by Nick Ryan
A certain pleasing symmetry occurred between the hurricane of October 16 1987 and Black Monday on the 19th, as if the gods were reminding us of our frailty in the face of nature, both elemental and human. The immediate question raised is whether it is not time that the cult of the stock market — vulnerable as it now seems in the light of these events — should give way to the traditionally more popular and recently less volatile property market as a natural home for pension fund money.
Historically, pension funds have had a love-hate relationship with property. It is worth recalling that, once upon a time, trustees were to a large degree precluded from investing in anything other than gilt-edged or other blue-chip loan stocks and mortgages. The idea of funds owning things was anathema.
But then benefit structures began to change, and increasingly in the 1950s through to the 1970s pension schemes started to offer benefits related to earnings at or near retirement. In an inflationary world these are real benefits, as against the old style monetary benefits expressed as so many shillings a week, and to match them the trustees need real, not monetary, assets.
Among the first institutions to perceive the value of real property were, of course, the monarchy, the church and the ancient universities — though admittedly all those centuries ago there were very few other assets in which they could invest. Nearer the present day the life insurance offices became major investors in the 19th century, while not eschewing other asset classes. But a glance at the first issue of the Financial Times in 1888 shows that most of the other assets were mines, utilities, railways and other “single” undertakings, often with heavy debenture or preference elements which almost pushed them into the fixed interest class. Moreover, the single undertaking feature made such investments more akin to today’s venture and development investments, with correspondingly high levels of risk. The big conglomerate joint stock companies just did not exist, so that the potential of diversifying away inherent risks could not be done to anything like the extent implicit in modern portfolio theory. Real property was truly real, virtually risk-free and of low volatility, and had things all its own way.
Property assets did, and still do, have a drawback from the point of view of the investor. They are inherently illiquid. In the last century this was not such a problem — at least relatively — if only because the comparatively small trading volumes experienced by other assets made them, by today’s standards, illiquid too.
But the growth of stock markets in the 20th century — even in the 1930s, after the 1929 crash, still more so after the second world war — changed all that. Equity shares became far more available, liquid and diversified, and investors big and small deserted the more traditional havens for their savings. At the same time employment and other government policies made pension funds a highly attractive savings method for both companies and employees, and these rapidly growing funds started to buy significantly into the equity markets which were also expanding rapidly.
Such is human inertia that property remained a major component in investment policy. As late as the mid-1970s insurance companies were recommending a 30% to 40% exposure for pension funds and even the crash of 1974 did little to dampen such enthusiasm since most assets were equally affected.
But pension funds were moving out of the insurance company “nursery” and looking at newer kinds of benefits, including final salary and protection against inflation.
It was really the latter that was the bad news for property. Rightly or wrongly, property was perceived as being less able to respond quickly to depreciating monetary value than equities, and at the same time the abolition of UK exchange controls in 1979 opened up an entire new world of possibilities. Property proportions declined and might now be typically 5% to 10% of portfolios.
But then came the twin October hurricanes and property is once again seen as a more stable form of investment. If we are not merely to advocate the herd reaction, now that some of the glamour has gone out of equities, we should be seriously studying the property market. For that market is itself changing.
What are the things that particularly interest pension funds about the property scene today? I would suggest that there are four important groups of questions:
- asset allocation and the place of property in the strategic process;
- direct v pooled assets and the liquidity problem;
- performance measurement and the valuation dilemma; and
- management, advice and conflicts of interest
It is a growing practice for pension funds to adopt a much more structured process when determining asset strategy. The old-fashioned “well, what percentage in property?” has given ground to fund-modelling by computer, as a result of which proportions are assessed under such headings as “real/monetary” and “marketable/illiquid”. Property then has to justify itself as a representative of these characteristics. Part of that justification will lie in active management of the properties within the portfolio to produce superior returns. “Buy and hold” is no longer enough.
Property is of course a real asset, but historically illiquid. This has led many pension funds to use property unit trusts, but even these have proved difficult to sell. A small secondary market did develop, trading at substantial discounts to bid price. The impending market in single property instruments (SPIs) may correct this. Many people, however, have expressed reservations about entry to the SPI market, ranging from fears that it will be stuffed with previously unsaleable buildings to worries that it will trade at heavy discounts to open market values. On the other hand, bodies such as the National Association of Pension Funds (NAPF) are working closely with both the UPM (Barkshire) Committee and the PINCs Association — who are also co-operating closely — to ensure that these fears are groundless. NAPF has also published its “Ten Commandments” on single property unitisation.(1)
In fact, the discount problem is not new, as witness the troubles of property unit trusts in the past. However, 1987 saw the successful sale of PFPUT and Robert Fleming Property Unit Trusts at substantial premiums to valuation. No doubt this reflected the purchasers’ perceptions of future development and management-added value, but it also raises questions about the value of valuations. What does the valuation mean as an input to the policy process? And what does it mean as input to performance measurement? NAPF has recently made known its grave reservations about the results of valuation-based measures.(2) I hope that the professionals at the Property Index and Investment Property Databank can put their heads together.
One problem is the inherent conflict of interest when the agent who manages the portfolio provides the valuations that go into the measurement service that determines his performance. SPIs may help by providing a more regular market test, but by and large pension fund trustees are wary of the property market as comparatively unregulated and inefficient. Once again, work is in hand. The RICS has a working party which is identifying sources of the problem and possible solutions. The chairman, Colin Vaughan of Debenham Tewson & Chinnocks, tells me that they have come up with a “mileage chart” identifying about 400 potential conflicts and are now trying to decide which ones are of little consequence, which can be dealt with by disclosure, and which will require stronger measures.
So we can see that, although there are real problems, the property profession is working on them. “Tis not in mortals to command success”, but we all have a powerful incentive to make the market work. I look forward to the next year or so with great interest and a personal belief that the property component of pension fund portfolios will very soon be on the increase.
(1) The Unitisation of Real Property, Pensions World, October 1986.
(2) Property Performance Measurement, NAPF Investment Committee, December 1987.