Click here to read the full paper including graphs: LGC article – Ian Gleeson and Achal Gandhi
Over the past 20 years, real estate has become an established global asset class for institutional investors, in common with equities and bonds. While UK pension funds have maintained a home bias with respect to real estate, the allocations to global real estate have been steadily increasing.
Our experience has been that investors, recognising the benefits of global real estate, have opted for 25-50% of their total real estate allocation to be directed internationally.
This contrasts with data from the Local Government Pension Scheme community, which shows that in aggregate, as at March 2018, global real estate represented less than 2% of total asset allocations (source: CBRE Global Investors analysis of individual LGPS fund reports 2018), whereas institutional investors around the world typically have allocated approximately 7% to global real estate (source: INREV).
We believe that increasing exposure to global real estate is a compelling opportunity for the LGPS, primarily due to the higher risk adjusted returns and diversification benefits that the sector affords – including protection against muted performance in domestic markets.
While the UK has a relatively large real estate investment market, it only represents about 5% of the global investable universe*. By broadening allocations to include markets outside the UK, investors can substantially increase their opportunity set.
The range of opportunities for investors is diverse across the three principal regions of continental Europe, the Americas and developed Asia Pacific.
Over the past five years (to the end of 2019) global real estate has performed favourably against UK property, and looking forward we expect this to continue given political and economic uncertainties. As such, a UK pension fund with an allocation to global real estate would have outperformed a UK pension fund with a sole domestic property portfolio. From purely an absolute returns context, the case for making an allocation to global real estate is compelling.
While an accretive return profile is important, investors have long been attracted to global real estate due to the diversification benefits that can be achieved. Income returns from property have proven to be relatively stable, however total returns display higher volatility. Real estate is a cyclical asset class; these cycles differ significantly from country to country because of their specific demand and supply drivers.
The upshot is that real estate markets are not perfectly correlated because of this local nature of the asset class. Therefore, having exposure to more countries and markets can create a more stable total return profile than investing solely in one country – a globally diversified real estate portfolio is likely to have a lower overall risk than a pure domestic portfolio.
A globally diversified portfolio is therefore somewhat insulated from local shocks or dislocation. This has been evidenced by the performance of the UK property market since the Brexit referendum result in 2016 when compared with the global property market returns over the same period.
The cyclicality of real estate markets is reflected in the wide variations in returns across markets as illustrated in the graph. Dispersion between the strongest and weakest performing real estate market globally peaked in 2008 at 47.3%. The UK recorded a total return of -21.9% in that year. Being exposed solely to the domestic market in that year would have been extremely damaging to investment performance. In short, in our view this cyclicality creates an opportunity to earn excess returns – and greater downside protection – through top-down market selection by tactically tilting allocations towards markets that offer better return potential at each point in time. Top-down market allocations and investment selection both offer considerable opportunities to generate enhanced risk-adjusted returns.
For many investors, environmental, social and governance factors are high on the agenda, especially as it relates to real estate. Our experience from investing globally has been that in many markets energy efficiency measures and certifications are increasingly common place, and in some cases such as Australia, they are significantly ahead of the UK, thereby giving investors comfort over the sustainability of their real estate exposure globally.
In conclusion, there is a strong case that adding global real estate market exposure to a pure UK real estate portfolio should reduce overall portfolio risk. These attributes have made increasing global real estate exposure a key focus for a number of institutional investors and we expect this to continue into 2020 and onwards.