The Wealth of Nations Sovereign Funds and Sovereign Wealth Funds The Wealth

It ofis estimated Nations that Sovereign Wealth Funds control $7.4tn worth of assets globally, similar to the combined value of the economies of the and Japan. These funds continue to grow rapidly, having roughly doubled their assets under management within the last six years. Allocations to real estate have also increased at a steady pace, rising from 3% in 2012 to 6.5% last year. The aggregate value of global SWF real estate exposure has, as a result, grown by a compound 29% per annum over that period, and is currently estimated at c$450bn†.

Sovereign Wealth Funds have been investing in European real estate since Growth of SWF the 1970’s, but their activity has grown dramatically this decade, with half of the $65bn total invested within the last three years. In their 2016 Global Real Estate exposure Sovereign Asset management Study, Invesco notes that “real estate has since 2012 become the primary driver of increasing alternative allocations”.

The UK has to date been the dominant target for sovereign wealth Source: Invesco Global Sovereign activity in Europe, with gross investment of almost $40bn*. The bulk of Asset Management Study. this has been in London, which is one of the global gateway markets into which most SWF make their first forays into direct real estate investment. Looking forward though, how might a prolonged period of lower oil prices affect SWF demand for real estate, and could Brexit reduce the appeal of the UK as a location for investment? 29% per annum Top 10 SWF by assets under management

Fund Country Assets (US$bn)

Government Pension Fund Global Norway 885 China Investment Corporation China 814 Abu Dhabi Investment Authority UAE - Abu Dhabi 792 Kuwait Investment Authority Kuwait 592 SAMA Foreign Holdings Saudi Arabia 576 SAFE Investment Company China 474 Hong Kong Monetary Authority Investment Portfolio China 457 Government of Singapore Investment Corporation Singapore 350 Qatar Investment Authority Qatar 335 National Social Security Fund China 295

Source: Sovereign Wealth Fund Institute.

† Source: Invesco Global Sovereign Asset Management Study, Preqin Sovereign Wealth Fund Review. * Source: PWC – The major role of sovereign investors in the global economy. 2 Sovereign Wealth Funds

The evolution of SWF investment strategy for real estate

In their early forays into direct real estate investment, Sovereign Wealth Funds maintained a firm focus on large prime investments in gateway , with a preference for dry assets with limited requirement for GIC purchase share of Bluewater shopping centre asset management. Where comprehensive asset management or risk management was needed the funds would usually invest via joint venture partnerships with experienced local operators. A high profile example of this was the acquisition by Norges, on behalf of the Norwegian Sovereign Wealth Fund, of a share in the Estate. The deal established a joint venture with Estate which manages the estate and invests alongside Norges on development projects and complementary acquisitions. 17.5% In the last decade, some of the more established and experienced Sovereign wealth funds have also started to make substantial UK real estate investments outside of London. Potential targets have however always been limited by the requirement for scale. Smaller assets do not have sufficient size to make an impact on portfolio level returns and yet the cost and time required to manage them can be similar to that for much larger lots sizes. As a result, major regional shopping ADIA purchase share of Liverpool One centres have been a prime target for SWF investors, usually in a joint venture partnership with existing owners in order to retain management experience and expertise. One of the earliest such examples was the purchase of a 17.5% share of the Bluewater shopping centre by GIC Real Estate, part of the Singaporean Sovereign Wealth Fund, in 2005. Lend Lease remained as part owners and managers of the scheme. Further deals in 2006 and 2007 by GIC acquired part shares of the Metro Centre in Gateshead and West Quay in Southampton, with CSC and 35% respectively retaining part ownership and management responsibilities. The purchase by ADIA of a 35% share in Liverpool One last January, alongside developer and manager Grosvenor, demonstrates that the approach remains a popular one with SWF investors.

Norges purchase share of Meadowhall

50%

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How might a lower oil price environment impact on investment?

