is your property allocation right for you?

Private & Confidential Is Your Property Allocation Right For You? 19th July 2016

Is Your Property

Allocation Right for You?

Tuesday 19th July 2016


Post-Brexit Referendum

Property Update


Post-Brexit Referendum Property Update – What Does the Industry Think?

3

• General consensus among managers is that commercial

rental markets are expected to weaken due to

uncertainty.

• Capital Economics revised rental value growth forecasts

for UK property down from 2.9% to 2.4% p.a. over the

next 2 years.

• Many investment managers expect that City and West

End markets will be affected the most.

• Listed market reaction has been sharp (UK REITS fell

15%), although this could be partly due to investors

“bundling” REITS with financials.

• Managers see transactions and letting agreements

discussed before the vote are following through.

• Many expect sharp depreciation of Sterling to make

British property cheaper for outside investors.

• Many expect interest rate cuts/further QE and believe

this will be supportive for property returns.

• Some areas of property are expected to be more

resilient, e.g. long lease investments (vs. other property

types).

Uncertainty

Valuers are uncertain about

June valuations and have

applied heavy caveats to the

June figures.


UK Pooled Fund Redemption Suspensions

4

Funds That Closed to Redemptions

Threadneedle Property PAIF

Standard Life Investment UK

Real Estate Fund (PAIF)

M&G Property Portfolio

Henderson UK Property PAIF

Aviva Investors Property Trust

Funds That Are Open but

Apply Dilution Levy or

Considerable NAV

Discount

L&G UK Property

Fund

*The fund was suspended for redemptions between 6th July and 13th July.

Aberdeen UK Property Fund*


UK Pooled Fund Redemption Suspensions

Note that:

• All of the funds mentioned on the previous page are daily traded

• All of these funds have a significant exposure to retail money, not institutional

• Freezing redemptions when outflows rise considerably and when valuations are uncertain is prudent!

So what about institutional money funds?

5

Redington’s Top 3

Rated Open-Ended

Property Funds

Open/Closed to

Redemptions?

Redemption

Frequency

Redemption

Requests Since

Referendum?

“Fair Value”

Adjustments

Applied?

Bid/Offer Spreads

on the Fund

Changed?

Fund 1 Open Quarterly <0.5% of NAV No No



We are, however, aware of some other institutional funds that:

• Increased bid charge (exit charge) for redeeming investors;

• Triggered gating mechanism or decided to defer redemptions;

• Applied a haircut over the valuation to reflect uncertainty over where property marks at the moment.

That said, we believe that most institutional funds have so far experienced less redemption pressure than retail funds.


Is Your Property

Allocation Right for You?


Examples of Available Property Building Blocks

7

Value Add/Opportunistic

Property

Balanced Core Property

Long Lease Property Senior CRE Debt

REITSMezzanine/Whole

Loan CRE DebtFund of Funds

Sector Specific Funds

MBS

Private Rented Sector

Please note that this shows available, rather than currently recommended property asset classes.


Is Your Scheme in the Opening, Middle or End Game…

88

Opening Game

(RR above Libor + 250bps)

Middle Game

(RR between Libor + 150bps and Libor + 250bps)

End Game

(RR Libor + 150bps or less)

RR = Required Return to

reach full funding.

It encompasses: existing

asset allocation, sponsor

contributions, deficit repair

plan

Journey to full funding


…and What Property Is Appropriate for You?

99

Opening Game

Middle Game

End Game

Opportunistic Property

PRS

Balanced Core Property Balanced Core Property

Long Leases

Senior CRE Debt

Long Leases

Senior CRE DebtProperty

Building Blocks


Mezzanine CRE Debt Mezzanine CRE Debt

17

Higher Risk/

Higher Return

Lower Risk/

Lower Return


UK Commercial Real Estate Debt

10

Senior DebtUp to 65% LTVLibor + 2-2.5%

Equity

Mezzanine DebtUp to 75-85%

LTV10-12% IRR

Main Advantages Main Disadvantages

Significant downside protection (especially

for senior lending).

Volatile illiquidity premium (e.g. vs.

equivalently rated, equivalent term public

corporate bonds).

Contractual cash flows.

Capital deployment speed can vary

depending on market conditions and the

manager.

Liability matching characteristics if long-

dated and with prepayment protection.

Borrowers pay arrangement fees upfront

and these contribute to the total return.

What is Commercial Real Estate Debt (“CRE Debt”)?

• Private loans collateralised by commercial real estate;

• Market previously dominated by banks but now large number of investment

managers are active in the space;

• It comes in a variety of forms: floating rate (typically 3-7 years) or fixed rate

(typically 10 years+);

• Investors can also chose where they want to be in the capital structure,

effectively tailoring their desired risk/reward profile.

Capital Structure


UK Long Lease Property

11

What is Long Lease Property?

• Commercial property leased for 15+ years;

• Usually, a large proportion of leases in long lease portfolios (65%+) have

contractual inflation uplifts, often capped and floored;

• Nowadays, the choice of sectors is wider than before (e.g. supermarkets, hotels,

leisure, healthcare, student housing);

• Nowadays, a lot of long lease managers engage in forward funded development to

“produce” new assets. These tend to be considerably de-risked transactions,

whereby the manager is not taking construction risk.


Liability matching characteristics (for both

interest rate and inflation risk).

Uncertainty over the terminal value of the

property.

More predictable cash flow profile than

that of a lot of other types of property.Tenant default risk.

Defensive nature of the investment.


