Dipping a toe into foreign waters
Finland may not be the first institutional market that springs to mind when you think of serious international allocations to real estate. Nonetheless, Helsinki-based mutual pensions insurance company Ilmarinen, one of the country’s largest institutions, is dipping a toe into overseas property investment to diversify a portfolio heavily skewed towards direct ownership in the home market.
Timo Kankuri, head of real estate at Ilmarinen, came on board in 1998 having previously worked for Finnish company Rettig, where he was a manager of the group’s industrial properties.
The same year Ilmarinen established its own in-house investment department shifting investments and property from Pohjola, a Finish insurance company that had previously managed the firm’s assets. This move had been pre-empted by legislation stipulating that Finnish mutual pension insurance companies set up independent investment departments.
At the time of his arrival at Ilmarinen, Kankuri says the group had some e1bn of property on its books with a weighting in the overall investment portfolio of around 7%.
This real estate exposure was all invested in direct Finnish property, due mostly, says Kankuri, to the economic downturn of the early 1990s. “Few of the Finnish pension insurance companies had any investments abroad at the time as they were being very cautious.”
Upon taking the reins, the first thing Kankuri did was to start rewriting the strategy. “The idea was that our property department – myself and my secretary at that time – would focus on property investment and look at it as one asset class. We wanted to focus on total returns and the risk–return levels of portfolios. The second thing was that we did not want to have a property management company in-house. We wanted to be more flexible and focused. We then structured things so that we outsourced the non-strategic activities. This included everything like property management, maintenance and security etc.”
At the same time, Kankuri began looking at the organisation and what was needed in terms of core staffing. Today the real estate department has 11 people, with four taking care of the management issues, one responsible for operational steering and one staff member to manage the necessary construction and development networks.
However, while Ilmarinen was trying to outsource all non-core business, in 2000 the group bought the shares of Alexia Property Company from Nordea. This more than doubled the size of the real estate portfolio and pushed the weighting to property as a portion of total assets to around 14%.
The rationale behind the deal, says Kankuri, was that an optimisation process had shown property was a good risk–return bet for the portfolio and that the amount allocated to property could be pushed higher. “It’s difficult, of course, to achieve this through buying one or two properties and this was one way of doing that. The Alexia portfolio had a spread of properties that suited very well our own and made for good diversification benefits. We also got a very good deal on the price, which was around e1bn overall.”
The purchase of Alexia resulted in a total property portfolio of e2.1bn, all of which was directly invested in Finland. A portion of this allocation was then placed in a divestment portfolio to hive off properties that the fund deemed unsuitable.
Kankuri’s first target was to sell these properties: “We worked hard on this for a year or two and were quite lucky that the market was rising at the time we were selling.”
In addition, the deal included the adoption of Alexia’s 75-strong real estate portfolio management team, contrary to Ilmarinen’s outsourcing strategy. Says Kankuri: “As the goal had been to outsource as much as possible we kept this team in a separate property company with the idea of changing their role from an owner manager to a service provider status.”
Consequently the group began making operational and methodology changes to the Alexia business. “Our target was to achieve this within a two-year time horizon, but we were lucky again because it was a rather good property management team and we finished up selling the division to Aberdeen Property Investors (API).”
The Ilmarinen property chief says one reason for the sale to API was the desire to ally itself with a capable, independent and international property house to push forward its own real estate diversification plans. “We felt this partnership could benefit us through Aberdeen’s network and this has turned out to be the case,” notes Kankuri.
At that point, Kankuri says Ilmarinen started to think seriously about investing outside Finland and began relevant strategic research work. “We actually did this work with Jones Lang Lasalle and had the possibility to use their expertise and data along with our own.
“We carried out a portfolio optimisation process where the real estate portion was allowed to float freely and was not capped in any way.
“I would say this is not because the Finnish property market is not good at present, in fact it is vice versa. One of the issues, however, was that the Finnish data is not so good over any long period of time and it also includes the recession period of the 1990s, which explains a lot. What it did show was that diversification could benefit us a lot.”
The outcome has been that the fund has started to focus a small portion of its portfolio abroad, targeting firstly the euro countries. “This is not because there is a problem with anywhere else but because with the currency there is no issue and no need to hedge or anything.”
Furthermore, the fund also decided on a sector-specific approach to its investments, which Kankuri explains made for a more precise diversification of the international real estate exposure. To this end it was decided that allocations would be made in separate retail, office and logistic funds rather than taking a multi-asset class approach.
With advice from API the fund then looked at possible fund partners, earmarking seven to 10 indirect funds it felt suited its strategy. These potential investment partners were run through Ilmarinen’s due diligence process one by one.
