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The Actuary The magazine of the Institute & Faculty of Actuaries

Bricks and mortar

Property, as an investment asset, has recovered
much of the lustre lost in the early 1990s,
with particularly strong performance over the last three years relative to equities and bonds. Indeed, many pension consultants are recommending increased allocations to the sector, particularly for those schemes moving towards scheme-specific and absolute return-driven benchmarks.
Amid the focus upon return, it is necessary to question the understanding of risk within the property market. How can investors quantify the level of risk within their property portfolios? What tools are available to undertake this process? The recent Unilever v MLIM court action has highlighted the importance of investment managers being able to communicate as clearly as possible the risk profile of their proposed strategy.

Risk control
While there are many important measures of risk control within property, concerned mainly with diversification of capital and income, tracking error relative to benchmarks, these are primarily to prevent embarrassing losses, and to minimise manager risk. Lacking in the property market are useful tools for investment and financial risk management, not focused upon risk controls but upon performance styles and risk-adjusted returns.
This is particularly important within the property sector as index-tracking strategies by sector, and location are difficult to implement. Property investments are by nature individual assets with particular features in terms of location, build quality, and leasing structures, and therefore can show wide variance in performance terms from their industry categorisation. The stock selection variable within property market benchmarks has a consistently higher score in attribution analysis compared with strategy. Current industry classification (in terms of tracking error) is focused upon banding properties by sector and geographical category.

Categorising assets
Therefore, we have looked at an alternative way of categorising assets similar to methodologies employed by equity investors. Rather than categorising strategy merely by geographical and sector preference, we have identified five key investment styles within the property market. These are categorised by their reliance upon three key performance drivers, which are:
– Management involvement what proportion of future return is dependent upon the role of the property asset manager? Interestingly, the property sector offers opportunities for manager involvement to a far greater degree than with holding equity securities or bonds. (Over the last five years, active management has added 0.8% pa to overall market return.)
– Income security is the value stored in the lease structure or in the underlying depth of occupier market? A property leased to tenants with strong covenants, secured on long leases, will perform differently to the adjacent building that is 15 years older and about to be vacated. This is often referred to by property investors as the bond/equity trade-off within the market.
– Market performance is underlying growth in rental value the key driver to performance for this asset?
Figure 1 gives illustrative weightings to these factors for our five property investment styles. At the one extreme, we have defensive assets properties with long-term secure income streams, low volatility relative to the average, and limited scope for active management. Supermarkets are a good example of a typical asset type within this group. At the other extreme, we have ‘active risk’ portfolios, where the manager has a wider ambit to undertake management intensive activity such as development, and market volatility will have a significant impact on the outcome. In the middle of the spectrum are more mixed styles, ranging from long-term growth funds through to more actively traded and cyclically driven portfolios, and funds with a bias to income generation.
We believe that property fund managers should elucidate in more detail the style of fund they feel comfortable managing, and ensure that investment styles fit their clients’ investment objectives. For example, a mature pension fund may wish to build a defensive-style property fund, delivering secure income returns and low capital volatility.
Currently, much of the performance focus is upon relative return to a peer group benchmark. For example, a segregated pension fund valued at £300m will typically be measured relative to all pension fund portfolios within the IPD universe with a value between £100m and £500m. In fact, of all the pension fund portfolios within the IPD analysis service, 96% are benchmarked in this fashion.
In our view, these targets need to be viewed in risk-adjusted terms and we are seeking to quantify investment risk in order to achieve this. Clearly, risk-averse funds should be targeting more defensive strategies, and should adjust their target rate of return accordingly. It is probably more appropriate for defensive style funds to concentrate upon an absolute return target, rather than a relative benchmark.

Clear explanation
Using this methodology, a property fund manager can more clearly explain periods of relative outperformance or, as is often more important, poor years. For example, cyclically oriented portfolios will have provided strong returns in 1999 and 2000 as the London office market (a highly cyclical play) experienced its typical boom phase of the cycle. Defensively oriented portfolios will have underperformed in this period, but have been strong over the last half of 2001 and are likely to outperform this year.

Risk profile
We therefore profile our portfolios in terms of their risk profile, using a factor model to measure relative risk. We use an adapted asset pricing model, based upon the use of a risk-free market rate of return, adjusted by property-specific factors reflecting price volatility, income quality, building depreciation, and asset liquidity. First, this means that future returns can be measured relative to the risk of the asset, enabling investors to analyse risk-adjusted rates of return, rather than a nominal rate. Second, by weighting the factors above, we can categorise properties into particular return styles, and orient our portfolios accordingly, either driven by client preference or our top- down view.
In summary, this risk management approach enables investors to take a comparable approach to their property portfolios as to their equities, ensuring a consistent approach with regard to their key performance objectives and propensity for risk. Further research and development into delivering transparent performance measurement and risk assessment will ensure that property is viewed not merely as a cyclical performance play but as a key sector within a balanced fund.