The Benefits and Pensions Monitor Interview
Benefits and Pensions Monitor's executive editor, Joe Hornyak, recently had an opportunity to discuss real estate with Russell Chaplin, chief investment officer, property, with Aberdeen Asset Management.
Q: What is the mood towards real estate right now in Europe given what is happening there?
A: It continues to be uncertain. That is the best way to describe it. Things are changing on a daily basis so effectively, what we are trying to do is look through that. We do not know the way things are going to turn out, but we know that the properties are still going to be there and people are hunting down real assets for that reason.
Q: Are investors parked on the sidelines waiting to see if all of a sudden there are a bunch of bargains?
A: Perhaps some are. What we have seen in the last couple of years as the markets recovered was that people started to think more broadly about investment in all asset classes and for property that has meant that, certainly for Canadians, there was a tendency to go outside of Canada and it was quite high in 2006. In 2007, it shrank enormously to almost zero in 2008, 2009, and then, in 2010, it came back again.
We are beginning to see that across the globe. Many Canadian plans have taken a strategic decision that they need to invest outside of Canada. However, they are very mindful of the risks that there are at the moment, but they still seem to have made the decision that now is the right time.
There is certainly a tendency for people to wait and see. However, the other side of that is you are seeing some people say if things do turn out badly, then that should create a real opportunity.
What we are trying to do is look through the next two to three years and just really work out where the best places are to invest. A lot of people have avoided markets such as Greece, Spain, and Portugal for the last two or three years, but at some point it will make sense to go back into those markets. It is probably too early now, but they are certainly markets we are monitoring despite everything that is happening.
At the moment, most people in Europe are focused on Germany, France, the Netherlands, and the Nordic markets of Denmark, Sweden, Norway and Finland. These have been the more stable European economies without too many of the current issues and many of the Nordic markets are not in the Eurozone anyway.
However, the bulk of capital in Canada seems to be going to the UK which is interesting. It is being seen as a safe haven outside of the Euro. It is a large liquid market with a wide range of possibilities for people to pick and choose. What that has caused, in some respects, is to raise the pricing to quite high levels. Some of the pricing in central London is back to the levels we saw before the crisis in 2007. It has gone back up very sharply to those levels, which makes you start to wonder whether those are the right prices.
The UK economy does not have any secret to it. It has been just as affected as many other markets across the globe, on the demand side in particular. The financial services sector did very well actually in the last couple of years and this has been the primary driver of the central London office market. Now, if you look at the statistics which are out on new employment hires and available positions in the city, it has come right down and that normally is a good indicator of what happens to rental growth afterwards. Things are weakening in the UK following a very strong run.
Q: Real estate investing from places like Canada into Europe has, at least in recent history, been primarily more city focused as opposed to country focused. Is that still true today?
A: When you are looking at global investment, the temptation is always to shrink the problem. The globe is a big place so you come up with a list of 50 cities across the globe, which are the ones people feel comfortable about. They are typically the capital cities in most markets. So, everyone starts to look at investing in the same way and that generates international pricing in those markets.
What we tend to do is to look one or two levels down from those cities and try and identify assets in local markets which are core markets, perfectly acceptable locally for the local institutions and just the kind of markets that would be acceptable locally here in Canada. That is typically where we see more value at the moment.
Obviously, we have to make sure we have people on the ground that understand those markets and do our research thoroughly, but it is not all about the capital cities even though that is where a lot of the money flows to first. The strategy of just deploying to that list of 50 cities does have a very straightforward advantage if you are actually looking to deploy large amounts of capital as this is generally where the large buildings are. It is maybe not the best approach in terms of diversification, but if you want to deploy large amounts of capital, that is where you find the big assets. If you are investing from a distance, then you probably want to try and minimize the number of assets that you are looking at. This advantage is also a potential pitfall.
We have also seen other approaches which include teaming up with local partners and going a little bit further down through the markets and broadening that investible universe from 50 to 200 to 300. That is typically where you see the value. There are things that you can do in those markets whereas cities such as central London and Paris are very highly institutionally invested markets. You can typically do more interesting things outside of those markets.
Q: Is it getting harder to find prime properties in those major centres because pension funds, in some ways, are treating real estate as a substitute for fixed income?
A: Exactly, they are after income because there is no income where they typically get income from ‒ such as cash or bonds. They are looking for something to substitute that. They are looking at prime property across the globe to deliver that income.
