March 5, 2021
Patrick Freestone, Associate Director
The COVID-19 pandemic will long be remembered for turning our world upside down and kickstarting dramatic change across all aspects of our everyday lives. It is fair to say no family, community, industry or economy has been left untouched by the pandemic.
Across the world, unprecedented fiscal stimulus has propped up economies in the hope that the vaccine roll out will revive dormant economies this year. In the UK, the OBR estimate government borrowing at £355bn for the year to March 2021 (1) – almost 2.5x higher than the peak of the financial crisis. With 3 year and 10 year gilt yields at 0.01% and 0.64% respectively at the time of writing, the need to service this debt pile is expected to anchor nominal yields ‘lower for longer’ – unhelpful to pension funds seeking real returns from fixed income.
The DB landscape
The Pension Protection Fund’s The Purple Book 2020 provides the most comprehensive data for the UK’s private sector defined benefit pension universe with 5,327 schemes included. With 89% of these schemes either closed to new members, new benefit accrual or winding up (2), the majority of these schemes should be de-risking by transitioning towards liability driven investment strategies to match liabilities.
However, according to the latest PPF 7800 Index (3) 59.2% of these scheme are in deficit (approximately 3,150 schemes) with a total estimated aggregate deficit of £212.4 billion.
Can Real Estate plug the gap?
Against this backdrop, it comes as no surprise that institutional investors have been reviewing the tactical positioning of their portfolios and increasing allocations towards higher-return cashflow-generating assets, such as Real Estate.
UK real estate average net initial yields currently provide a 400-450 basis point spread over UK 10-year gilt yields (4), a gap that has been steadily increasing since the GFC and will increase further should negative interest rates be utilised by the BoE. This yield gap alone might be an attractive enough proposition for some investors to increase real estate allocations into traditional beta strategies such as indirect investment into core balanced funds.
However, this simple metric masks the true impact of the dramatic acceleration of structural changes during the pandemic, such as the growth in on-line retailing and home working, which has polarised returns and performance outlooks across sectors. Years’ worth of change occurred within a matter of months and some forms of real estate that seemed fit for purpose pre-pandemic now appear functionally obsolete.
Take the much maligned retail sector as an example – Savills recently reported there is 142 million sq ft (5) of vacant retail space in the UK at present and estimate there could be as much as 308 million sq ft by the end of the decade. Not all retail should be tarred with a negative brush but it is clear that the sector is in a period of transition and so we expect the polarisation of performance within the sub-sectors to continue.
By their very nature, balanced funds’ underlying real estate is likely to be exposed to all sectors, guaranteeing technological, physical and environmental obsolescence risks that will require significant capital expenditure to upgrade or repurpose. Owners who cannot or will not make the investment to off-set change will need to exit to preserve value, incurring high transaction costs associated with recycling portfolios, often as much as 8%. Whether a landlord exits or invests in the asset, both scenarios are likely to drag performance.
Because of these challenges for owners, we believe a better solution to defined benefit pension schemes seeking income and growth and positive social impact comes through selecting one of two investment strategies:
- Liability Matching through Core, long income – focus on secure, long dated and progressive income to protect against inflation and physical, technological and environmental obsolescence through lease duration. Strategy to target income distribution 4.0%+ p.a.
- Return Seeking through Value Add – generating alpha returns through the creation of core, ESG and technological resilient assets that meet the needs of the customer and investor of tomorrow. Strategy to target net returns of 12%+ p.a. over a fixed fund life of 4-6 years.
Fiera Real Estate is actively investing for both of these strategies through two vehicles – The Fiera Real Estate Long Income Fund UK “FRELIF” and the Fiera Real Estate Opportunity Fund V UK “FREOF V”.FRELIF Factsheet FREOF Factsheet
Transition of existing portfolios
Investing in these strategies may be an easy decision for investors making new allocations but what are the options for maturing schemes with existing direct real estate portfolios with legacy assets suffering from structural headwinds – especially when transaction costs make rebalancing portfolios additionally dilutive?
Most of these portfolios have been constructed over the past 15-40 years and, as with the balanced funds, many will have high exposures to underperforming sectors and non-core assets that are most at risk of physical, technological and environmental obsolescence. The value erosion of these assets will continue to accelerate and these assets could turn into liabilities without early and significant intervention.
As pension funds holding these portfolios continue to mature, trustees will face the difficult decision of whether to try to sell illiquid assets at a discount, crystalising poor performance whilst still facing a large funding deficit, or seek to protect wealth and create value from actively transitioning existing portfolios. Here at Fiera, we firmly believe performance can only be captured from these portfolios with support from specialist managers, with local presence and with experience in execution of these transformations.
Another benefit of transitioning these assets is that it provides local government and corporate pension schemes with the unique opportunity to create holistic returns beyond financial performance. Social impact investing is nothing new to pension funds but by repurposing their own redundant portfolios, they could become market leaders in creating sustainable assets and generate positive social and environmental returns.
The biggest threat is from doing nothing, as this almost guarantees under performance, with value ebbing away from a static assets whilst the environment around it undertakes structural change.
Fiera Real Estate’s competitive advantage
Fiera Real Estate UK is a leading creator and manager of assets via its regulated fund management business and ownership stakes in eight UK property companies. The firm (previously known as Palmer Capital) was founded in 1992 and directly manages £740 million of AUM. In addition, c.£438 million of property is managed by its property companies with third party investors as at 31st December 2020.
Fiera Real Estate manages around USD4.9 billion of real estate globally, through its investment funds and accounts. It is wholly owned by Fiera Capital Corporation, a leading multi-product investment-management firm with more than USD141 billion AUM.
Through our 16 years’ experience managing opportunistic funds, coupled with our unique network of eight specialist regional operating partners, Fiera Real Estate UK has a deep pool of expertise that enables us to identify opportunities, mitigate risks and effectively create value from existing portfolios.Download FRE Core Market Update Download FRE Value Add Market Update
(1) Source: OBR Economic & Fiscal Outlook March 2021
(2) Source: PPF ‘Pensions Universe Risk Profile (The Purple Book) 2020’
(3) Source: PPF 7800 Index February 2021
(4) Source: MSCI Quarterly index Q4 2020
(5) Source: Savills Re:Imagining Retail #2