Investment Appraisal

Prepared by: Dr. Roberto Garrone Date: 21st December 2013

Index

1. Methodology

2. UK Economy

3. UK Property Investment Market

4. Property Role in Multi Asset Portfolio

5. Portfolio Structure

6. Historical Series

7. Notes

1. Methodology Before giving any kind of advice on the portfolio we will first formulate a simple setup using as reference macro and micro data, then we evaluate the provided portfolio using the Black-Litterman asset allocation model in order to assess the behaviour of each asset class.

2. UK Economy

The current price of a bond ought to be equal to the discounted value of all future cash flows, then, other things being equal, a fall in the discount rate ought to lead to a rise in price. But are other things equal? Low real interest rates should suggest low expectations for future growth. This is true whether it is the result of supply and demand for savings or whether low rates has been engineered by Central Banks [ECO2].

The economy is growing, but the durability of the recovery will depend on the extent to which productivity grows up alongside demand. CPI inflation fell to 2.2% in October 2013. Although official statistics suggest that capital expenditure is yet to increase, companies’ investment has also improved on the back of reduced uncertainty and improved access to credit, as well as stronger demand prospects. But access to finance for small businesses remains constrained. Strong employment growth in the face of weak demand has weighed on productivity, unusually weak since 2008.

The necessary adjustments to indebtedness and competitiveness within the euro area could be a drag on growth. Regard to yields, at longer maturities, sovereign bond yields exhibit a high degree of correlation, mainly because investors see advanced-economy bonds with similar risk characteristics as close substitutes [BOE], [OECD],[CHOU].

3. UK Property Investment Market The top 10% of households own about 91,4% of outstanding stocks and mutual funds, up from 84,5% in 2001. The richest 1% owns almost half of all stocks and mutual funds [ECO1].

The property market, especially the residential sector, had inflated from 1990 until 2008, with a rate of growth in prices that cannot be compared with the rate of growth of wages. After the credit crunch in 2007 the mortgage banking sector had been experienced one of the longest period of tight liquidity. Today the investment market is dominated by two overriding themes. The first is the continued importance of foreign capital. This is particularly evident in the Central London office market where cross border flows accounted for 62% of all transactions in London in 2011. Another persistent feature of the investment market is the widening of the yield gap between prime and secondary property as the majority of investors focus on prime properties with long income streams. Whilst the number of banks actively lending to commercial property has not completely dried up, terms remain prohibitive on all but the best stock and in the short term this may exacerbate the prime/secondary divide [SAV],[RICS].

Commercial Sector

The yield improvements that had been restricted to prime properties are now being experienced across the quality and geographical spectrum. This is mainly for two reasons: the scarcity of prime continues, thus the definition of ‘secondary’ widens, and the downward shifts in prime yields required by persistent stock constraint. The UK's retail market was probably the hardest hit during the downturn as the high street and out of town markets saw the disappearance of a number of retailers. In the office sector the most successful regional office markets will still be the strong private sector towns and cities where public sector cuts are less relevant, all of the key cities have seen a supply fall over the last 12 months. The hotel sector has turned a corner with its sixth month of consecutive profit growth. Serviced apartments are finally evolving as a recognized sector in the UK as private equity funds enter the market through the creation of their own brands and operating platforms [SAV],[RICS].

Residential Sector

The improvement in market conditions is becoming more widespread. The pace of demand exceeded that of supply in every part of the country, pushing up prices. Certain policies such as the Bank of England’s Funding for Lending scheme, which has contributed to the current low level of mortgage rates, and the government’s Help to Buy scheme are helping to boost the demand for housing. In the rental market, conditions are little changed over the month, with landlord instructions more or less stable and moderating growth in tenant demand, partly because mortgage finance is becoming more readily available. Rent expectations are more or less unchanged from last months, and are expected to grow by 1.7% over the coming 12 months [SAV],[RICS].

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Regional Aspects

London has outperformed the rest of the UK since the middle of 2005, effectively on both sides of the downturn. In the residential sector, London and the South East remained the strongest performers. While prices continue to escalate in London, growing yields and affordable prices in Scotland are attracting capital from UK and international buyers, mainly because of the improved mortgage lending. In the London hotel sector, the ended Olympic Games are weighting on the operational performance but occupancy continues to improve. In the last ten years the London's principal shopping streets had increased their density of shops more than 50%; generally in the retail sector, despite a reduction in occupational demand, prime rents have continued to increase. The scarcity of investment stock coupled with increasing demand levels has pushed up the yields in the office sector, the proportion of investment outside London rise by 14%. Previously, from 2002 to 2007, the level of investment outside London accounted for two thirds of the total, since 2008 just to 50% [SAV],[RICS].

