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Shining a light on Danish real estate valuations

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In recent years there has been enormous effort to unify regulations and practices governing investments across Europe. However, there is a long way to go before any level of uniformity can be achieved given local and regional variations. Perhaps one of the most peculiar and lesser known ones is property valuations in Denmark.

In an already diverse market where performance numbers are difficult to compare because of the differing guarantee levels of the pension funds and pension and life insurance companies, the lack of independent valuation of property investments does not help the matter, according to investment professionals in the country.

Some argue that performance of property investments can be arbitrary and be used for marketing purposes because the valuations are subjective as they are conducted by the fund boards, rather than by an independent third-party. Even consultants argue that property valuations can be used to boost performance when other investments do not look quite so rosy. However, few funds seem to be willing to discuss their property investments.

Analysing performance numbers for 2006, it is apparent that real estate in particular was a boost to Danish pension fund performance. The asset class was the top performer for pension funds in Denmark, where the weighted average performance numbers were 3.8% before tax and 3.4% after tax, according to local consultancy Kirstein Finans.

Jan Willers, a consultant at Kirstein, says the valuation method for property investments is blurring the picture and makes it impossible to compare property returns. He adds that the way around it is to separate out property returns from other performance numbers.

Tine Heerup, deputy director at Finanstilsynet, the Danish Supervisory Authority says that the self valuation process for property, investment property and owner-occupied property is well-established and causes no concern.

"According to the Danish accounting provisions for financial companies, pension funds shall recognise and measure investment property at fair value. We do not think that this is more risky than most other fair value measurements, for example of securities."

She does concede that the practice is not entirely independent because the valuation is done in-house or possibly by a preferred party.

"We have in an annex to our accounting executive order describing the methods the pension funds have to use when they measure their investment property to fair value. The pension funds are allowed to base their measurement, or elements of the measurement, according to the prescribed methods on a valuation made by an external broker. The management of a pension fund is, however, responsible for the measurement and responsible for ensuring that the calculations are based on relevant data."

She adds that as property is recognised in the annual report, the measurements are part of the annual audit process. "The auditor shall as such assure that the measurements of property comply with the accounting requirements"

She adds that the regulator, in a selective way, checks the measurements made by the pension funds and that it has among its staff experts in property valuation who occasionally perform on-site inspections of the property. "It is, however, not very often that we find reason to require the pension funds after such a check to change their measurement of property."

Søren Andersen, CEO and founder of Invensure, a Danish investment consulting firm with a co-partner agreement with Mercer, explains the valuation method of property as an annuity that goes on forever. "You take the net rent, or profit, of a property, after costs, and divide it with a specified interest rate of the annuity. If you have 10% interest on net profit of a Dkr50m (€6.7m) investment, you have a valuation of Dkr500,000. You have to do this with each individual property."

He adds that this interest rate can vary from year to year and between types of properties held, leading to tremendous discrepancies in value. He notes that in theory, pension funds should have a valuation close to market value, but that is difficult to determine without an official valuation. He says it is mainly when funds buy property for the first time that an external valuation is done.

He continues that because of the amount of work involved it is impractical and impossible for the regulator to check all holdings, hence the current practice is likely to continue. He adds that a large Danish fund recently sold property holdings totalling Dkr1bn and was visited by the regulator shortly after. Heerup declined to comment on any individual cases but said it is rare that valuations change after a check. "We do not see the current practices as a problem and are not at the moment planning any changes", she notes.

Andersen argues that although he questions the valuation of property, it is not a criticism of any single fund because the system applies to all funds. He agrees with Willers in that property returns are used as buffers when returns are low. He also notes that separating the property investments from the rest is a step forward but that it is still difficult to compare property investments.

"When funds report returns it is of course impossible to do this with each piece of real estate owned. So instead they calculate the overall real-estate returns using an average interest rate. That interest rate can vary hugely, depending on the property you own. Housing might have a 2% rate whereas farming land has up to 15%."

Because of the various rates used and properties owned by Danish pension funds it is impossible to know the real value, he argues.

Some funds, such as Industriens Pension, have stayed clear of the issue, which does not seem to be much of a controversy in Denmark, by not investing in property much.

Jan Østergaard, chief investment officer at Industriens Pension, says the fund was a late investor into property but not because of any specific negative views on the asset class. "It is a question of priorities and we are still a young fund, established in 1993, starting from scratch with Dkr30m and investing in listed securities and bonds only."

He says the fund has invested in some Danish real estate on a very small scale and is winding those investments down. Instead the fund is in the process of investing in global property funds of funds, where the issue of valuation does not come up.

The fund is building its own team for manager selection, with the real-estate team becoming part of the fund's private equity team. It currently has three members working solely on private equity and is expected to grow, according to Østergaard. He says the aim is to have 5% of assets in real-estate investments, keeping up with the pace of the fund growth of €800m per year, and in the long-term have as much as 10% in property globally.

Andersen at Invensure says the move away from the domestic market to global property, and in particular real estate fund of funds, will lead to better transparency and possibly eliminate the valuation issue of Danish property investments.

Industriens Pension prides itself with having a forward-looking mentality. For instance, it moved into private equity investments between 2000 and 2003, ahead of many others and now it is looking at international real-estate, without first having gone the usual domestic investment route. During the first half of 2007 the fund has increased its private equity investments to 5% from 3.9% and has now one of the largest allocations to the asset class among Danish funds, he says.

In addition to increasing its property and private equity allocations the fund is also moving into infrastructure to boost returns and spread risk. The fund plans to boost allocation to 5% in the asset class over the next few years, Østergaard notes. The fund returned 2.3% for the first six month of the year with private equity contributing 16.7% to performance.

Other examples of six month returns are ATP, the largest pension fund in the country with assets totaling Dkr374bn, returned 3.5%, with property returning 6.9% for the six months to end of June. LD, another large Danish fund with assets of Dkr67bn reported returns of 2.2% for the first six month, whereas property returned 16.7%.

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