On a relative value basis, that looks quite good. You have assets that could be yielding five or six per cent against the local bond yield, which has yields of two to three per cent globally. On that basis, it looks quite attractive and you can see why people step in and try and pick that income up.
The situation is that we are in a strange time in terms of the pricing of bonds. If we get to a point, which I guess we will at some point although it may be further out than we thought, where those bond yields do start to rise, that gap is going to close up quite quickly. It then starts to make those assets look quite heavily priced. That is our concern that they look relatively good value, but on an absolute basis, are they really good value?
Also, where are you going to get growth from in a very low growth environment?
One of the things we are seeing is if those assets are bond substitutes, then there are others looking for index-linked bond substitutes. In some of the markets in Europe, the lease is tied to inflation explicitly so you get income ratcheting up with inflation. The problem there is if the market rents are not growing as quickly as inflation, then you get to a position where the tenant may default or renegotiate because they are paying a rent which is actually above the market rent.
There are some asset classes that we see where not only do you get indexation to inflation, but also the market rental growth is actually quite strong. Typically, that is something like hyper-markets, supermarkets, and some food-anchored type retailers where the planning system limits the creation of many more of these. The planning systems are very different across Europe so you have to make sure you are picking the right ones. In general, they are quite protective of high street, town centre retail. With a lot of those kind of supermarket properties, it is difficult to create more of them so you get this indexation to inflation where the supermarket chains are very happy to sign up to long leases with inflation indexation, maybe with a cap and a collar and on that of maybe say one to four per cent in preference to experiencing very strong market rental growth. Otherwise, it is just indexed to inflation, but that gives you some long-term index-linked, bond-type asset.
To us, those seem to be perhaps a better value than the prime office where you are more subject to market rental growth and fluctuations and where there is more volatility.
Q: Are we starting to see more interest in emerging markets?
A: If you work your way through Brazil, Russia, India, and China, there is continued interest in China. Everything points in a good direction over the medium- to long-term. There is always this constant concern about the pricing in China and the role of government in controlling prices, but we continue to see quite a lot of activity going towards China.
One of the things we are very mindful of is China is not a market where you put capital in and then expect to get your 15, 20 per cent IRR, whatever may have been offered at the beginning. It is more a market where you need to deploy through phases. There is a lot of vintage risk by just putting your money in and then just letting it stay there and work. In our view, a better idea is to try and capture the growth trend by deploying through vintages. However, the omission of a vintage is just as risky as only having exposure to one vintage as well. It is a market, which, we think, in the long term, is going to get good growth.
It is also interesting that we are beginning to see people starting to talk about core real estate in China whereas for the last 10 years or so we have been really talking about development projects, opportunistic development projects. Now, we are getting to the point where there are assets, which are, at least for good tenants, a good investment. Actually, they could be treated as core real estate.
India is a bit different. It does not have the advantage of the ability to create infrastructure which is required in a very short and efficient manner as does China. That does not typically happen in India. The infrastructure is something that tends to hold India back.
Certainly when we look at it on a long-run basis, it is something we are very mindful of. The demographics and everything else point in the right direction, but if you want to be investing in real estate, you have to have some of the infrastructure.
Q: Is there political or government will there to start creating that infrastructure?
A: I think there is. It is just that you have two very different political systems, one, which is effectively a command economy and the other one which is a democracy of a lot of people. If you need a consensus behind putting something together and doing it, often times it takes a lot longer in a democracy than a command economy.
We do not really look at Brazil a great deal, but I think we will be increasingly because we now have three people based in Philadelphia, PA, on our multi-manager side whose remit it is to cover the Americas investment universe. Russia, we are not invested in at the moment.
Q: Are there any particular reasons why?
A: It is not really in any of the products that we manage as part of our investible universe. We would probably put Russia at the bottom of the list of the four BRICs. We just find it more difficult to do business – among the BRICs, Russia ranks the lowest on Transparency International's Corruption Perceptions Index. That does not mean we will not do business at some point.
Then, you can start looking at other markets in Malaysia, Indonesia, and so on and we have some investments in those markets as well through the multi-manager business in Asia where we are now on to our third real estate investment for the Asia/Pacific region. Again, they are markets where there is risk, but, if you have people on the ground with knowledge, you can start to take advantage of the opportunities.
