REAL ESTATERoundtable

HOT PROPERTY The Rise of Real Estate in DB Pension Plans

Just a decade ago, real estate was considered an alternative asset class — the domain of big investors with deep pockets, who snap up properties around the world. Much has changed in the years since then — today, real estate has grown and evolved to play a much more significant role for defined benefit pension plans in Canada, both large and small. As the universe of products has expanded, so too has access to this important asset class. And it couldn’t have happened at a better time — real estate returns have been stellar over the last few years. Real estate has also proven to be an excellent match for long-term liabilities at a time when bond yields are at historic lows.

In this roundtable discussion, experts share their views on the past, present and future of real estate in Canadian pension plans. Where does it fit in

the typical pension portfolio now — and how are plan sponsors using it differently today than they did in the past? Going forward, how will real estate continue to perform in an era of rising rates and slowing economic growth?

2 Sponsored Supplement Real Estate Roundtable

EXPERT PANEL:

BEN ABRAMOVAssociate Partner

Aon Hewitt

TRACEY LUKEDirector, Product Management

Invesco Real Estate

LUIGI LUPPIDirector, New Business and Investor Services

Morguard

MIKE MORRISONDirector of Real Estate Investor Relations

Fidelity International

DEREK WARRENAssistant Vice President

Lincluden Investment Management

PAUL ZEMLAChief Investment Officer

Bentall Kennedy Canada

NEIL CABLEHead of European Real Estate Investments

Fidelity International

MICHAEL PECKSenior Vice President, Head of Canadian Institutional

Invesco Canada

PHILIP (PHIL) GILLINSenior Managing Director and Portfolio Manager, Canadian Property Investments

Sun Life Investment Management

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Over the last decade, has the role of real estate evolved within Canadian

pension plans?

BEN ABRAMOVIn Canada, the very large plans saw the benefits of real estate early on — they’ve since evolved from investing through managers to become direct global players in the real estate field, with some plans, like OMERS-Oxford Properties, becoming essentially internalized REITs and managers themselves. Smaller plans have been slowly getting into real estate. They might have seen it as an alternative in the past, but, as they see the potential returns and as equity and bond markets look less promising, they’re making much larger allocations.

TRACEY LUKEBoth large and small plans have begun to understand the benefits of real estate. According to a Preqin study, the top three reasons investors look at real estate is for the diversification, the inflation hedging and steady income. I also think real estate’s become more accessible. Smaller plans can now invest in global real estate through global funds — they don’t need to have extensive internal resources to invest directly into global real estate.

MICHAEL PECKSo far the conversation’s revolved around the asset side, but a big part of the growth over the last decade has come from an increasing focus on pension plan liabilities and liability-driven investing. Real estate is a really good match for liabilities, and can act as a partial substitute

for fixed income. Some pension plans are also using real estate to deliver a little bit of growth.

PAUL ZEMLAReal estate used to be considered an alternative asset class, but over the last decade or more it’s become a widely accepted, core asset class for most pension funds. Real estate is a hard asset that provides a stable income return, with potential for capital appreciation over time and the opportunity to match, or even exceed, inflation. In addition, you can employ active management in the real estate sector to increase the performance of assets over time and drive returns. And, over the past decade, you have seen Canadian pension funds steadily increase their weighting to real estate as the asset class continues to perform.

What can smaller plans learn from large Canadian plans in terms of how

they are approaching real estate?

TRACEY LUKELarge plans around the world have used pooled or co-mingled strategies as a way to learn a market, to get to know the managers and players within these markets. They’re then in a better position to move to co-investments and even direct ownership. Pooled strategies are an excellent starting point for smaller plans without the resources to build a global real estate portfolio, especially because there are more products than there were even five years ago.

MICHAEL PECKSmaller pension plans always try to emulate the large plans, but there are internal resourcing and governance issues. They often don’t have the talent, the skill set,

Both large and small plans

have begun to understand

the benefits of real estate.

— TRACEY LUKE

Foreign currency risk in

the real estate market is

also difficult to manage — in

order to hedge your residual

value, you have to know when

you’re going to sell.

— PHIL GILLIN

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the human capital inside the organization to actually make real estate decisions effectively. They’re stretched. For them, it goes back to vehicles — and there are a plethora of them out there that they can take a look at.

