How big is the fund and how is it expected to grow?


The fund is governed by its own specific legislation which sets out that the State make an annual contribution of 1% of GDP, currently €1.5bn. The total size of the fund now is €18bn.

We are working to a five-year plan which started in 2004 when we first invested in real estate. When we put our business entry plan together we estimated that the fund would reach €25bn by 2009. Now it appears likely that the total will be closer to €30bn thanks to a very good year in 2005 when it returned about 20%, following some recovery in the equity markets. The €30bn forecast is based on an estimated annual return of 9%; the more prudent assumption is 7% which would give us €28bn by 2009. So the €25bn is looking a little light at the moment.


What was behind the decision to introduce real estate to the portfolio and what is the current/target


The idea behind including real estate was to enhance returns without increasing the overall level of risk in the fund. It was part of a wider decision to include alternatives. Real estate is seen as an asset class in its own right but is still included in alternatives.

The target allocation for real estate fixed in 2004 was 8%, the same allocation as that for private equity, with 2% to commodities, making a total allocation to alternatives of 18%. This allocation has been revised but the real estate weighting has been left unchanged. Currently real estate accounts for 2.5% of the total fund value.

The allocation of 8% was based on a risk frontier analysis. A consideration of what other pension funds were doing as well was incorporated to provide a reality check; the analysis on its own may have come up with a different number. Although a consultant was used to set the fund's asset allocation when it was set up in 2001, when the review was carried out in 2004 there was sufficient in-house expertise for this purpose.


Given the nature of the fund, do its investment principles differ from those of a normal pension fund?


We don't have immediate liabilities so one key difference is that we can take a longer term view than a normal pension fund with more immediate payout obligations. For example, we can focus on private/unlisted vehicles. For the initial period our entire real estate investment programme has focused on the private/unlisted vehicle market. We do not acquire properties directly, partly because the acquisition of direct assets may be seen as government expenditure which would weaken our budgetary position, leading to possible breach of the rules for Ireland's euro membership. If we invest in unlisted funds it is not counted as expenditure.


Why do you invest indirectly?


We decided that the best way to invest would be to invest indirectly so we wouldn't need a large in-house staff. It also means that we can take a more global view. Furthermore real estate is becoming more securitised so it is becoming much more as it should be - a financial asset. Historically people have bought buildings in local markets for control, among other reasons, but the market has now moved on.


Is the attraction of unlisted the fact that it better reflects the underlying real estate market?


It does but the market is changing, and the fact that real estate investment trusts (REITs) are coming to the UK and Germany gives investors further options in terms of how they access the real estate market.

The range of options for investors is far broader than it was 10 years ago. We have not invested in listed securities yet but we are about to conduct a search for a couple of managers to run listed real estate securities programmes for us. We plan to award two or three mandates, allocating up to 20% of the portfolio in that area. Listed securities do not provide a complete reflection of the underlying real estate market but they are closer to real estate than they are to equities over the long term.

There is also greater use of investing in different parts of the capital structure, be it equity or debt. A fund as large as ours does not have to be invested exclusively in the equity slice of the capital structure. We have some exposure to mezzanine funds and funds that are structured as convertible bonds, both of which provide additional diversification. This practice is more prevalent in the US where we have the mezzanine exposure. With core real estate quite expensive, this gives core exposure without necessarily the same level of risk. It might seem that we are moving up the risk curve but we don't think we are.


How do you structure your portfolio?


We have allocated 30% to core, 50% to value-added and 20% to opportunistic, which reflects the long-term profile of the fund and also our view of the current market pricing. I think there is more value to be had in assets that need active management in special situations. Furthermore yields that have been attached to core prime assets place quite demanding growth assumptions on them.

We have also put together a plan to invest in each of the main regions in the world, with an allocation of 50% to Europe, 35% to the US and 15% to Asia.

There is no specific allocation to domestic real estate. Within Europe, Germany has been flavour of the month, and we have had some exposure to German real estate which has performed well for us.

I also think that other large European cities like Paris offer some interesting possibilities and good liquid markets. We don't have very much exposure to Spain; we would like some but not in residential which we think may be overheated. Spanish office and commercial will do well.


How do you invest in the US?


We made our first investment in the US last year. The fact that it is a single market makes it is easier to invest and formulate strategies. Furthermore I think the real estate industry is more sophisticated in the US than in Europe because they have been doing it for longer.

