Richard Ziman, chairman and chief executive officer at Arden Realty, southern California's largest owner of office property, says the worst joint venture partner he ever had was a pension fund. At the height of the last property boom, he had an offer to buy out a development for more than 50 per cent above its recent purchase price. His joint venture partner, however, refused to sell. "He thought the market was going like this," Mr Ziman says, forming an endless upward slope with his hand. Pension funds, Mr Ziman argues, should not own property. They have neither the management infrastructure nor the entrepreneurial culture needed to get the best out of real estate.
However unhelpful Mr Ziman's sentiments may be for the property market, they are hardly his alone. The collapse of US and European real estate markets in the early 1990s has forced many smaller pension funds to withdraw from direct property investment. Moreover, the rise of the real estate operating company - companies that attempt to achieve outperformance through intensive management of property - raise questions about whether pension funds ought to be the direct owners of real estate at all.
"Pension funds were sold a bill of goods to invest in this asset class called real estate," says John Lutzius, an analyst at Green Street Advisors, a California real estate securities research firm. "I think they have been misled."
Mr Lutzius says property has been treated as a separate asset class because of historical data suggesting its returns are less volatile than those of equities or bonds. However, he says, the absence of volatility may really reflect the illiquidity of real estate when markets collapse. Moreover, property appraisal is backward looking, reflecting the last price at which similar properties changed hands. Appraisal, Mr Lutzius argues, is a lagging indicator which understates volatility in fast-moving markets.
Analysis of real estate volatility, both in the US and the UK, suggests it is indeed less volatile than stocks or bonds. But in both markets, it underperforms.
Robin Goodchild, research director at CIN LaSalle, manager of £1.8 billion sterling in pension fund property assets, notes that the standard deviation in property returns, as measured by the Investment Property Databank Index, is 0.2 per cent, against 0.6 per cent for bonds and 0.8 per cent for equities. "But reduction in volatility is not enough when you consider the reduction in returns," he says.
According to data from WM Company, the performance measurement service, UK property has returned an average 10.5 per cent annually over the past 20 years, while UK bonds have returned 12.7 per cent and UK equities 17.7 per cent. Government bonds, a risk-free investment with almost no management costs, offer better returns than property. Why invest in property at all?
In the US, history is similar, according to Property & Portfolio Research, a Boston-based advisory firm. Between 1982 and 1997, the firm's bespoke property index shows annualised returns of 7.3 per cent against the Lehman Brothers Government/Corporate Bond Index which showed annualised returns of 11.7 per cent. The S&P 500 Stock Index had annualised returns of 18.0 per cent during that period.
Indeed, the UK data show pension funds cannot even match these admittedly low returns. According to IPD, UK pension funds did worst as real estate owners between 1980 and 1997. While the industry achieved average annualised returns in that time of 10.1 per cent, pension funds earned only 9.7 per cent, well below the 11.3 per cent returns earned by "other" managers - a category that includes property companies. Pension funds have only managed to outperform the IPD index in four of the last 17 years, their data show.
Mr Goodchild argues that property is a different animal to bonds or equities, and notes that between 1971 and 1998 it has outperformed both in each of eight years. "Profits lead earlier in the economic cycle," he says. "Rents come later."
Real estate is an asset that, like equities, moves with inflation and economic growth, two levers driving pension fund liabilities, Mr Goodchild says. Moreover, the traditional long-term UK lease means property will always pay out cash, unlike equities which may withhold dividends.
But if there is a demise of the UK "institutional" lease, which requires the tenant to bear all of a building's occupancy risks, the argument for UK pension fund investment in property is much less strong, Mr Goodchild concedes. Pension funds are clearly unable to run their estates to achieve economies of scale or customer-driven marketing strategies.
"For a pension fund, that is a high-risk strategy," he concedes. Indeed, as property ownership may prove to be altogether.