LUIGI LUPPISmaller plans are no different than larger plans when it comes to the role of real estate as part of their investment portfolio. The difference, however, is how the smaller plans access products and, ultimately, get comfortable with the investment risk.

BEN ABRAMOVBig plans are generally early entrants. They have large pools of capital and also have people on the ground in centres where they invest — London, Asia, Latin America. It means they have a different level of confidence that smaller plans will take more time to develop, especially because these asset classes have an inherent lack of data and transparency. As the smaller plans see their larger peers making inroads, it provides an additional layer of comfort for smaller plans. It’s not just in real estate — we’ve seen it in infrastructure, private equity, hedge funds, et cetera.

What are some of the barriers for Canadian plans when it comes to

global real estate?

MIKE MORRISONI think it’s very difficult to build a global direct real estate portfolio. In some areas of the world, such as Asia, you have issues with transparency, compliance,

governance and the legal framework. Tax is another big area — a number of institutions that have invested into Europe through offshore structures are now thinking about how to exit those assets. They are having to look very closely at the structure, in particular [at] real estate transfer tax and withholding tax.

PHIL GILLINCurrency, taxation and market knowledge are all major hurdles, especially in the U.S., where Canadian investors are subject to heavy taxation they aren’t subject to in Canada. In some jurisdictions, it’s impossible for foreigners to own real estate at all. Foreign currency risk in the real estate market is also difficult to manage — in order to hedge your residual value, you have to know when you’re going to sell. And not all investors are prepared to make that commitment. And while cash flows can be fairly consistent, it’s hard to hedge things like re-leasing risk.

LUIGI LUPPIThe Canadian real estate market is traditionally considered small compared to the total amount of investment activity internationally. Due to increasing allocations to alternative assets, some of the large Canadian pension fund investors had to move outside Canada simply because the amount of capital they

The Internet is shaping

real estate — how it

interacts with the high-

street shopper, for example,

is already affecting where

buildings are located, how they

are being built and then used.

— MIKE MORRISON

We see a risk of a housing

correction. However,

most plans do not have direct

exposure to the homebuilding

and condo markets.

— DEREK WARREN

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have to invest in real estate is not matched by the product available domestically. Other barriers plans face are the limited transparency of some of the foreign markets, tax and legal considerations, deal execution and country-specific expectations when partnering in investment platforms.

BEN ABRAMOVAlthough pension funds invest globally in fixed income, hedge funds and private equity, real estate is perhaps the furthest behind when it comes to globalization — there’s still a significant home market bias. Keep in mind that real estate is very much a local business and fundamentals tend to be very local in nature. It’s also hard to buy and sell real estate if you’re not on the ground in that region. As a result, there are no global private real estate managers in Canada — most managers focus on Canadian real estate only. Tax and structuring can also be a major barrier for investors. Some tax and investment structures take a long time for investors to digest and can be a major deterrent.

What is the role of real estate in a pension portfolio?

PAUL ZEMLAIn our view, real estate has become a key, core holding for Canadian pension investors. It has strong income characteristics and potential for capital appreciation over time. Years ago, illiquidity was one of the negative aspects of real estate that investors would point to as a particular risk. Today, the focus is likely a little different. Real estate isn’t necessarily the first thing a pension fund would or should sell out of its portfolio. It has now

become a large part of most pension portfolios because it has characteristics that match the plan’s liabilities over the long term — so short-term liquidity is much less of a concern.

BEN ABRAMOVAt the end of the day, it’s about dampening volatility during market downturns, but with better returns than fixed income — and providing diversification. Plan sponsors could also consider a core plus approach to generate added returns, but keep in mind that this type of real estate should play a different role in the portfolio. Non-core strategies could generate high returns but also with high risk — you need to be mindful that a return-seeking real estate approach means you’re not just looking for beta; you’re seeking alpha.

DEREK WARRENWe’re seeing interest on the REIT side too. Investing in real estate through a REIT can provide transparency and liquidity. Some plans will pair REITs and direct investments to add a layer of flexibility. In the United States, most of the pension plans will have 10 to 15 percent of the real estate allocation in real estate equities. But the U.S. REIT market is more advanced, more mature.

