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Wellcome’s Pereira Gray: ‘You need to alter your risk return’

The CEO of the investment division at the UK charity says performance targets will need to change as real estate becomes more operationally intensive.

The faster turnover of leases has made real estate more attractive for investment, according to Peter Pereira Gray, chief executive of the investment division at the UK health charity Wellcome Trust.

“I quite like the pricing power that comes from having assets that typically are available,” said Pereira Gray, speaking during a PERE LP Insights Deep Dive interview last week.

When he began his investment career 30 years ago, tenants were on 25-year leases where rents were reviewed once every five years, he said. “But I’ve always been really interested in the possibility that you could review your rent every six months or every 12 months because in a real estate cycle, where on the whole, assets go up and rents go up for two or three times the length of time that they go down, to be able to reprice regularly should, in theory, intellectually and directly enhance your ability to drive returns.”

Notably, Wellcome owned iQ Student Accommodation, the UK student housing provider, from 2006 until 2020, when it was sold to Blackstone for a record $6 billion in what was the largest-ever private real estate transaction in the UK. “Businesses where you actually let your assets very regularly give you that pricing power ability, rather than long leases with low risk, low return,” he said. “I much prefer the higher risk, high return from that point of view.”

Peter Pereira Gray Wellcome
Pereira Gray: shorter leases can give an asset greater pricing power

Real estate has always been an operating business, Pereira Gray noted. However, landlords were less aware of the operational requirements of a building when 25-year leases were the standard. “What’s happened now is, as lease lengths have become so much shorter, the landlord is far more exposed to that themselves.”

In the late 1980s, most institutions avoided investing in residential real estate because the assets were operationally intensive, he recalled. But “as I look where we are now 30 years later, actually there’s a whole lot of hassle everywhere in the commercial sectors,” Pereira Gray observed. “The nature of real estate has changed as a result of that, and you need to alter your risk return.”

‘We need to get much cuter’

The days where a 25-year lease was effectively a bond adjusted upward every five years on rent reviews are nearly over, he added. “We need to get much cuter about how we manage the asset, how we improve it, how we ensure it remains attractive to tenants, and that is a skillset that not everyone has yet really learned. That’s probably good for us because I think it means that real estate can earn a higher return as it becomes more equity like.”

Real estate, moreover, has become more attractive from a return perspective relative to the other asset classes in Wellcome’s portfolio. “While real estate has gone up marginally as a result of the shift in the character of the assets, the prospective forward look returns from other assets, in my view, have come down quite a lot and it’s not reasonable to expect they will earn the same returns going forward from today’s prices,” Pereira Gray said.

Wellcome, which does not use strategic asset allocation as an investment model, typically makes property investment decisions by comparing the potential returns in real estate to that of its other asset classes such as equities or venture capital. “If we don’t think we can get somewhere in the order of 7 to 8 [percent] unlevered out of real estate, it’s going to struggle to compete with what we think we can do with our money if we were to deploy it into other asset classes,” Pereira Gray said. “So that’s the way I tend to think, breaking everything down into cashflows, prospective returns and growth over time.”

Wellcome managed a £29.1 billion ($40.1 billion; €33.8 billion) investment portfolio as of September 2020, according to its 2020 annual report. Property, which accounted for less than 7 percent of its total holdings, generated a one-year annualized return of 9.6 percent, compared with 9.9 percent for public equities, 17.1 percent for hedge funds and 12.7 percent for private equity.