Considerations for future investments

The economic performance of today’s cities and regions could suggest a profitable strategy of investment. Clearly the outcomes of the different effects of globalization on any region or country will depend on the structure and history of the region, the actual scale of the local technological and institutional changes, the existing spatial structure and the extent of urban clustering. In advanced countries like United Kingdom, urban clustering is associated with the spatial concentration of particular types of high knowledge workers with the peculiarity of increased interregional mobility. In the last years we have seen an unprecedented level of urban

growth which is taking place at global scale. The economic tissue of a city or region may suggest the reasons: for small firms the local context is important as a source of both market knowledge and inputs while for large firms the local context serves to improve knowledge of specific inputs and the wider national and global context is the source for market knowledge. We already know that productivity is greater in dominant cities, we can also infer the importance of connectivity (a city is a connection hub for business relations, usually face to face, and a knowledge hub for the networks linking the global economy). Looking at numbers, recent studies suggest that a doubling of city size is associated with a productivity increase of 3-8%; of the world’s 75 highest productivity cities, 29 are small metro areas (<= 3 mln inhabitants) and 32 are medium-large metro areas (between 3 and 7 mln inhabitants). Since economic growth, both national and regional, is driven by rates of return on capital and not by productivity levels it seems that, among all the others, one important feature to determine urban scale, and thus possible growth for the property investment, is connectivity. Keeping in mind that local knowledge is a key factor, we should look at growing cities that expose the features of connectivity and (still increasing) productivity, presence of large firms and high knowledge workers. We can suggest as the main areas of investment infrastructure and retail for the long term and office for the short term, profiting from the relaxation of planning policy to convert residential space into office space. With investors focusing on the very narrow prime end of the market, we believe opportunities may exist in ‘good secondary’ properties. These properties are typically average quality property in a good location, where growth can be achieved by improving the quality of the income stream or the asset itself [SAV],[RICS], [GPRO],[UBSI].

4. Property Role in Multi Asset Portfolio Canada’s public pension funds (CPP Inv. Board, PSP Inv. and Ontario Teachers’ Pension Plan for instance) own assets all over the world, including property in Manhattan, utilities in Chile, international airports and railway connecting London to the Channel with returns well above 10%. They brought most of their investments in-house, reducing costs to a tenth [ECO3].

Property exhibits return-risk characteristics that can be, at some times, defined attractive but these features are strongly correlated with, among others, the country and the economy where the property is, the interest rates curve and the currency exposure. Depending on the emphasis put on return or risk, each of the above factors can improve or deteriorate a position in property. Direct property investment by financial institutions, insurance companies and pension funds differs in each country: in the UK the residential sector is scarcely considered while in France and Switzerland is quite common; therefore social, political and historical reasons are still dominating property investment. Computing average returns and standard deviations in different markets and times, with and without valuation smoothing and taking in account the illiquidity premium, points to figures that suggest yields and risks well below the ones of shares and bond. This result is coherent with the fact that usually property investment is leveraged. In fact, when geared, property in mean-variance context positions itself between bonds and shares. Other studies have explored the characteristics of property as a diversification asset, reporting correlation coefficients moderately positive or near zero but not stable over time. These results have been justified with theoretical considerations in three main areas: property market efficiency, index construction technique and adjustments in supply. The same results apply for commercial and residential sector, whilst the estimated weights in mixed asset portfolio are slightly different: in the UK, 20-25% for commercial and 20-30% for residential (because of higher yields). The indirect property investment, using REITS or property derivatives, usually is less correlated with direct markets and more influenced by stock market factors but, curiously, the correlation with shares lowers when REITS are degeared. One important clue of REITS is their level of floating-rate debt: a sudden rise in interest rates could reduce cash flows significantly, thus, most funds hold some interest rate caps on longer term floating rate debt. Another issue could be the sensitivity to interest rates: while theoretically REITS should be a hedge against inflation and rising interest rates, usually, when the slope increase, in the short term the shares of REITS drop. Conversely, when economy stagnates, secondary property is divested by small firms and traded at bargain prices, thus large funds can profit in the long term. We remember here that international real estate investment will not provide effective diversification for pension plans but could enhance returns when properly used and it is naturally currency edged when leveraged. It could be easier to diversify risk with a careful allocation of funds to sector and regions. For a small property fund we can suggest to use direct property investment to build wealth in the long term and to lower the risk profile of the portfolio whilst the indirect investment should be used to reduce the risk of the held assets when the volatility of the overall property market increase and could be part of a short term multi asset tactical strategy aimed at increasing performances and ranks. For instance, swapping all property returns for other asset classes: equities, using the stock index, or cash, using a borrowing rate; conversely increasing exposure

to real estate swapping a long position on a property index. For larger funds, indirect investment is more used with the aim of reducing running costs and specific risk [GPRO],[UBSI],[EFF],[PROP].

5. Portfolio Structure Pension investing is more a process of matching assets to liabilities, with the ultimate objective being to pay retirement income. Usually a young plan can afford greater risk because of longer time horizons. The solvency of pensions and insurers suffered as yields fell because it increased the present value of their liabilities, which were difficult to match with assets [ANONYMOUS].

