Pension funds should increase exposure to real estate

By Bridging Loan Directory 30th May 2019

In the last 20 years, real estate as an asset class has provided better returns than equities at a much-reduced level of risk, according to new independent report by Cluttons Investment Management.

The report highlights that a key factor in real estate’s relatively low volatility is the key contribution to total returns made by income. In the last 20 years, 70 per cent of real estate’s total return comes from income.

Long-lease real estate can leverage this beneficial income characteristic and satisfy the demand from pension schemes for secure, long-dated, inflation-linked cash flows that can match their long-term liabilities.

In addition to the security of a long-term, index-linked income stream, pension schemes now find themselves in a stronger funding position, thanks to rising equity markets over recent years. For schemes looking to reduce their exposure to higher volatility associated with equities a switch to property is prudent. History has shown that property has produced better returns than equities, with nearly half the volatility of returns. In today’s environment, this is an attractive proposition.

Historical correlations between the performance of cash, gilts, UK equities, global equities and UK real estate indicate that the addition of property to a portfolio can reduce the portfolio’s exposure to volatility and increase risk-adjusted returns.

Real estate assets on their own provide a good hedge for pension fund liabilities linked to inflation or wage growth in the UK economy. However, this attribute can be reinforced by explicitly index-linking long leasehold arrangements.

Commenting on the report, Jamie McCombe, head of Cluttons IM, says:

“In the very long-term UK real estate has provided a real annualised return of 3.7 per cent over 45 years since 1973. For a well-funded pension scheme, this supports our argument that a diversified portfolio of long-term index-linked leases can produce a good alternative source of total return and should play a much larger part in a scheme’s asset allocation than it has historically.”

To conclude, the report outlines a compelling argument for a meaningful increase in pension funds’ real estate exposure, from the current modest average allocation of around 5 per cent, to somewhere above 10 per cent, (depending on individual schemes’ risk tolerances and liability profile). This would give plan sponsors exposure to very attractive long-term yield and capital growth opportunities, whilst lowering exposure to more volatile asset classes such as equities.