October 7, 2024
In his latest commentary for Property Week, Charles Allen, Head of European Real Estate discussed the potential of pooling UK pension funds to enable investment into high-quality assets central to the UK’s ESG agenda. Larger capital allocations could accelerate the modernisation of the built environment and address key areas like affordable housing and healthcare.
The UK real estate sector’s offer of long-term income generation, risk-adjusted returns and liability-matching qualities has always been attractive to pension schemes. The problem is that the offer has often been let down by poor-quality and mismanaged portfolios.
To address this, 86 local pension funds in England and Wales are now being pooled into eight massive funds with a combined £375bn under management. The pooling is enabling these funds to invest at scale in high-quality assets central to the UK’s ESG agenda.
Pooling has also enabled the Local Government Pension Scheme (LGPS) to enter partnerships with fund and investment managers to deliver on more specific and bespoke objectives, which has led to an increased appetite for alternative strategies such as affordable housing and healthcare.
This pooling agenda is resemblant of the models in Canada and Australia, where highly sophisticated mega funds can deploy large volumes of capital into real estate. For example, AustralianSuper acquired the government’s stake in King’s Cross Central for £371m in 2016. There were no UK funds in that bidding process.
Charles Allen, head of European real estate at asset manager Fiera Capital, says this mooted creation of a pooling model will be a “genuine paradigm shift that has the potential to accelerate the modernisation of the built environment [in the UK]”.
Similarly, Hugo Llewelyn, chief executive and founder of real estate investment manager Newcore Capital, says: “Pooling pension funds could reshape the investment strategy in UK real estate – similar to models in Canada and Australia – by enabling larger capital injections into key societal assets.”
Economic, social and environmental factors all represent a major part of the investment thesis of LGPS funds: rental property captures long-term, inflation-linked and defensive income streams; high-quality real estate is linked to social mobility; and it addresses the need to upgrade and retrofit UK real estate to future-proof against evolving legislation.
So partnerships between managers and large pension funds such as Northern LGPS, LGPS Central or Border to Coast are likely to be more demanding in both seeking returns and delivering ESG targets. Research from Octopus Investments, which was carried out among 27 UK LGPS schemes in April, reveals that almost all (96%) of LGPS schemes invest in clean or renewable energy, while 64% invest in sustainable infrastructure.
Key areas for social impact
Additionally, 60% have allocations in both affordable housing and healthcare, and 40% in natural capital. More specifically, in 63% of schemes, affordable housing – including mid-market rent, shared ownership and social housing – is considered the most important area for social impact.
Jack Burnham, head of affordable housing at Octopus, says: “We acknowledge the LGPS must balance the need to deliver ESG and impact alongside the need to meet its fiduciary duties. The delivery of ESG and impact objectives are not generally considered a substitute for financial returns and, as such, they play an ever-increasing role in decision-making for the LGPS.”
Dan Berger, director of property and funds at investment manager Delancey, says the state of UK housing offers an opportunity for the LGPS. “The urgent requirement to green our built environment, both through new development and the refurbishment of existing stock, is a huge opportunity for these funds to meet their strict ESG criteria and deliver long-term returns from an environmental, financial and social perspective,” he explains.
While investments in real estate from these funds are being made across all sectors, there is a preference for residential-rental and industrial strategies. This is because these sectors are benefiting from a structural undersupply of fit-for-purpose real estate.
“Exposure to ground-up development in the urban logistics, infrastructure and build-to-rent sectors is increasing, where these funds can access core and value-add returns through the development of real estate with best-in-class ESG credentials,” says Allen. “This represents a departure from a historic focus on investing in older, existing buildings.”
At UK real estate fund manager Moorfield Group, there is a preference for the living and storage sectors, with residential for rent a key area of focus. Its co-chief executive and chief investment officer Charles Ferguson-Davie says: “It is a huge market that is still in its infancy as an institutional investment product, with most investors underweight. There is an opportunity to develop new housing, which will have the best environmental credentials, but perhaps the bigger opportunity is to decarbonise the existing housing stock with energy efficiency enhancements – especially as high build costs make many new developments unviable, currently.”
In July, Legal & General (L&G) launched a new partnership with its L&G Affordable Housing Fund with an initial pipeline of 750 homes, supported by a £125m commitment from the LGPS and ACCESS.
Pete Gladwell, group social impact and investment director at L&G, says: “Pension fund investment can play a fundamental role in creating healthy, productive societies if it’s invested into assets like affordable housing and social or digital infrastructure that meets social need.
“We partner with central government and local and combined authorities to understand that social need, which enhances our impact and long-term risk-adjusted returns, and have seen increasing amounts of co-investment in this space from the LGPS with similar return horizons.”
Gladwell adds: “There’s no doubt that our values and credentials in the sustainability space have attracted much of the recent co-investment appetite we’ve seen from the LGPS, but also the likes of NEST and PGGM, in the build-to-rent space.”
‘Point of tension’
However, Llewelyn argues that pooling pension funds to enable large capital injections into key societal assets “is not a straightforward solution”. He adds that the appeal of lower management fees and faster decision-making is dependent on actual investment performance and the challenges posed by infrastructure projects – such as those seen with Thames Water.
“The LGPS should prioritise sustainable investment strategies that offer low leverage to effectively address these challenges, support local communities and fulfil their commitment to benefit their members financially,” says Llewelyn.
According to Berger, the extent to which the government is working with these pooled pension funds to ensure their investments align with regional housing needs is a “point of tension”. He adds: “The reality is that investment strategies must be guided by what is best for members, not local delivery targets.”
The LGPS is a defined-benefit (DB) pension scheme, which has traditionally been a long-term funder of UK property, but UK defined-contribution pension schemes are gradually replacing DB schemes.
“I wouldn’t say that we are seeing net inflows yet as the market is still impacted by the withdrawal of DB pension schemes, open-ended fund redemptions and reduced activity from councils,” says Ferguson-Davie. “This has particularly reduced investment into core and core-plus real estate opportunities. Hopefully, UK pension funds will support the delivery of UK infrastructure projects as well as domestic real estate investment as this will help support economic growth and create a virtuous cycle.”
At a time when it may be difficult to persuade international investors to buy in the UK, Ferguson-Davie says the UK needs its domestic institutions to be encouraged to do so, whether that be in the UK listed sector, where domestic pension fund investment is far lower than in other countries, or in private markets. He adds: “Now would be a good time for UK pension funds to invest in real estate in the UK as we are on the cusp of the market turning.”