Dipping a toe in the water

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On the surface, Icelandic pension funds are not by any means big investors in real estate. By law, a pension fund may not invest in real estate or chattels except to the extent that such investment is necessary for the activities of the fund.

In fact, over the past few years, it is indirect investments in the residential market which have made up the bulk of pension fund assets. According to the Central Bank of Iceland, investing in residential property via bonds and mortgages made up practically the whole of pension funds' net assets in 1980, and was still around 40% in 2004.

Residential property as an asset class is split into two distinct sectors.

First, pension funds buy bonds which have been created to finance the state housing loan system. These are issued by the Housing Financing Fund and in 1980 made up nearly 60% of pension funds' net assets. By the end of 2004, this proportion had halved to 30% of net assets.

Secondly, pension funds make mortgages available to members, secured against residential housing. In 1980, these formed about 40% of pension fund assets, but have also fallen, so that by the end of 2004 they amounted to 10% of net assets.

But pension funds have always been allowed to invest indirectly through real estate mutual funds, and it is this portion of their portfolios which is likely to grow in the future. However, there is a long way to go.

"Icelandic pension funds are considering investing in real estate funds, but have only made a few investments so far," says Hrafn Magnússon, managing director of the National Association of Icelandic Pension Funds. "I can vouch for their interest, but they are still not out of the starting blocks when it comes to investing in real estate funds."

Magnússon says that the main focus is in both single real estate funds and fund of funds, mainly in Europe and the US.

"The main strategies under consideration are core funds, value added funds and opportunistic funds, with expected returns of 8-15% depending on strategies and funds," he says. "Real estate funds, and especially funds of funds, are a relatively new asset class. But we are expecting to see further developments in the near future regarding the sector."

Some big names are already lining up to take the plunge. For instance, this year the Gildi pension fund is allocating up to 5% of its portfolio to alternative assets, including real estate.

"We have been looking at real estate for diversification and returns, although we have not made any big investments yet," says Tryggvi Tryggvason, Gildi's chief investment officer.

"We are going to invest - we think that real estate offers good diversification," says Robert
Robertsson, chief investment officer, LSR, the pension fund for state employees. "We have
already made one commitment into a limited partnership, which was made to test the water and speed up the learning curve. We are currently formulating the target allocation for the portfolio."

Under current legislation, pension funds in Iceland are not allowed to invest directly into real estate.

"Exposure to domestic property comes through the bond portfolio for pension funds, mainly bonds issued by the Housing Finance Fund and loans to members (mortgage bonds)," says Robertsson. "LSR will invest into fund of funds to begin with, with the target of getting a global diversification."

For those Icelandic funds already investing in real estate, the vehicle of choice appears to be private equity, rather than listed funds. Many of these are run locally.

For example, in March 2006, Kaupthing Bunadarbanki, a locally based bank which runs its own investment funds, launched an opportunistic private equity real estate fund, the International Real Estate Fund, now worth €60m.

This vehicle is a fund of funds investing in between eight and 10 real estate funds.

"The funds it invests in are mostly European because there are tax problems with US funds," says Bjarni Gudlaugsson, chief investment officer, Kaupthing Bunadarbanki. "The fund can invest in any sector, both commercial and residential. Most of the investors are Icelandic pension funds and other institutions."

One investor in Kaupthing Bunadarbanki's International Real Estate Fund is Nordurlands Lifeyrissjodur, the Northern Province Pension Fund.

"We are fairly new to real estate, starting two years ago," says Kari Arnor Karason, managing director, Nordurlands Lifeyrissjodur. "However, we are only investing in foreign property markets. As well as the Kaupthing Bunadarbanki global fund of funds, we also invest in the Standard Life European Property Growth Fund."

He says that diversification is a key factor behind the inclusion of real estate in the fund's portfolio.

"This is an interesting asset class in that it gives uncorrelated, or less correlated, returns to traditional assets," he says. "Furthermore, it has given a fairly good performance over the years. Some other markets are getting expensive because there is a lot of money pouring in. That may also be the case for at least part of the property market but I still think in the current low interest rate environment that real estate is an asset class which is worth looking at."

At present real estate makes up less than 1% of Nordurlands Lifeyrissjodur's €560m portfolio.

"At the moment, we are planning to increase our allocation, and looking at two other funds," says Karason. "We would be satisfied with a real estate allocation of 3-4%."

His fund has, however, not used outside consultants as yet. "We have had a consultancy to review the market, but not in terms of selecting funds or managers," he says. "We have looked at global property markets and tried to form a view as to where to go. Tax issues are important also. We started with managers we already had a relationship with, because real estate is a fairly small part of our portfolio and will continue to be so. We want to be with someone who has experience and whom we know well. That saves a bit of due diligence."

According to Karason, there are Icelandic pension funds which have used listed vehicles to invest in real estate.

"We've looked at it ourselves and it is not a decisive factor, but all other things being equal, we do prefer to invest through listed funds," he says.

"This is because by law, the portfolio has to be at least 90% invested in listed securities. We want to save the other 10% for private equity and occasional unlisted bonds."

He says that most pension funds are still well below the 10% limit for alternatives, but that that does not mean that real estate holdings will soar: "I suspect that most of the 10% will be taken by private equity."

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