The Change In Pensions That’s Slowly Strangling UK Real Estate

Headlines on the sharp drop in UK real estate investment over the past 12 months have discussed interest rate hikes, construction cost inflation and distress in the office market.

But there is one factor that is consistently overlooked. It’s subtle, a bit nerdy, and it's slowly and surely draining one of the biggest sources of investment in British property. 

“Unfortunately, in the UK institutional real estate world, we've not been able to get a diversification of capital into our funds,” BlackRock Global co-Head of Real Estate Paul Tebbit told the audience at Bisnow’s UK Real Estate Outlook and Trends event, held at the University of Chicago Booth Business School’s London outpost last week.

Tebbit was talking about changes in the way funds flowed into pensions in the UK over the past decade or so. Slowly at first, then all of a sudden — exacerbated by the September 2022 mini-budget of former Prime Minister Liz Truss and former Chancellor Kwasi Kwarteng — those changes have essentially removed one of the biggest buyers of UK real estate from the market.

That is having an impact on deals of all stripes, but in the long term, it will be particularly detrimental for deals and regeneration efforts outside of the UK’s biggest cities and the prosperous south-east of England. 

“A lot of our pensions in the room [are] invested in defined benefits [pension schemes],” DWS UK CEO and Head of European Real Estate Portfolio Management Jessica Hardman said. “And that's shifting now to defined contributions, this new model. At the moment, that is not a great warehouse to be buying alternative sectors like real estate.”

For decades, the most common type of workplace pension scheme in the UK was the defined benefit plan, sometimes called a final salary pension scheme, mostly paid for by employers. Under that model, the worker received a pension of about the level of the salary they were paid when they retired. 

But at an accelerating rate since the late 1980s, defined benefit pension schemes have been closed to new employees and replaced by defined contribution pension schemes. In these plans, employees pay into their pension scheme, sometimes matched by employers. The schemes are cheaper and easier for employers to run since they don't have to pay as much into them, and they aren’t solely responsible for predicting how much they need to pay out in the future.

UK defined benefit schemes liked real estate and were significant investors in the sector. The long-term, stable income property provides was good for planning to pay out pensions years or decades in advance. 

Defined contribution pension schemes, not so much. Those have typically favoured more liquid assets to make sure pension holders are paid out without any hitches. That difference is highlighted in the asset allocations of defined benefit versus defined contribution pension schemes: The former has about 4.7% invested in property compared to just 1.8% for the latter, according to data from the UK Investment Property Forum. 

Defined benefit pension schemes had underpinned the UK market for decades. 

“I've always wondered why, historically, you have four times more liquidity in Manchester than in Lyon,” M&G Real Estate Head of Investment Strategy José Pellicer said. “Similar-sized cities, similar-sized employment, similar-sized office stock, so why was there four times more liquidity in Manchester? Because there's a very big pension fund industry in the UK that tends to invest only in the UK. But those guys are de-risking.”

As they come to the end of their lives and get to the point that they are paying out pensioners rather than taking in new money, defined benefit schemes have been selling out of real estate for the last few years, moving into more liquid assets that they can easily sell and make their payouts, attendees heard. 

That sell-off was turbocharged by the events of September 2022.

A budget containing unfunded tax cuts set out by then-UK Prime Minister Truss and Chancellor Kwarteng sent inflation soaring, which in turn pushed up interest rates. For defined benefit schemes, that had an impact that directly hit real estate. Defined benefit schemes became fully funded, meaning their assets exceeded their future liabilities. To do so, they became sellers of illiquid assets like real estate. 

“This is one of these weird, idiosyncratic factors where you've almost got to be outside of the UK to understand quite how significant it is,” BlackRock’s Tebbit said. “But in the UK post-September 2022, with the Truss-Kwarteng mini-budget debacle, we saw gilt rates spiking, we saw many of our corporate pension schemes had their liabilities crushed, and as a result, they were significantly more than full-funded. 

“All in one go, I think we might have got about £75B of core capital, which sits in UK pension schemes, all looking to de-risk and sell out of UK real estate, all at the same time. All at the same time doesn't mean literally within a day — it's going to be over the next couple of years.”

The sell-off is having an outsized impact on UK real estate investment volumes, which had their worst year since 2010 in 2023. It is what those funds typically buy as much as the fact that they are not buying that is important. 

“There is international money out there, but it is not necessarily funding retail parks in the north-east or residential developments in third-tier cities,” DWS’ Hardman said. “What has done that is the UK pension money. We need to ensure we have better models of investment structures to allow for that capital to be invested all around the United Kingdom.”

Industry bodies like the IPF, the British Property Federation and the Association of Real Estate Funds are lobbying the government and working with the pensions industry to propose regulatory tweaks and new structures that would make it easier for defined contribution pension schemes to invest and feel reassured that long-term assets like real estate are not risky. 

Tebbit pointed to the creation of a structure called a long-term asset fund, which would allow funds investing in multiple asset classes like stocks, bonds and alternatives to invest in property more securely.

Yet for now, there is an interregnum between the money that was once invested in UK real estate and new money that has not yet arrived.

Defined benefit schemes could sell assets in a rush to private equity players at discounted prices at the bottom of the market, then be scooped up by defined contribution schemes, Tebbit said. But whether they will be there or not is open to question, and that is causing everyone to sit on their hands. 

“At the moment, we are in this slightly uniquely worrying and unstable position where on the value-add side of our business, many people investing at the moment are assuming that after three to five years, they're going to be exiting to UK core capital,” he said. “But at the moment, it doesn't necessarily exist. It hopefully is coming. But it's not there yet.”