In the central and eastern Europe (CEE) region second pillar systems are by nature conservative. Although privately managed, they are funded by social security contributions diverted from the first pillar. In Estonia's case the pensions are financed by 2% of an employee's gross wages and 4 percentage points of the 33% social security contribution paid by employers. At the end of September 2006 the system totalled EEK6,634m (€424m) in net assets under management, a year on year rise of 59%. There is also a smaller, fully private supplementary private pensions system, which had assets of EEK597m.

Estonia's pension system differs from that in Latvia and Lithuania in that investment limits are significantly more flexible. There are no limits on overseas investment because the country itself has had, by law, to run a balanced budget, removing the need for the state to issue Treasury bonds. The domestic stock market is also small, with less than 20 companies listed on the Tallinn Stock Exchange.

By law all mandatory pension fund managers must provide a low-risk bond fund, targeted at individuals approaching retirement, and have the option of providing other funds with varying proportions of equity, of up to 50%, and other riskier assets, including property. There are six growth funds currently on offer in the mandatory system, and a further three so-called balanced ones with an intermediate risk profile. As of the end of September direct property investments in growth and balanced funds totalled EEK26m.

Estonian mandatory funds can invest up to 10% of assets directly into real estate, with a maximum 2% in any single investment. Supplementary funds can invest 20%, with a maximum 5% in a single property. Total investment in real estate, real estate funds and funds deemed to be real estate funds under foreign legislation is capped at 40% of a mandatory pension fund's assets at market value, and 70% in the case of voluntary funds. Currently, however, the portion taken up by property and related investments remains small. According to Vahur Madisson, pension fund manager at SEB Uhispank Investment Funds, which runs Estonia's second biggest balanced and growth mandatory funds, the growth fund has 9% in such assets. "Real estate has made a positive contribution to portfolios consisting of equities and bonds in terms of risk and return pay-off. It smoothes some of the volatility of public equity and debt markets, while having attractive expected returns."

Robert Kitt, fund manager of Hansa Pension Funds, which include the largest growth and balanced pension funds, adds that Hansa aims for returns in line with nominal GDP growth from its real estate related investments, which in Estonia's case means an exceptionally high return of 15% this year. The country's real GDP grew by 10.5% in 2005 and 11.7% in the first half of 2006. Direct investment into property remains complicated, with responsibilities and obligations on the owner. According to Kitt, Hansa's pension balanced and growth funds are the only ones to do so in Estonia. Such investment includes property in a shopping mall in Tallinn that provides a rental income stream. "Some 75% of our direct real estate exposure is based on rental cash flows, mainly office with some residential," he says. This provides a measure of protection against falls in the prices of the property itself. "We have been quite conservative regarding property price appreciation," he adds.

Most real estate investment takes the form of equities. "We have not made direct investments in real estate assets; instead we have invested in real estate companies, funds and structured products such as equity participation notes," adds Madison. "There are a few local real estate managers that manage mostly institutional and high net worth individual real estate assets. They have been very innovative in terms of product structuring and have created considerable portfolios."

However, as Kitt explains, "the use of equity structures for real estate investment also acts as a constraint: such investment eats up the equity portion of the fund." Hansa's equity-related investments include funds runs by Baltic Property Trust Company, including Danish Aktieselskab (public limited liability) and Luxembourg SICAR structures. There are currently no Estonian structures with tax advantages comparable to US real estate investment trusts (REITs). Within the CEE region Bulgaria is the only country with a REIT market, which started in 2005, and which Hansa buys for its portfolio.

In November the Estonian parliament approved amendments to the local investment fund act. These come into effect at the start of 2007 and should make it easier to set up Estonian real estate funds. The amendments include raising the limit for direct property and land and investment (immovables) from 50% to 60%, and the limit on securities related to real estate from 75% to 80%. Closed-end real estate funds will no longer be required to have a depository, which should reduce overall costs.

Geographically most of the funds invest extensively in the Baltic and CEE region, taking advantage of economic growth rates well above that of the "old" EU, and which have fed into the local property markets. The Baltic countries themselves have experienced dramatic property price rises. According to a report by the Royal Institution of Chartered Surveyors, in 2005 Estonian house prices registered the fastest rise in Europe, of 28%, following on from a 25% rise the previous year. The rise started in 2002 when the country's construction boom took off and is being currently propelled by a number of factors reflecting the country's recent history. Most Estonians still live in cramped Soviet-built apartments of two to three rooms, but demand for larger houses is well ahead of supply. Bank lending for housing has grown at a breathtaking pace of more than 80% year on year in 2004, 2005 and the first three quarters of 2006. Tax benefits and heavy bank competition for market share have made Estonia's mortgages, largely denominated in euros, the cheapest in Europe.

Similar pressures exists in the commercial sector. Foreign direct investors into the economy have pushed up demand for office space, especially in the centre of the capital Tallinn where, according to a recent survey on the Baltic markets by Colliers, vacancy rates are a mere 2%, while the pre-booking rate for buildings under completion averages around 70%.

Foreign investors are creating a parallel demand for industrial property. In the retail sector rising wages along with a tourist boom that started after Estonia joined the EU in 2004 has led to an explosion of shopping malls and related developments, with demand again exceeding supply. Bank of Estonia, the country's central bank, has been warning of the widespread risks of a collapse in property prices for the last two years; since contemporary Estonia has yet to see a property boom complete its cycle, these warnings currently fall on deaf ears.