Student accommodation, logistics bases and retail parks could represent an overlooked opportunity for defined contribution (DC) pension schemes seeking exposure to private markets.
Speakers at the Pensions UK Annual Investment Conference in Edinburgh this week argued the UK real estate market is now emerging from a sharp valuation correction as a result of rising interest rates and the aftermath of the pandemic.
David Scott, head of UK investment research at Aberdeen, said the asset class had the potential to provide diversification and a stable income stream.
He said: “There’s been a number of empirical studies recently on why real estate benefits portfolios.
“One of those is the lack of volatility within portfolios, but also an improved Sharpe ratio.”
Scott said UK real estate was often mistakenly treated as a single asset class and explained how it can be used to provide significant diversification using different sectors and strategies.
“If we think about UK real estate in the context that we view it, we have the ability to diversify across multiple sectors — logistics, multifamily living, student accommodation and different types of retail.”
He also explained how property investments can be accessed through a variety of routes including, lending, real estate investment trusts (Reits) and multi-manager strategies as well as ownership itself.
Global interest in UK real estate
A renewed interest in UK property, particularly from global investors including Australian institutional pension funds, follows a downturn in values which was exacerbated by the Covid pandemic and lockdowns of 2020, 2021 and 2022.
Scott said the UK experienced one of the steepest corrections on record during the monetary tightening cycle.
“In the second half of 2022 we saw the sharpest correction in UK real estate recorded in the MSCI index.
“At the all-property level, capital values fell by around 25 per cent.”
We still see real estate as a core holding because of its income characteristics, with capital growth largely being driven by rental growth
Offices were among the hardest hit due to structural changes following the pandemic, including the rise of hybrid and remote working.
However other sectors of real estate including retail parks, West End offices and logistics assets proved more resilient.
Scott said: “Retail parks, for example, are generating a lot of interest from institutional buyers.
“Industrial and distribution warehouses continue to benefit from supply chain reconfiguration and onshoring.”
Some sectors have already begun recovering part of their lost value, he added, with yields now more attractive than in previous years.
Income-driven returns
Scott emphasised that property should be viewed primarily as a long-term income asset which does present a challenge to pension funds managing both accumulation and decumulation strategies for members.
“We were never overly bullish on yield compression driving capital growth.
“We still see real estate as a core holding because of its income characteristics, with capital growth largely being driven by rental growth.”
He claimed constrained supply would lead to rental growth across a number of real estate particularly as construction costs have risen in recent years.
“As building costs have increased materially, that naturally curtails the supply pipeline.”
DC schemes reluctant to invest
Despite these characteristics, the use of direct property in DC pension schemes remains limited said Hannah Long, head of investment at Mercer.
She claimed the asset class has been underutilised in DC arrangements.
“It’s really not something that has been widely used within the average DC trust arrangement.”
Long noted that some schemes that invested in property funds before the 2022 downturn have also been cautious about increasing their allocation to real estate estates.
“There is a little bit of buyer’s remorse from those that were particularly hurt in 2022 and haven’t yet seen the recovery.”
Growing pressure on pension schemes to increase allocations to private markets may change this.
“We know there’s a huge amount of pressure on schemes to consider illiquid assets.
“Real estate is definitely part of that conversation around trustee tables.”
Real estate’s role as a potential driver of income in retirement was also discussed.
Michael Robinson, head of investment development at Aegon, said the asset class can act as an important diversifier in some DC portfolios.
“It’s about understanding where it sits within the portfolio, whether that’s in the growth stage or through retirement.”
He noted that liquidity and governance have historically been barriers to wider adoption, though the industry is developing more sophisticated ways to manage those challenges.
Real estate as hedging mechanism
Nalaka De Silva, head of private market solutions at Aberdeen, said one of the key attractions of property for long-term pension investors is the inflation-linked nature of many lease structures.
“If you run a long-duration portfolio, you want to capture some of that inflation upside over time.
“In many cases the income is linked to inflation or to the credit quality of tenants, which can provide useful characteristics in a long-term portfolio.”
De Silva suggested allocations of 5 to 15 per cent to core real estate could make sense from a pension perspective.
He added that a key advantage of property is the transparency of its underlying cashflows and also in enabling pension savers to understand where their contributions were invested.
“Understanding those cashflows — whether they come from tenancies, inflation-linked leases or demand-driven sectors like supermarkets — is really important.
“And that transparency is one of the reasons the asset class can work well in long-term DC portfolios.”
Samantha Downes is a freelance financial journalist