Core assets, transparency and ease of access are often sought in the early phases of international diversification.

At Natixis Investment Managers, we are convinced that diversification into international real estate makes sense for European pension funds. Although real estate is popular with institutional investors, international diversification is still relatively low. Take Switzerland, where most of my own clients are based: more than 88% of the real estate assets of Swiss pension funds – CHF185 billion out of a total of CHF209 billion (according to provisional data for 2020 from the Swiss Federal Statistical Office) – is made up of domestic real estate, both direct or indirect. This lack of diversification has not actually been detrimental given the steep rise in Swiss real estate valuations over the last couple of decades.

In fact, most Swiss institutions are highly satisfied with the performance of their concentrated real estate portfolios. But this performance is unlikely to be repeated and concentration of assets may no longer be beneficial. A decline in yields, excessive prices and the difficulty in finding attractive assets in the Swiss market now make a strong case for new money to flow to markets with higher yields and more affordable prices. So how can institutions achieve better geographical diversification and an improvement in yields?

Four Ways of Diversifying Real Estate

Pension schemes with substantial assets and investment resources can diversify through direct investment in foreign real estate. For the majority of schemes, however, international diversification is only possible through a variety of collective schemes. There are four main types of collective investment vehicles:

  1. Real Estate Investment Trusts (REITs), which top allocations among Swiss institutions.
  2. Private Equity Real Estate funds
  3. Diversified funds of real estate funds
  4. Open-ended real estate funds
The first three options have their advantages, but they also have serious disadvantages, which in our view explain the still limited development of this asset class within Swiss pension funds.

Pros and Cons of Each Approach
REITs have the advantage of liquidity but, being listed real estate companies, they also have the disadvantage of volatility. Thus, it was not unusual to see REITs lose 25% to 30% of their value in the first quarter of 2020, even though the funds were counting on real estate to stabilize their assets and, by extension, their coverage level.

Meanwhile, private equity real estate has the advantage of providing access to specific real estate segments such as value-add and opportunistic. These segments often have high performance potential, aiming to create value through the transformation or conversion of buildings, or even the complete redevelopment of sites or districts.

The disadvantages of these funds are the lock-up periods which tend to be 10 to 12 years and, above all, the high levels of leverage which can exceed 50%. These factors make it impossible to classify them as international real estate in an asset allocation, but rather as private equity, which resides in the alternative investments pocket.

In our view, private equity real estate is generally suitable for large institutions that are able to deploy capital in a highly-targeted manner in specific sectors or regions, but less so for medium-sized institutions or those with limited resources taking their first steps towards international diversification.

Then there are diversified funds of funds. These have the advantage of simplicity of implementation and a degree of liquidity, but the disadvantage of piling up management fees. These fees range from 1.5% to 2% or even more if the TER of the underlying funds is included. There can also be a geographical or sectoral diversification that is sometimes much greater than that initially sought by the fund. Would a pension fund wishing to expand its real estate investments beyond the Lake Geneva region wish to invest in shopping centers in Florida, offices in Barcelona or logistics warehouses in South Korea? Not necessarily because, for the trustee boards, without necessarily being hostile to this type of diversification, it is difficult to assess the risks involved.

The Case for an 0pen-Ended Approach
In our opinion, simple open-ended funds dedicated to core or residential real estate can be an efficient way to meet the desire for international diversification of real estate investments in the current uncertain economic environment. However, they currently represent only a small part of the available offer to institutions.

This shortage of supply is why we have developed, together with our real estate affiliate AEW, a new approach tailored to European institutional investors, focused on quality European residential real estate.

It has quarterly liquidity after the initial two-year period. It aims for a stable and regular, yet attractive, return and has a degressive pricing structure in line with Swiss equivalents. The debt ratio will usually be just 30% to 35%, with a maximum 40%, which is in line with the Swiss rules on the classification of real estate investments.

AEW’s Broad Platform
The investment team is based in Paris where AEW Europe has its headquarters. With more than 40 years of experience in the industry, including 25 years in Europe, AEW is one of the world’s leading real estate investment companies. It has more than €77billion of real estate assets under management, including approximately €37billion of European real estate and €4 billion of European residential real estate.

AEW employs nearly 800 professionals worldwide, with 440 based in 10 European countries. The group’s size and experience give it privileged access to off-market transactions (40% to 60% of completed transactions), which favour low acquisition costs.

Furthermore, AEW is a member of the Global Real Estate Sustainable Benchmark (GRESB) and its approach integrates concrete sustainability objectives (objective: Article 8 SFDR/4 GRESB stars on a scale of 1 to 5, 5 being the maximum).

Diversification and Future-Proofing
The strength of AEW’s resources mean it can invest across sectors and countries in Europe on a single platform. The team will invest primarily in Germany and France (50%-60%), but also in the Benelux countries (10%-20%), Italy, Portugal and Spain (0-15%) and possibly in other countries in the eurozone (0-15%).

Investments will be mainly in quality residential real estate in sought-after areas (80%), plus a maximum of 20% in student housing, senior housing or co-living in urban areas benefiting from regeneration.

It is expected that 40% of the investments will be made into existing real estate and 60% will be into ongoing projects. This combination allows the construction of a real estate portfolio which corresponds to both current and future environmental standards.

Expected Yield Designed to Meet Institutional Needs
So will an open-ended approach with international diversification provide the yield and consistency of return that institutions need?

We think so, particularly if we look at a previous, similar strategy launched by AEW, which raised and deployed some €600m. The target size of the new approach is a minimum of €1bn, with deployment of capital over a four-year investment period.

The investment team targets a rental yield of 3.5% and an internal rate of return (IRR) of 6%*. We believe this meets the income needs of a great many Swiss and European pension schemes.

Published in January 2022
* Investment strategies mentioned include a risk of capital loss. Target returns are indicative and not guaranteed.


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This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

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