because you are outsourcing portfolio allocation to real estate specialists who should know what is going on in each town and what is going on in each sector.

I do believe there is a place for residential within those portfolios. Traditionally, commercial real estate managers have separated out residential. Partly, there was a reputational dimension to that separation, because no scheme wants to be on the front page of a newspaper accused of evictions. Ultimately, however, the right question to ask is what is the right mix of asset classes to deliver long-term diversified returns? We will see residential take a much bigger share of total portfolio composition, but it needs to be managed appropriately.

Martin Collins: The political risk in residential is significant. If anything goes wrong in residential investment, pension funds are seen as having deep pockets – easy targets for the government. What is happening at the moment with regards to cladding is an example of that.

Alan Pickering: Now is the time to really embrace residential property, because we can manage the reputational risk much more easily in master trusts than in branded single employer trusts.

In terms of economic growth, people need somewhere to live, and there is a scope for having a housing market that does not regard owner occupation as premier and renting as for poor people. We need a mix of owner occupation and renting – by helping to provide this, we can tick lots of boxes and we will be meeting the needs of real people.

What are your key takeaways or concluding comments from this discussion?

James Coke: I think it is a really exciting time for real estate… The market has repriced [by circa 28% since June 2022], so we are no longer talking about super low yields and downside risk, and rental growth has really surprised on the upside. On top of this, in the macroeconomy you have inflation falling back to target, the expectation of lower rates, and a stable, politically centerish government making very pro-growth statements. I feel more optimistic about forward-looking returns prospects than I have felt in a long while.

The challenge is that it is no good having that positive and supportive environment without the right messaging or the right solutions in place for our investors. We believe we can offer those solutions, so what I would take away from this discussion is that while the investment outlook is supportive, we need to continue to make the case that UK real estate is where you should be putting your scheme members' money, in a discerning and competitive real assets marketplace.

Lynne Stewart-Brindle: I have always thought that real estate has a part to play in long-term investment, and I will continue with that view. I think probably, at the moment, I might move from my 5-10% allocation view to the 7-10% view, because I feel that there are some great opportunities out there now, probably more than I might have felt some time ago, so yes, I am a fan.

Martin Collins: I think real estate has always been the alternative to public markets. There are new kids on the block coming in, but I think it retains the role it has always had, so I would probably continue my long-term, 5-ish percent in the asset class.

Andrew Brown: This has been a really interesting discussion. It feels as though we are transitioning from a prolonged period where diversification disappointed as bond yields ratcheted lower. Real estate, alongside other return drivers will help to smooth long-term investment journeys. 

UK property has unique characteristics. It is well diversified and has regulatory requirements that align with investors' interests, for example, sustainability and energy efficiency with a robust market infrastructure and legal system. Furthermore, this is a tangible asset class members can see and broadly understand, with the ability to create a meaningful impact and positive change to the local environment. 

Alan Pickering: I think the intellectual and fiduciary arguments for real estate are very powerful. The political argument is also very powerful – through real estate and residential in particular, we can make a real contribution to economic growth, and because of our scale, and because of our fiduciary principles, we can hopefully do so in a way that politicians will find more acceptable than if it were just pure money people doing it.

Finally, there is a really good member story here. I do like to give members an idea of what use is being made of their money, and I think we can really bring it home to them in the annual infographic if we can show what we are doing in the real estate space in general, and in owner occupation and quality renting, in particular. They ought to get a real warm feeling from reading that.

Tim Giles: The strategic case for real estate is strong. It is a real, long-term asset which should be part of DC investment for people with a very long timescale for their investments. It is probably also the most understandable asset. Saying that, however, it comes with problems around liquidity, which DC schemes are now grasping through LTAFs and other vehicles; and it does come at a higher cost, but you need to understand that the costs of managing real estate are greater, and value, ultimately has to come before costs. So you need to deal with those liquidity issues and you need to deal with the price issues and come through both of those things.

From an ESG angle, it is a long-term investment, so you have to be focused on how it is going to meet environmental considerations, but I equally think, given where the demand for real estate is and the supply that there is, there is a strong social aspect with this asset class too.

Alison Leslie: I do not disagree with any of that. I think the case for real estate has always been there and it continues to be there… It is an exciting time generally in investment for DC. The real estate world is opening up in a way that it hasn't for a while, and I think the shift in the macroeconomic landscape also presents a lot of opportunities. There is the risk/return and diversification aspect, which I really like, but I also really like the real-world impact that you can get from real estate as an asset class. To Alan's point, I think there is a member story there as well in terms of it being easy for members to understand and relate to, which is always helpful.

This roundtable was held on 16 July 2024 in association with Columbia Threadneedle Investments