We construct our benchmark portfolio using the following indexes: FTSE 100 for UK equities, RUSSELL 2000 Growth for Overseas equities, UK Debt Management Office Gilt Index for UK Gilts, NAREIT MIXED USE for Property and BoE Interest Rates for Cash. Each index is sampled monthly; since we have limited access to historical series we can use data just from April 98 to December 2008. We remember here that it should be better to use a longer period or a higher sampling rate. All returns are log returns. The weights for our equilibrium portfolio are assumed to be the same of the evaluated portfolio: 50% for equities, 15% for bonds, 5% for Property, 15% for overseas equities and 5% for cash. The proposed allocation, that it is assumed to be on efficient frontier, had not provided high returns and it is to be revised.

The table above reports the figures for the ten years considered, we use JS estimation to account for the effects of volatility.

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Since the portfolio should be considered for a pension fund, we first look at the effects of a returns shock: we see a -7.6% expected return. It is interesting to look at the effects of the 5% allocation in property: looking at the covariance of property we easily infer a lower performance. Indeed, the expected return decrease of 1.45%. We remember here that NAREIT indexes exhibit more volatility than transactions indexes because of its liquidity and the number of financial tools that are built on it. Using a transaction index the figures below can just improve, but historical series are not available.

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When the economy improves, or when we assume that our target expected log returns derived from the sampled means of the first table improve, we see that returns improve, resulting in a performance of 2,45% and up to 6%.

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We construct the efficient frontier using the same historical series and frequency of sample:

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Since we do not know the utility function required by the pension fund nor the restrictions on neither the assets

allocations nor the liabilities requirements we just analyze the efficient frontier and provide general suggestions [RMON],[CHOU],[PROP],[MOST]. As expected to increase returns we need to take in account more risk, faced with the problem to allocate 10% more we need to make some assumptions on the future economical conditions of UK and Europe. Given the long time horizon of a pension fund it seems that it could be wise to reinforce the positions in UK stocks or UK Corporate Bonds that still trade at bargain prices. Adding an asset, like UK Corporate Bonds, can just improve the performance of the fund but we are not aware if it is a feasible option. We assume that all the liabilities of the fund are set with the initial asset allocation and we suggest to have 25% more in cash than needed to fund all the liabilities (at the margin). The new suggested asset allocation is reported in the table above, individuated by the 10% return label; changing weights on assets require just 5 mln of the 100 mln provided by the merge, and we can expect to pay 5 mln in transaction cost and losses. The rest is evenly reinvested.

We summarize our proposal using the SWOT analysis above:

• Since the beneficiaries of the pension fund had already earned the right of receive the future payments we can think of the whole fund as long term bond, which performances will be mainly driven by interest rates behaviour: the return is the percentage change in the ratio (assets – liabilities) / assets and the risk is the change in its variance. Optimizing this performance is part of a well planned fund strategy.

• Define an investment horizon compatible with the expected returns and the desired risk of the beneficiaries of the pension fund, matching investment horizon and expected behaviour of interest rates is essential to provide the expected performance and it must be included in the fund strategy.

• Manage diversification: one option could be adding more asset classes. Since we already know that in case of economical shocks correlation tables are not reliable we base our decision on asset classes with high liquidity and anti cyclical features. Diversifying trough markets can just add complexity (for instance the need to adjust liabilities for currency hedging) and it not proved to be efficient. This will be part of the fund tactical and dynamic asset allocation.

• In source strategic services like stock picking, assets management and market analysis. • Relate the fund strategy to its performance, not just analyze the returns. Holding-based attribution

can provide valuable feedback to the fund strategy both in implemented positions and in forecasts. It has the advantage of being closely linked to the real economy [RMON],[CHOU].

• Buy low, sell high. Increase the role of property, keeping in account the points highlighted in Section 4.

6. Appendix

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7. Notes

Rics, www.rics.org, surveys, [RICS]

Savills, www.savills.com, research, [SAV]

The Economist, www.economist.com, 03/06/13, Buttonwood, [ECO1] 20/04/12, Buttonwood, [ECO2] 03/03/12, The Economist, [ECO3]

Bank of England, Inflation Report Nov 2013, [BOE]

OECD, www.oecd.org, statistical profiles, [OECD]

Morningstar Fund Report, www.morningstar.com, [MOST]

Ubs Asset Management, www.ubs.com, Pension Fund Indicators 2013, [UBSI]

Black-Litterman, www.blacklitterman.org, The Black Litterman Model in detail, [BLTM]

Running Money: Professional Portfolio Management, Stewart, [RMON]

Global Property Investment: Strategies, Structures, Decisions, Baum and Hartzell, [GPRO]

Bonds and Money Markets: Strategy, Trading, Analysis, Moorad Choudhry, [CHOU]

Efficiency in the UK commercial property market: A long-run perspective, Devaney, Holtemoller, Schulz, [EFF]

The Role of Property in Mixed assets Portfolio, Hoesli, MacGregor, Adair, Mac Greal, [PROP]