With the plunge in oil prices from more than $100 a barrel in 2014 to less than $50 for most of 2016, it might be logical to expect SWF investment from oil-rich countries to slow. However, data from JLL suggests that there was no change at all in cross-border purchases by Middle Eastern investors in the first half of 2016. The Middle East was the source of capital for c$8bn of cross-border acquisitions in H1 2016, second only behind the US. Nonetheless, a prolonged period of lower oil prices would inevitably have some impact on investment from these countries. Four of the five largest SWF are from oil producing countries (Norway, Saudi, Abu Dhabi and Kuwait), and the impact of low oil prices can be estimated with reference to the oil price that these countries require to balance their budgets.

Although the cost of extracting oil is lower in Saudi Arabia than any other major oil producing country, the kingdom relies on oil profits to balance a major fiscal deficit across the rest of the economy. As a result the IMF estimates that Saudi Arabia need oil prices to be at least $100 a barrel to balance their budget. This is reflected in an almost 10% decline in the Saudi Arabian Monetary Agency’s (SAMA) foreign exchange reserves in 2015, raising the possibility that their approach to real estate investment may change.

In contrast, Norway and Kuwait can balance their books with oil at around $50 a barrel. Nonetheless, Norway made an historic first withdrawal from the Norwegian Government Pension Fund Global (GPFG) in 2016, and the Norwegian finance ministry have forecast that withdrawals may increase by 25% this year. The GPFG decided in 2014 to make a push to allocate 5% to global real estate, moving from little more than 1% at the time, and setting a target allocation of $41.5bn. A separate leadership team was established for real estate, and staff numbers were expected to double to manage the increased exposure. This recent strategic decision makes it highly unlikely that allocations to real estate will diminish on the back of lower oil prices, even if the overall size of the fund may be reduced.

Oil prices needed to balance budgets (IMF estimates)

$47.70

$51.80

$57.80

$67.50

$82.70

Over $100

$207

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Total assets under management in Middle Eastern SWF have declined in the last year, but this may not necessarily lead to a disposal in real estate holdings or even a reduction in future allocations; rather it may lead to a change in approach from a traditional prioritisation of wealth preservation to a greater requirement for income. Indeed, a number of Middle- East based SWF have reportedly turned their focus away from London towards markets such as Spain and Central Europe in search of higher yields and more opportunistic returns.

The other side of the coin is the impact on net importers of oil, who will have benefited substantially from lower oil prices. China is the most notable example, and state-backed Chinese investors have been a conspicuous presence in London in recent months, taking advantage of reduced competition and slightly softer pricing to increase their exposure.

What impact might the EU Referendum have on SWF investment in the UK?

It has been notable that since Mid-2015 Middle Eastern investors have dramatically increased their exposure to the US largely at the expense of London. This could easily be seen as a response to the uncertainty around the EU referendum. However, Terry Leahy of RCA points out that the decision by the US government to relax tax rules for foreign institutional investors will also have had a significant effect in making the US a more attractive location for real estate investment.

The impact of uncertainty around EU negotiations on SWF inflows to the UK will depend largely on the extent to which investors think that the drop in Sterling is reflective of weaker long-term growth prospects. The head of real estate at a major Middle Eastern SWF was asked about the reaction of his employers to the referendum result. “London just got cheaper” was his response. The 15% decline in the value of Sterling versus the dollar, combined with a c5% fall in the value of large institutional quality assets represents a significant incentive to invest in the UK if you believe that long-term fundamentals of the UK market remain reasonably robust.

The impact of uncertainty around EU negotiations on SWF inflows may increasingly consider that the bulk of their core exposure should be denominated in US Dollars or Euros, and therefore that their investments in the UK should be required to deliver higher value-add or opportunistic style returns. This could potentially lead to a gradual reweighting away from core investments and toward more development activity and increased exposure to alternative sectors.

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How is SWF investment likely to develop in the future and what impact might that have on the UK real estate market?

SWF investment is characterised by the need for large lot sizes and by Real estate share consequence a restriction to deep and liquid markets. Even in the US, SWF tend to focus on the gateway cities of New York, Los Angeles and of SWF overseas Washington, and in the UK London is perceived by many as the only show in . Indeed as these funds grow in size it seems more likely that they investments – 2015 will consolidate in the largest markets in order to reduce the granularity of their portfolios and to maintain greater liquidity even in challenged Source: Università Commercial Luigi Bocconi markets. A recent example of this is the decision by ADIA to sell Saltire – Sovereign Wealth Fund Annual Report. Court in Edinburgh, an asset they have owned since 1993, as part of strategy to exit from smaller holdings. The lot size of c£70m is on the small side for ADIA but very large for the local market, meaning that the hold cost is higher as a percentage of the value whilst the required return also needs to provide a higher liquidity premium.