MIKE MORRISONThe concern that I have is that time horizons can be different for fund managers than for institutions, which inherently should be longer term. We have seen a lot of co-investment deals agreed on between closed end funds and investors. It will be interesting to see how these exit because I’m not convinced the parties always have the same expectations.

TRACEY LUKEReal estate provides diversification benefits and can dampen volatility in a multi-asset class portfolio. That

There’s been an enormous

oddity in this real estate

cycle that has never really

happened before — the vast

price gap between prime

property and everything else.

— NEIL CABLE

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being said, pension plans should approach real estate with a long-term mindset. In order to fully realize the diversification benefits, you can’t really “time” the market — you need to realize there will be ups and downs. This may become more relevant as we see a divergence in monetary policy and economic outlook across different markets going forward.

How will a a less-than-rosy economic outlook in Canada and around the

world impact real estate performace?

PHIL GILLINObviously, economic activity drives true demand for real estate because, at the end of the day, the tenant is

at the centre of it all. Robust economic growth drives strong real estate values and returns — similarly, weaker economic growth will dampen those returns.

BEN ABRAMOVOur internal forecasts for real estate returns over the next 10 years show a 6% to 7% net expected return for the majority of OECD markets. Returns will vary across countries and that is net of fees. That’s with an inflation assumption of 1.8% for Canada. It’s certainly not terrible, but it’s a lot lower than it has been over recent history in Canada. Our reasoning for the forecast is that yields are already relatively compressed. A significant component of the positive return we’ve seen in real estate was due to capitalization (cap) rate compression. Going forward, cap rates will not likely compress further, and net income growth is also expected going to be growing slower.

NEIL CABLEThat’s actually a pretty strong real return for any asset class over the long term.

BEN ABRAMOVEven though the future expected returns in real estate are lower than recent history, they are reasonably attractive, especially relative to other asset classes. Once you include the benefit of diversification, it still merits a sizeable allocation in a portfolio.

MICHAEL PECKGiven what could happen to bonds in a rising rate environment and with 1.8 % inflation, bond returns can become negative for investors. Real estate in this context looks really attractive. And, if you could hold on for the long term to take advantage of the typical growth in net operating incomes, that’s a compelling advantage relative to bonds.

PAUL ZEMLAReal estate simply houses the economy. So, while a less-than-rosy economic outlook will certainly have an effect in the longer term, we think real estate will, to some extent and in the nearer term, be insulated from slowing growth simply because it’s structured through leases with a longer-term commitment and, typically, built-in rent escalations. This is, in part, why you don’t see real estate react to the ups and downs of the economy quite as significantly and with as much volatility as we see from some of the other asset classes. What slowing growth does is affect speculative development. As a case in point, there is no question challenges in the energy markets are affecting the Alberta real estate markets, and particularly office space. It has certainly put a pause on development, not to mention the pressure on existing assets.

Canadian real estate

investors really need to

look at global diversification.

They need to ensure their

portfolios are exposed to

different growth drivers,

different economies, because

that lessens the impact of

single country risk.

— MICHAEL PECK

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What’s the outlook for real estate in a rising rate environment?

TRACEY LUKEWill we see real estate returns moderate? Absolutely. But will values decline? That depends on the ability for net operating income growth to offset outward yield movement.

PHIL GILLINInterest rates are probably at the top of most folks’ list as far as risk, but rising rates have the potential to affect virtually every asset class. And rising rates are also likely to come with some economic growth, which is obviously good for real estate.

NEIL CABLEThere’s been an enormous oddity in this real estate cycle that has never really happened before — the vast price gap between prime property and everything else. The note of caution would be to watch out if you’ve got a big exposure to prime assets. There has been a huge amount of foreign investment in the top five cities

in Europe, so cap rates are now well below 4% in some cases. After expenses and fees, you can see the growth is already behind you to a large extent in those markets.

DEREK WARRENWe are not seeing a lot of inflation pressure currently and, as a result, we would expect any rise in interest rates to be modest and gradual over time. In that environment, we would expect REITs to perform quite well — yield will remain extremely attractive compared to bonds and traditional equities. If this scenario unfolds as we expect, investors will need to pick their places — quality holdings and appropriate levels of leverage will be key determinants of success.

PAUL ZEMLAThis is where real estate expertise and strong management can help. Even in the face of rising rates, with real estate you can actually get your hands in there and affect the performance of the asset. You can reposition real estate, choose to lease or not to lease, choose to spend capital or not spend capital. And you can improve it over time. This isn’t typically the case with stocks or bonds.

