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Buying overseas
Local Government Chronicle Finance Supplement–16 November 2006

Foreign property isn't the sole preserve of rich couples on reality TV... pension funds should also be looking further afield, says Mark Smulian

Should a council pension fund own a supermarket in Sorrento, or an office block in Ostrava?

Overseas property is becoming a serious option for those seeking to diversify from equity investments.

But if a fund prefers to stick to UK property, it will find a new vehicle available from 1 January, the real estate investment trust - or Reit.

The arrival of Reits and the rise of overseas property as an investment option are indications of the prominence that bricks and mortar will assume in pension portfolios.

Overseas property investment has, perhaps, been seen as complex, risky and of little interest to council pension funds that have had ample opportunities in UK property. But the search for diversification makes the previously exotic seem normal, and Lancashire CC's fund is among those that are looking hard at what is on offer.

Finance director Jim Edney says: "Overseas property is on the agenda because of the need to diversify into different investments. Looking at how the property market has developed in some parts of the world, it seems there are opportunities there to gain a very good return.

"It is an aspect of globalisation, and I'm struck by the returns offered, probably in Europe first then elsewhere."

Mr Edney says the growth of firms expert in advising on overseas property markets has eased the way for council funds whose managers might struggle to understand several dozen foreign tax and legal systems.

Even so, he prefers something familiar. "The EU is a more attractive prospect than elsewhere because of the relative familiarity of the legal and tax systems, and there is strong interest in rising property values in eastern Europe," he says.

"Caution is essential though and it dictates a desire to pool funds to spread risks.

"Indirect investment means we can buy into larger scale property than we could on our own - shopping centres for example - and there are experts managing the funds for us."

David Hemmings, fund manager at Henderson Global Investors, runs a fund of funds for overseas property.

This works like any other fund of funds in that it seeks out opportunities abroad that appear to offer good returns and puts client's money into them.

"We have seen a lot of interest in Europe," he says. "Our challenge is to create a vehicle constructed for long term returns and which reduces risk.

"It is a huge market with a lot of different legal systems from Portugal to Germany and to be an expert on it all and on the legal and tax systems would be very difficult."

The solution is for Henderson to partner local experts and to avoid the wilder claims some might make for their prospects.

Mr Hemmings says: "We will use our fund of funds in a way that might mean we miss out on the very high returns in the 20-40% range, but we will try not to lose 20-40% either.

"Returns are good in the UK with yields around 5%, but in European property 5% is more like a minimum."

He has 470 funds to choose from and as well as the properties they own, looks at the calibre of their management and whether that will "still be good in 10 years' time".

Henderson's core investments go into western Europe, and despite most of the continent's east now being in the European union, he is cautious about this less well-established market.

"I should be concerned if a fund was in speculative projects in eastern Europe, because the risks are very high," he says.

"Eastern Europe is not generally appropriate, though that may change over time.

"We are also looking to Asia and America, on the same fund of fund basis, but UK investors tend to look at Europe first."

Henderson's fund is 'open ended', that is, it and offers liquidity so that "investors can come in and out of it and dip a toe in the water if they want to," Mr Hemmings says.

Meanwhile, the arrival of Reits brings the UK into line with property investment rules in other major economies.

A Reit will be a quoted company that owns and manages property, and must distribute at least 90% of its taxable income to shareholders. In return, it will be largely exempt from corporation tax.

This means investors will no longer suffer from what has been a drawback to investment in property funds - double taxation caused when the property company pays corporation tax and then pays a dividend to investors on which they are in turn taxed.

Investors should therefore find returns from investment in property funds become closer to those from direct ownership.

They will also benefit from liquidity, as investments in Reits can be easily bought and sold.

Many large property companies are expected to convert themselves to Reits from 1 January.

Michael Patrick, business development manager at Legal & General Property, expects most prominent property companies will rapidly convert to Reit status "because of the tax advantages".

Given the usually upward movement of the property market, the '90% rule' means that "there should be high pay-outs resulting that could be very attractive", he says.

Mr Patrick explains: "I would expect Reits to become part of the equity portfolio of funds for large investors, and they are certainly attractive if they are not already in property.

"Reit status is clearly a benefit to investors and should be attractive to pension schemes. They will be a good diversifier."

Peter MacPherson, director of business development at ING estate investments management, says: "I think it is a good idea for local authorities to look at Reits as they will add depth to the market and will be of interest to widen their portfolios.

"They will be more liquid than other types of property investment and returns should be closer to actual growth in property values. They also have the advantage of transparency."

As markets overseas become less murky - allied to the advent of Reits closer to home - it could be that bricks and mortar give pension funds a clear shot at diversity.