Q: Are we starting to see more uptake from mid-sized and small pension plans, particularly in Canada, towards the fund of fund approach to get into real estate?
A: We expect to see increasing demand from a lot of those plans and I think they are beginning to come to the conclusion that this is going to be something that they will do. They are taking their time, which is very sensible, and really want to understand exactly how a fund of funds strategy works and what they are going to get out of it, which I think is a very wise approach. We have seen other investors step outside of their domestic market into products which maybe were not necessarily appropriate for them or maybe the investors did not know exactly what they were going to get out of those products.
I think it is a long-term trend. The larger investors in Canada are already out there doing the direct investments. For those smaller, medium-sized pension funds to access those markets, fund of funds seems like a straightforward approach. I think we will see a drift into that over the next few years.
Q: What does an investor get out of the fund of funds? For example, are they sharing in the income stream?
A: Exactly, effectively, it is a one-stop solution to investing outside of Canada. You can go in core, value add, or opportunistic. We think probably the core approach is more appropriate due to the lower risk level. You are probably not going to get surprised by big capital losses. That is not really what pension funds want to see.
In that core environment, what you are doing is effectively investing in something like 10 to 15 underlying investments in the U.S., UK, Continental Europe, Nordics, and in the Asia/Pacific region where, typically, Japan and Australia are the two largest core markets. Then, what we do is we put those together and manage them on an ongoing basis. We have liquidity provisions in there and a distribution target of around four per cent per annum delivered back into Canada.
Obviously, this comes with the longer-term prospect of capital growth which is broadly linked to economic growth across the globe. The key thing is that you are getting diversification very quickly and you end up being exposed to a very large number of assets and a very large pool of capital for a very small investment. That is why the fund of funds works.
We have looked at this for a long time and we have a very large database of investments across the globe, more than 2,000 property investments that are potentially investible. However, we think that the actual pool of investments which is suitable for the core strategy is relatively small ‒ only around 100. Therefore, we believe it is a pretty compelling thing for us as well as for the investors. There is a small pool of investments out there, yet they are, by definition, the most transparent investments in their local markets. The fees are at the lowest level possible in their local markets albeit there is some variation globally. That means that you are getting the best of what people are doing locally and are very happy with.
It is not necessarily straightforward, however. You have issues of taxation and currency and so on, but taking care of that is exactly what happens inside the fund of funds. That is why it ends up being this one-stop solution. It is a relatively straightforward step. It is investing in the kind of assets that you would invest in in Canada or somewhere else. It is no more risky necessarily, than investing in Canada if you are investing in the same kind of assets in the same kind of markets.
Effectively, you are investing alongside a whole group of Canadian investors, but you are also investing alongside a whole group of pension funds in the U.S. or pension funds in Continental Europe because they have, effectively, the same targets. It works as a simple way to get things done.
Q: What sorts of opportunities are there in the U.S. now?
A: In the past couple of years people have been looking very strongly at the apartment market. We recognize the strong market fundamentals in terms of supply and demand in this property type but apartments have been and continue to be over priced in gateway cities such as Los Angeles, the District of Columbia, and New York. Chicago has even seen apartment deals trade during 2011 at near 2007 price levels.
There are some office markets which have been more robust and will continue to be we think. Offices located in primary, but non-gateway cites such Denver, Austin, and Minneapolis look attractive on an absolute price basis. They have strong ties to the technology sectors, but are more economically diversified than many of the gateway cities. These typically have a broad economic base, not necessary just financial services. The Washington, DC economy has been an anomaly relative to the rest of U.S. since the end of the 2009 recession – home prices rose and its employment base grew. But, significant government cuts are a major risk for this economy.
Retail is probably the most uncertain given the environment. That is a pretty difficult market to think about, but if you can get the right assets in the right locations that are very dominant, then that is going to work year in, year out.
One other thing we see just as a global trend is what everyone was expecting to happen with internet retailing 15 years ago is actually now beginning to happen. That is starting to detract from having to have the store there. The retailers are still working out how to exploit both ends of that ‒ what stores do they need, which do they not need, and how do they exploit the internet portal for sales. The trend among U.S. retailers has been to shrink store size since more and more consumers are shopping online. And major e-commerce retailers such as Amazon are reconsidering their big box warehouse strategies as a result of more online shopping. They want to move to having more regional, smaller warehouses where they can ship goods even faster regionally.