Is there a risk of a Canadian housing correction and could it impact the

kinds of investments that Canadian plans are making?

BEN ABRAMOVEven though there is little direct connection between residential real estate and commercial real estate, the main concern is contagion. If there is a housing correction, my guess is it will drag down the rest

Plans normally start

investing indirectly,

and move to more direct

structures as they become

more comfortable with the

asset class.

— LUIGI LUPPI

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of the economy. Look at all the cranes out here in Toronto and then figure how much of the economy and GDP growth is coming from residential real estate construction. If all those jobs are eliminated, what economic impact will it have and how is it going to affect demand for office buildings, industrial buildings and retail consumption?

DEREK WARRENWe see a risk of a housing correction. However, most plans do not have direct exposure to the homebuilding and condo markets. They look for the the cash flow that comes via multi-family rental. As rental apartments tend to be older buildings at a price point far below the cost to buy a home, a housing correction is not a large source of risk to most portfolios. House prices would have to experience a very deep correction before apartment dwellers would leave their rental apartments to all buy houses. I just don’t see that happening.

LUIGI LUPPIDue to strong immigration growth and consequent rental demand, the multi-residential market in Canada remains one of the key strategic investments for Canadian plans. This is due to the inherent stability of the residential sector. Also, demand-supply imbalances will support the growth of rent, although this could happen at a slower pace than in previous years. And, as concerns over housing affordability grow, a rising number of Canadian households are choosing to rent rather than buy.

How are pension plans investing in real estate — direct, indirect?

PAUL ZEMLACanadian Pension Funds who are of a large enough scale have generally chosen to invest in direct real estate, deploying a myriad of strategies across various product types and geographies. For those who don’t have the scale for large, direct investment programs, many have chosen commingled vehicles such as open funds that allow for diversification by owning units in a vehicle with a diverse holding of a number of real estate assets, rather than consider investing in REITs.

PHIL GILLINThere are a number of institutional and individual investors who have chosen the indirect investment approach through REITs as a way to access real estate. They offer the benefits of diversification that Paul describes, along with greater liquidity through the public markets.

DEREK WARRENInvestors can use both. Those using REITs as a pure proxy for real estate have a long-term view and understand that they have more short-term volatility than direct property. But they also provide similar exposure over the long term. By using both, plans have the flexibility to find underpriced assets. That is because REITs and direct markets can be over or underpriced at different times.

LUIGI LUPPIThere are obviously advantages and disadvantages to using direct and indirect strategies. This is, ultimately, a trade-off between control and liquidity. Direct real estate can allow plans to invest in specific asset classes in targeted markets, but these strategies are management-intensive and have exit risk. In pooled funds — open and closed — investors share the risk and rewards of owning real estate, with the added ability to liquidate the investment by selling a share of the fund. Pooled investments are fairly diversified, but investors have less control over the asset. Plans normally start investing indirectly, and move to more direct structures as they become more comfortable with the asset class.

NEIL CABLEPeople used to use REITs as a proxy for physical real estate, but today hardly anyone does that because of

Real estate is perhaps

the furthest behind when

it comes to globalization —

there’s still a significant home

market bias.

— BEN ABRAMOV

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the high correlation with underlying equity markets. However REITs make sense in some difficult-to-enter markets, like Asia. For other markets like Western Europe, Canada and Australia, roughly two-thirds of returns comes from income, not capital growth.

MICHAEL PECKPension plans are taking both routes to investing in real estate. REITs can play a role in a portfolio. But if the plan sponsor is investing in real estate for protection and stability when markets are bumpy, it’s not going to give it to them. REITs tend to behave more like stocks and trade like stocks — I worry that people don’t understand that, sometimes.

What are the big risks you see in the real estate space right now?

DEREK WARRENThe first thing I look at is debt — it is so cheap right now that it’s tempting to lever up to increase returns. History has proven that that can be very dangerous. This is a big question for pension funds — if they are going to use leverage and, if so, how much?

