Pension funds have sharply reduced their property exposure over the past year, and there is little sign of new investment, with the consensus expecting further falls in values.
Many institutional property investors scaled back their exposure to offices, shops and warehouses last year, as property prices started to fall. While many funds have now amassed cash, ready to re-enter the sector, property managers say opportunities are still scarce.
“In the past 24 months, the main trend in portfolios we manage has been to reduce exposure to real estate, as prices became unsustainable,” says Christopher Cooper, head of investment management at DTZ Investment Management. “More often than not that money hasn’t been reinvested.”
Mr Cooper says a number of clients are looking at rebuilding their exposure to commercial property, but have struggled to find assets that are realistically priced.
Mr Cooper estimates that there was an average of 10 to 15 per cent net property disinvestment by pension funds in the 18 months to the end of last year.
Pension funds started to sell fairly early in the cycle, although some have had to sell throughout the downturn to meet investor redemptions, sometimes making a loss. Managers say there has been a limited number of distressed sales.
There is now something of a stand-off between buyers and sellers, as their expectations differ so greatly. Investors fear prices have further to fall, but vendors are not yet willing to agree to the discounts they are demanding.
“In terms of current pricing, property yields have moved to a point where traditional investors see no real benefit in selling unless they are forced to, either to respond to portfolio rebalancing demands, or through retail investor redemption flows,” says Pen Jones, lead director in Jones Lang Lasalle’s investment advisory team.
Funds that have retained exposure to commercial property can expect the market to remain tough for some time.
Mr Cooper says that after the recent sharp fall in capital values, the market is entering a potentially more difficult second phase of falling tenant demand and possible rent cuts.
Big redundancies are expected in the City, which could trigger a downturn in the office market, while retailers are suffering weaker consumer spending.
Buyers may expect an even higher initial rental yield to compensate for the risk of higher defaults.
Mr Cooper expects negative total returns this year and single-digit returns in 2009 across all sectors. He says investors can expect to work hard over the coming months.
“UK institutions are having to turn their attention to some pretty aggressive active management to generate out-performance,” he says.
“Pro-active business planning and exploiting value-add asset management initiatives will be a focus for many in the short to medium term.”
But although property managers do not yet believe the bottom of the market has been reached, they are warning investors not to leave it too long before re-entering the sector, as they risk missing out on any bounce.
“Markets can adjust fairly quickly,” says Tristram Frost, head of international investment at King Sturge. “Investors should look to buy within 10 per cent of the bottom rather than leave it too late to start buying.”
He believes that some interesting opportunities will emerge over the next two years.
“There may be a bit more pain first, but investors may be able to pick up some good opportunities without having too much competition,” he says. “When markets turn quickly, they may lose out in the rush.”
As pension investors are buying for the long term, he says they should aim to enter the market at prices that look good compared with a year ago, even if they think they might have slightly further to fall.
Mr Jones believes investment returns could start to look attractive again towards the end of 2009. “If investors are pocketing initial yields well above 6 per cent, they could look very healthy,” he says.
So far the few pension investors to have re-entered the market have been acquiring good-quality, defensive stock with long lease terms to secure covenants.
Mr Jones says a number of deals linked to the retail price index have been made to provide security of income cover for future liabilities.
Mr Cooper says pension funds are taking more of an opportunistic approach to markets, rather than going for one particular sector. They are trying to secure good deals on individual properties and are looking at areas with strong fundamentals.
For example, he says opportunities could emerge earliest in the retail sector, as this area has suffered heavier repricing than the others. But, he says, investors will only want the highest quality, most central properties that offer the highest rents.
Mr Jones believes that pension funds will be in a good position to take advantage of any possible bargains in the market, as they are typically equity-rich buyers.
However, he does not anticipate that institutions will start aggressively buying again in the UK until 2009 at the earliest.
In the meantime, he says, a number of institutions have been looking at international investment, both through indirect vehicles and direct property ownership.