Nonetheless, sovereign wealth capital is still likely to impact on regional markets indirectly through increasing levels of investment via joint 36% ventures and corporate acquisitions. Individual lot sizes are not as large, allowing for greater liquidity and reducing idiosyncratic risk, yet portfolios are of sufficient scale to deliver management cost efficiencies. Recent examples of this in the UK include the £2.1bn acquisition of P3 Logistics by GIC, and an investment by Norges alongside Prologis in a £250m industrial portfolio acquired from LondonMetric. The latter was just the latest acquisition of a joint venture partnership that started in the US in 2012 with a $3.1bn logistics portfolio. In December, ADIA invested in a Joint Venture with another US logistics specialist, Property Group, which also has investments in the UK. This is likely to become an increasingly common trend as SWF investors look to get exposure outside of gateway offices and shopping centres.

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However, perhaps the most significant trend will be the rise of giant national pension funds and their increasing exposure to cross-border real estate. These have been prominent in North America for many years, with notable examples being Properties and CPPIB from Canada and CalPers and Teachers from the US. While the US institutions have largely concentrated their core direct investments in their domestic market, accessing UK exposure through REITS or PE funds, Oxford and CPPIB have been significant players in the UK. The former have been focussed on London; with major investments in Paternoster Square and the Leadenhall Building, both in the City. CPPIB own a share of the Bullring and Grand Central shopping centres in Birmingham and in 2015 acquired student halls operator Liberty Living and their entire portfolio for £1.1bn.

The fastest growing pool of new pension fund capital will come from emerging market economies. Although currently small in absolute terms, they are likely to become an increasingly important source of investment as the middle class populations in emerging market countries grow. Invesco estimate that defined benefit state pension funds in emerging markets are already “the most significant contributors to growth” of sovereign investor assets. Many have only recently been permitted to invest overseas, so are likely to follow the well trodden path of focussing on gateway cities and core product. However, their greater focus on income, and relatively smaller lot size requirements may allow them to look further afield, including other regional UK markets. Cities with international profile such as Manchester, Liverpool and Edinburgh can be expected to benefit, as might those such as Birmingham that have strong cultural ties to emerging market countries.

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The enduring appeal of UK real estate SWF investments in UK real estate

After the US, the UK represents one of the largest and deepest real estate markets in the world, with high levels of transparency and favourable conditions for international investment. Against a background of a “lower for longer” interest rate environment and the global search for yield, sovereign wealth funds have been steadily raising their allocations to real estate. Investment in the UK may increasingly include more opportunistic strategies such as speculative development, most probably in collaboration with local partners. A whole new wave of international capital is likely to come from emerging markets, some taking the well worn path through prime Central London while others seek the higher income returns available elsewhere. Their approaches may vary, but sovereign wealth funds and overseas institutions are only likely to expand their investment in UK real estate in the $40bn coming years.

Source: PWC.

Real Esate Market Size (bn):

220 240 260

US $2562

UK $707

Japan $663

China $397

Germany $383

France $344

Hong Kong $286

Canada $263

Source: MSCI. 8 Sovereign Wealth Funds

Get in touch Our real estate finance specialists are based throughout the UK and are available to visit you on-site to discuss your ambitions for your business.

For more information on how we can help you, or to arrange for one of our specialists to get in touch, please contact us by:

Derek Bonnar Stuart Heslop Regional Director, Real Estate Finance, Managing Director, Real Estate Finance, London & North 020 7672 1998 0131 523 8960 [email protected] [email protected]

Paul Eyre Tom Sharman Managing Director, Real Estate Finance Head of Strategy & Insight Midlands, and Southern England Real Estate Finance 020 7672 0164 0207 672 4942 [email protected] [email protected]

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