The two sectors of the market which we invest in are office and multifamily. We felt that with interest rates rising people would be tightening their belts which would impact on the retail property sector.

Office had performed poorly, producing an oversupply of space. With improving economic fundamentals over the past year - falling unemployment and rising employment - we predicted that vacancy rates would drop, which has happened. We see this continuing in the short term. So we invested in a couple of office funds which worked out well for us.

In the case of multifamily we thought the pricing was aggressive in terms of the yields but we felt that rising interest rates would impact on the single family housing market and that as a result people would be more likely to rent apartments, and meanwhile rising employment would impact positively on that sector, which has turned out as predicted.


What is your view of real estate investment in emerging markets?


Emerging markets account for 6-7% of the global equity market but 10-12% of the global real estate market. If you choose not to have exposure to those markets you are cutting out a significant portion of the global real estate market and the global economy. Markets we are looking at include China, South Korea, Thailand, Malaysia, India, the whole of eastern Europe and Turkey. But we won't invest in markets that have less than investment grade sovereign credit ratings.


Which countries are of most interest?

China looks very interesting in terms of its economy and demographic factors as well as the fact that it has set a path and been on that path for a number of years. The Chinese have placed restrictions on foreign ownership of residential property but my understanding is that foreign ownership accounts for a very small part of the market. Overheating is a concern - when an economy is growing at that pace there are real challenges, but it does have the momentum to support it.For quite a while there were concerns about Ireland overheating and I think that is true but you can see that once an economy gathers a bit of steam it becomes a self-sustaining momentum. And favourable demographics given the movement of population in the country add to the interest.

We are less excited about India - its emergence is rather new. There is quite a big infrastructure deficit there so we are not rushing in, but we will keep an eye on it.

Japan seems to have been a very favourable market in the last couple of years although it is one that people may have been a bit cautious about. But we think that the recovery is solid - there was evidence of that two years ago when we put the plan together and this has been borne out.

The 15% allocation to Asia is fixed for a while. We are in the second year of a five-year programme and we haven't reached stabilisation yet. The issue of whether we can overweight or underweight particular markets will become more relevant as we get further into our five-year plan.


What are the challenges of investing in these markets?


While these markets might account for a large proportion of the world economy, the issue for us is the proportion of this which is investible using private/unlisted funds.

One of the key things with investing in private/unlisted vehicles in a foreign market is the need for very strong confidence in the local partner, be it the manager or the person you are investing with directly. They need to have a credible platform; the alignment of interests needs to be impeccable.

Alignment of interests is important in that the terms are fair and incentivise the manager. This means that a significant proportion of a manager's remuneration should be delivered through the performance fee mechanism.

Most of the funds which we invest in exhibit good alignment. But we do have some concerns - there is a huge amount of money out there chasing real estate and it is very tempting for some managers to increase the size of the funds which they are raising simply to gather more assets under management.

I think this will be difficult to guard against because there are investors who want to put money into the market and managers who are remunerated based on commitment fees. Most managers would say that this would be a very short-sighted way to run the business. But whether people actually have the discipline to stick to this principle - time will tell. I think everyone will recognise that that is a possibility.


Do you have some more general concerns about the industry?


The lack of a benchmark to measure the performance of unlisted funds - ie, what we invest in - is a concern. INREV is working on an index but it is not yet at the stage where it can be used as a benchmark. There is a feeling in the investor community that managers have been too slow to contribute their performance data and that this lack of data is actually holding back the development of this index. From my discussions with other investors I sense a growing degree of frustration with managers on this issue.

The whole area of transparency is one that needs to be worked on. In the US and UK private equity is attracting a lot more scrutiny from the regulators and inevitably this will happen with the real estate sector as well as this part of the market develops. It is up to the industry to police itself, promote best practice and to address the obvious gaps. The lack of a benchmark is not the main driver for our move to listed but it is certainly easier to benchmark from listed, that's for sure.

Resource is also an issue for investors. We need to think about how we cover the various areas of real estate investing. I think attracting and building a team is something that is important for us and we are about to start building up our internal resources. We need more investment managers - people capable of sourcing deals and managing portfolios.

As for gearing - the overall level for the portfolio is 60%. It had been 50% but given what we were seeing we felt that was too low. We don't have a limit on individual funds.