BEN ABRAMOVObsolescence and technology risks are are always present, especially as Internet sales are taking a bigger bite out of retailers and require different logistics centres. At the same time, office tenants are demanding different space than they were before. Liquidity risk is a big one. Will you need money at the worst possible time? Would you be able to get your assets out and the capital out? Vintage is another possible risk if you’ve invested in closed-end funds. Are you going to put all your capital

into 2015-2016 vintage funds at the top of the market, or do you think about diversifying over a period of time?

TRACEY LUKEDuration is a key theme for us this year — how do we position our core portfolio to endure headwinds? Do we blend and extend leases? Is it time to sell assets we don’t want to own through the next cycle? We also need to be aware of where we are in the economic cycle. That being said, the biggest risk we all face is a prolonged lack of global economic growth.

MICHAEL PECKBut how do you mitigate some of these risks? Canadian real estate investors really need to look at global diversification. They need to ensure their portfolios are exposed to different growth drivers, different economies, because that lessens the impact of single country risk. Many of the same benefits that we all intuitively understand when looking at the benefits of global equity investing apply to global real estate. So, too much home country bias may not be beneficial.

MIKE MORRISONOne way to mitigate risks is to look at the trends that are shaping the future and respond to them. The Internet is shaping real estate — how it interacts with the high-street shopper, for example, is already affecting where buildings are located, how they are being built and then used. I think the U.K. is slightly ahead of the curve here, but Europe will catch up. How space is used will continue to offer opportunities (and risks). There is also a trend towards greater urbanization in Western Europe. Cities that have well-supported infrastructure will continue to see success. So, there are lots of reasons that make me very excited to be involved in this industry. Of course there are risks involved, but we shouldn’t underestimate the enormous opportunities in the changing market. l

Real estate is a hard asset

that provides a stable

income return, with potential

for capital appreciation over

time and the opportunity to

match, or even exceed, inflation.

— PAUL ZEMLA

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Bentall Kennedy is one of North America’s largest real estate investment advisors and one of its foremost providers of real estate services. Bentall Kennedy is a recognized global leader in Responsible Property Investing, currently ranked first globally in its category in the Global Real Estate Sustainability Benchmark (GRESB) study, the broadest measure of governance quality and sustainability performance in the global real estate industry. Bentall Kennedy is a member of UN Principles for Responsible Investment (PRI) and has received the Energy Star Partner of The Year—Sustained Excellence Award for the past 5 years.

The Sun Life Investment Management group of institutional investment management companies comprises Bentall Kennedy Group in North America, Prime Advisors, Inc. and Ryan Labs Asset Management Inc. in the United States, and Sun Life Investment Management Inc. in Canada. These operations have combined third-party assets under management of over $55 billion, as of September 30, 2015. Sun Life Investment Management is supported by the investment division of Sun Life Assurance Company of Canada that manages over $134 billion in assets under management for the Sun Life Financial group of companies as of September 30, 2015.

With approximately US$756 billion† in assets under management and offices in 20 countries, Invesco is a leading independent global investment management company.

Invesco provides a comprehensive array of investment vehicles for institutional, retail and high-net-worth investors across Canada and around the world. Our specialized investment teams deliver diversified strategies, ranging from equities and fixed income to alternatives, including real estate, private equity and risk parity.

With extensive experience in the pension market and in-depth knowledge of regulatory and market environments, we understand what it takes to help plan sponsors meet their fiduciary obligations. Engaging clients and consultants as partners, we tailor solutions to their unique needs to seek a sound financial future for the individuals and institutions we serve.

www.institutional.invesco.ca

† As at September 30, 2015.

Fidelity Investments Canada Institutional is focused on serving the needs of institutional investors. We provide world-class investment solutions for corporate and public defined benefit and defined contribution plans, endowments and foundations, insurance companies, and financial institutions. We offer dedicated service and multi-asset class active and risk-controlled disciplines including; Canadian, U.S., global and international equity, fixed-income, real estate, asset allocation and custom solutions.

Philosophy and ApproachAt Fidelity, the cornerstone of our investment philosophy is a belief that outstanding research drives results, and we are guided by two simple goals: superior investment performance and exceptional client service.

We offer our clients a number of advantages for a successful outcome:• A commitment to understanding each client’s business, goals

and expectations• A client-service culture premised on accountability,

accessibility and transparency

Morguard is a fully integrated real estate company. We own, manage, and invest in high-quality, well-located, geographically diversified assets across North America.

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