UK Core/Core+ Balanced Direct Property

12


Diversifying source of returns. Capital values can be volatile.

Over long time periods income constitutes

ca. 70% of the total return.

What is Core/Core+ Balanced Direct Property?

• Diversified allocation to “core” = stable, income producing property;

• The “plus” means that the property is actively managed and refurbishments, re-

letting, extensions, etc. will be carried out to add value;

• High levels of occupancy and income generation remain a priority;

• In the UK, over 50% of institutional property allocation tends to be in London and

South East.

41%

31%

19%

2%7%

Retail Office

Industrial Residential

Other

Source: MSCI/IPD

Data as of March 2016

Sector Breakdown of the UK Quarterly

Property Index


European Value Add/Opportunistic Property

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Potential for high returns coming both

from beta and alpha.

Higher risk strategy compared to other

types.

Capital efficient way of accessing property

returns.Very slow speed of capital deployment.

High levels of complexity.

What is Value Add/Opportunistic Property?

• Opportunistic property strategies are leveraged property investments, with a major

focus on increasing capital values through refurbishments, extensions,

redevelopment, re-letting, vacancy reduction and change of use;

• The idea is to acquire the assets at a discount, carry out necessary work to bring

them to institutional quality, stabilise the income by putting in high quality tenants,

and to sell the assets at a considerable premium;

• Opportunistic property strategies typically target in excess of 15% IRR at ca. 65%

portfolio level loan-to-value ratio.


UK Private Rented Sector

14


It takes advantage of the fundamental

imbalance between demand and supply in

the UK residential market.

Sourcing remains challenging.

A differentiated source of property returns.More regulatory and reputation risk than

for other property sub-asset classes

Exit risk – it is not yet clear how

established this market will be in a few

years.

What is Private Rented Sector (“PRS”)?

• Residential property that is not occupied by the owner but rented out by private

(as opposed to social) landlords.

• It currently represents ca. 19% of the UK residential market.

• Fragmented market dominated by private owners. However, there have been

pressures over the last few years to “institutionalise” this market.

• Forward funded development of new stock (while minimising construction risk)

and renting out the new units out to private tenants.

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

Owner Occupied

Rented privately

Rented from housing associations

Rented from local authorities

Source: ONS

UK Dwelling Stock by Tenure


What Property Is Appropriate for You?

1515

Opening Game

Middle Game

End Game

Opportunistic Property

PRS

Balanced Core Property Balanced Core Property

Long Leases

Senior CRE Debt

Long Leases

Senior CRE DebtProperty

Building Blocks


Mezzanine CRE Debt Mezzanine CRE Debt

23

Higher Risk/

Higher Return

Lower Risk/

Lower Return


Don’t Forget about Other Considerations!

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Consideration Why is this important?

Overall illiquidity budget

Importance of maintaining sufficient liquidity to satisfy collateral calls,

capital calls and pension payments. Liquidity of both the vehicle and the

underlying assets should be considered.

Overall risk budgetProperty risk should be considered in the context of the overall scheme

risk to ensure that the scheme as a whole is not taking excessive risk.

Governance budget

Some strategies are more complex than others – it is important to

ensure that schemes with limited governance budget spend it on

decisions likely to generate most impact.

Maturity of the schemeThis will impact the importance of cash flow generating characteristics of

the assets invested in.

Relative importance of liability matching

characteristics

Some property investments, such as long leases, can provide a liability

hedge. The relevance of this may vary, e.g. depending on the scheme’s

existing hedge ratio.

Aggregate property allocation sizeDirect investment requires sizable allocation. Smaller schemes may

need to use pooled funds for implementation.

Attitude towards leverage

Value add/opportunistic strategies tend to be levered. This can be

desirable or not depending on the views of the scheme’s Investment

Committee and the circumstances of the scheme.

Illiquidity premium levels at the point of investmentThese tend to be relevant for debt investments. Illiquidity premiums can

vary over time.


Property in a Liquid Format?

Property is inherently illiquid. However, some investors seek ways of accessing property in a liquid format. Some of the most

popular ways to achieve this are as follows:

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Implementation route Redington Comment

Real Estate Investment Trusts (REITs)

These are permanent capital vehicles listed on a public

exchange. They offer exposure to property risk, however they

also tend to capture some of the equity market volatility and

beta. We have seen some products that invest in a mixture of

REITS, listed infrastructure and public debt (where the

collateral is predominantly property-related) to address this

issue.

Property derivativesAlthough this market exists, it is still not large/deep enough

to satisfy the needs of most investors we work with.

Daily liquidity property funds

We advise against using this method, as it results in major

mismatches between the vehicle and the underlying assets,

exposing investors to risk in periods of stress. Daily funds

also tend to suffer from a cash drag.


What about International Diversification?

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• The decision whether to diversify internationally may

depend on the scheme’s size and governance budget.

In our experience, property allocation tends to be ca.

5% of a scheme’s assets (£50m for £1bn scheme)

and sizes of governance budgets correlate positively

with scheme sizes.

• Diversification decision often has limited impact on

the overall scheme for small to medium schemes.

• Very large schemes and/or schemes with large

governance budgets may consider international

diversification.

• However, implementation can be challenging:

• Not many global funds available

• Direct allocation requires very large investment

size

• Tax and fee implications

• REIT overlays can be an attractive option

although this introduces equity beta and extra

volatility.


2-6 Austin Friars, London EC2N 2HD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

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Disclaimer

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Direct Line: 0207 326 7106

[email protected]

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