Real estate is back in fashion, at least according to a range of recent surveys indicating the growing institutional investor appetite for bricks and mortar. After a tough few years for the industry and with European investors’ priorities changing, the possible renaissance might come with a marked change in investing patterns, though.
More control
The talk from large investors is frequently about gaining more control of their real estate investments, says Casper Hesp (pictured below), research 
director of European non-listed real-estate-fund investor association, INREV. His group has found that there is significant appetite from European investors to access real estate via joint ventures and ‘club deals’ – essentially small funds with carefully aligned investor priorities. The €29.5-billion ($38.44-billion) Finnish fund, Ilmarinen, and the $170-billion Dutch pension manager, PGGM, have both recently announced major real estate joint ventures.
Robert Stassen, head of capital markets research at real estate consultancy Jones Lang LaSalle, agrees there is a growing trend for direct investment. “One of the natural consequences of the crisis has been for funds that may have previously only invested indirectly to look at an alternative way of accessing real estate,” he says. These are generally being explored by the largest funds though, with those lacking the investment infrastructure for novel funding vehicles or direct investing still reliant on real estate funds, according to Stassen. Clemens Schuerhoff, managing director of the Kommalpha consultancy in Germany, says that liquidity crises in both the open and closed-ended mutual real-estate-fund industries in the country have enhanced the trend towards greater direct investing there.
Unipension, the $17-billion Danish pension provider, has recently shown enthusiasm for real estate funds, however, announcing it would sell its entire direct domestic portfolio and invest in international funds in order to gain “better risk diversification”. According to Hesp, “when the market becomes more positive, I think larger investors will turn to funds again”.
Noticeably, recent cheerfulness about real estate investing appears to have infused investors more in some regions than others. Areas where disappointment in the downturn was hardest felt are seemingly slower to return to investing in the asset class.
A study from alternatives research company Preqin found that Asian institutional investors are more than twice as likely as European ones to invest in real estate funds in 2013. “Asian investors weren’t hit as hard in the downturn as US and European investors, and a lot of Asian investors are also more recent entrants to the asset class,” says Andrew Moylan, Preqin’s real-estate data manager.
Investing from the church spire
Moylan says that in contrast to the past few years when investors have sought “core” real estate, “there is now an increased appetite for higher risk-profile strategies with IRRs of 15 to 20 per cent.” He thinks part of this is due to huge demand for core investments, and says that “there have been a lot of people arguing that core real estate investments aren’t attractive anymore as they have perhaps become overpriced because of the capital chasing them.”
“Opportunistic” investments with lower occupancy, short leases or development needs are gaining popularity, Moylan argues, along with debt and distressed real estate funds. He reckons this is due to “confidence and the belief that there are the opportunities out there to deliver that kind of return”.
While few would doubt the opportunities exist, the ability of pension funds to pursue these riskier strategies appears muted, however. The pension fund respondents to Preqin’s study showed a greater propensity than other institutional investors to claim they will focus forthcoming investments in core real estate funds. Schuerhoff explains that German investors have coined a phrase for a local focus resulting from a need to scrutinise risk in real estate, investing from the Kirchturm or church spire.
Hesp thinks it is large investors that are more likely to have the desire and inhouse knowledge to diversify beyond core holdings, as well as have more room for experimenting with riskier assets. Stassen sees some evidence that pension funds are upping their risk appetite. He claims that “in the UK, pension funds are looking at Manchester whereas two years ago they probably would have just looked at London.” These initial movements are creating their own momentum he adds, with it proving “difficult to get yield play” as plenty of capital chases slightly riskier yet high quality assets.
PensionDanmark’s head of real estate, Mogens Moff, says his fund has diversified its real estate investments to the extent that just 10 per cent are “retail in top locations” and 20 per cent “high quality residences”.
Stassen says opportunities are opening up further up the yield curve as “an enormous lack of debt financing in the European market”, which affects 
the riskier end of the market, “has significantly improved over the last six quarters”. His colleague Richard Bloxam (pictured right), head of European capital markets at Jones Lang LaSalle, says these improvements have primarily come in the larger European markets like Germany, the UK and France though. The situation is still “extremely restrictive” in Holland, he adds.
Hesp agrees that investors want to “take this risk in countries that are more stable”. Germany and the Nordic countries are the most popular European destinations for real estate investments according to a recent INREV report.
Hesp believes “that the majority of investors aren’t looking at southern Europe yet as they are still looking at the risks associated with the Euro crisis”. Investors are also not convinced that a “full price reflection” has taken place in the most troubled markets, he adds. Bloxam agrees that a pricing gap remains but says there has been “some movement” from Italian vendors and there is an increased interest in the Spanish market. Moff says PensionDanmark remains focused on the domestic market for its direct investments, despite being enthusiastic on overseas infrastructure investments.
More inflation caution
A combination of the ongoing hunt for yield and heightened inflation fears appear to have swung the pendulum of real estate sentiment back in the asset class’s favor. There is a “huge difference” between real estate yields and those of government bonds, Hesp points out. Jones Lang LaSalle figures indicate a spread of over 400 basis points between prime office assets and local government bond yields in London, Paris, New York, Frankfurt, Sydney and Hong Kong in the third quarter of 2012. Moff says PensionDanmark is doubling its real estate investments to 10 per cent of its $24 billion portfolio to offer a “solid anchor to compensate for the low yields on bond investments”.
Figures from Swiss investors certainly point to increased popularity of real estate investments at the expense of bonds. Swisscanto data claims that around 50 per cent of Swiss pension funds reduced their bond holdings in 2012 while another 50 per cent increased their real estate allocations. Stassen argues that real estate is also benefiting from expectations of “relatively high or increased inflation” becoming more pronounced as the global economy clicks back into gear.
While real estate offers something difference to bonds and equities, it has to compete for attention in investors’ portfolios against a range of 
alternative investments like never before though. Stassen says (pictured right), however, that increasing number of funds are seeing real estate and infrastructure as individual asset classes separate to their alternative allocations.
“In the medium to long term we expect investors to continue to diversify into alternatives but maintain their real estate allocation” says Moylan, who argues that pension funds rarely real estate for infrastructure or hedge funds. Stassen points out that while the illiquidity premium of infrastructure is an attraction for some investors, the flexibility of real estate tends to suit those wanting liquidity.
Another bubble?
With institutional capital predicted to increasingly flow into the same kind of assets, is there a risk of another bubble in some segments?
“It is important to understand that institutional investors are different kinds of buyers, buyers typically without leverage and with a balance sheet that allows them to sit it out if needed,” Stassen says. However, Schuerhoff argues that there is widespread talk of a bubble in core real estate in the biggest German cities.
Beyond any asset bubble fears, regulation could also seemingly put the break on increased real estate appetites in Europe. Schuerhoff explains for instance that many German pension vehicles are tied by both “very conservative” domestic regulations on asset allocation and the prospect of forthcoming risk-averse Solvency II insurance regulations. While a study from his consultancy has found that institutional investors would ideally like to double their real estate allocations, he expects a much more gradual increase to ensue, pending the impact of new regulation. Modest risk budgets are also making many funds hesitant to increase real estate allocations, a constraint funds the world over might recognise.