The result, says Kankuri, was that two funds were taken off the potential investment list. “This is not a property investment anymore, it’s an investment in a vehicle and in some of these cases the agreements and issues of corporate governance did not meet our criteria and we couldn’t accept them.”
Elaborating a little, he says the main stumbling block concerned the possibility for a manager to change investment strategy in a major way without full consultation with the investor.
Fee structures – often cited as an issue for institutions looking at indirect funds – were less problematic, he adds, noting that API has a tool that allows the investor to understand a lot about fees and return figures.
“With fees, either you accept them or you don’t. I think there should be some kind of simplification, though, because there are always ways to bend this issue and it’s difficult to go through all the small print in agreements and evaluate risks such as interest rates going up or markets in one country going down and how this can affect you.
“The issues of corporate governance and investor representation are more important though and in one case there was also a problem that the vehicle being offered was not tax-efficient for Finnish investors.”
Two of the managers selected, however, were then allocated tranches of assets, with one a retail and one a logistics fund. The fund is not naming the managers. Investments in these funds were rather cautious with about e30m divided between the two.
Kankuri is also looking to allocate the first commitment into a third fund, which will be an office portfolio.
Nonetheless, he concedes that to truly reap the benefits of internationalisation, allocations will have to grow. “What we have found is that to really achieve diversification benefits these small commitments will not be enough so we will need to increase allocations. This is a learning process though and we think we need to be quite small to begin with to see how things work.”
As a result, the fund search continues with the aim of investing in two others before the end of this year.
Kankuri notes that he is unsure about where this investment will go in terms of sectors: “As we’ve invested in the other sectors we’ve learnt quite a lot about how they function and how much risk is involved in different types of vehicles, so I’m not sure what will happen. It could be that a multi-asset portfolio could be interesting or a move towards other markets such as the UK, which is a significant market.”
One major issue, however, that could affect what Ilmarinen and other Finnish pension insurance companies do in the future on real estate is how much money can be put in indirect investments. Such investments are classified at the highest risk level under Finnish solvency laws.
“The Finnish solvency issues are limited to some extent and we would need to have better solvency margins to increase indirect property investment,” he says.
“As a Finnish pension insurance company we are not entitled to use any leverage in a property investment if our ownership is more than 50%, so basically every direct property investment is 100% our own equity. The fund can benefit from investing in real estate funds leverage as long as its share is less then 50%, among other constraints,” he explains.
Broadening the argument, he raises an interesting point on the comparisons made between indirect real estate and private equity, arguing that he sees clear differences between the two.
“In real estate funds you have the benefit of understanding the underlying asset and you can say, to some degree, whether you will realistically achieve the returns. You should also be in closer contact with the fund manager in a closed-end fund and they get a discretionary mandate to put the money into properties for a certain time.
“The property industry should explain this issue better to help with solvency issues for pension funds. For us this investment is a long-term 40-year thing, not five years, and we’re not interested in short cycles.”
Kankuri adds that the indirect approach by the fund in its internationalisation, rather than via quoted funds, comes down to not being able to find the right listed vehicles.
“Today we are looking though at the idea of exchange-traded funds (ETFs) because we do see that they are attractive in trying to achieve an overall property allocation and they could be part of our portfolio in the near future. If we went the quoted route we would probably look at a fund-of-funds type of approach.”
Nevertheless, the international indirect exposure still represents a very small part of the fund’s property assets and Kankuri says this is likely to remain the case for some time. “You can’t achieve big moves like this overnight, although we have just sold a large retail portfolio here in Finland to Doughty Hanson. This will give us a slightly more liberal approach to larger weightings, but it will take time.”
Finnish direct investment still represents some e2bn of the fund’s real estate assets and Kankuri says Ilmarinen doesn’t have any practical targets for increasing this: “A theoretical figure though would be to have something like 20–25% of the overall real estate assets in indirect.”
At the same time the fund has started to allocate to indirect investment in property companies in Finland, particularly in the residential sector.
Overall, Kankuri says the fund is happy to go the unquoted route into European property. “You can go indirect and use a discretionary mandate with a manager and give them some money without actually having too much detail on strategy etc. The way we have done it though is that we have gone quite deeply into the fund agreements and tried to understand the process, risk etc.
“There is a lot of work to do before you can understand what you are signing. Hopefully in the future there will be a process that will make this simpler with perhaps the possibility of some kind of fund-of-funds arrangement so that you don’t have to read every fund’s agreement.”
In a bid to translate such hopes into reality, Kankuri says Ilmarinen has become a member of INREV and he hopes the organisation can play a part in the development of the industry.
“It’s such a young industry really and at this stage you can have some kind of influence on how the future is.”