As the economy improves, Swedish pension funds are renewing their search for quality investment products at home, says Gail Moss

The stock market rebound this year has lifted Swedish property markets but rising equity prices have left real estate exposure decidedly underweight. "Swedish pension funds are generally maintaining their allocation, or even increasing it," says Ubbe Strihagen, director at Schroders Investment Management in Stockholm. "At the prime end of the market, they are happy to buy at a yield of 5.5-6%. To them, that yield looks very appetising compared with what they can get on bond portfolios at the moment, and with nothing from cash."

But this does not mean that Swedish property is out of the woods, warns Strihagen. The property market is lagging the UK by about nine months. "There has been a 15-20% drop in valuations, and they could lose another 15%," he says. "Things will get cheaper in Sweden over the next 12 months. However, the core sectors have already seen price adjustments, so it is the secondary sectors which will be affected."

Strihagen says the real economy has bottomed out and banks are starting to lend for property development. "Over the next two years, rents will stabilise, although we won't see any increase."

This renewed interest has been concentrated on the Swedish domestic market. The financial crisis has exacerbated a long-held reluctance to increase international allocations, following the banking crisis of the early 1990s. Swedish pension funds are also reluctant to increase currency risk.

AP3 is just one fund to bolster its Swedish exposure this year, buying stakes in two large Swedish real estate companies. It now owns 25% of Vasakronan, Sweden's largest real estate company, and 50% of Hemsö, which owns and manages public buildings such as nursing homes, schools and healthcare facilities. "Both these investments were made since they created interesting opportunities," says Christina Hillesoy, communications manager at AP3.

AP3's real estate made up 8.4% of its SEK188.6bn (€18.4bn) total assets as at 30 June 2009 and its target return is 10% per year over a three-year cycle.

Over the past two years AP3 has also acquired international real estate holdings totalling SEK0.7bn (4.4% of its real estate portfolio). AP3's international investments are held in pooled vehicles, with portfolios including retail, industrial/logistics and office in Europe and Asia. AP3's long-term aim is to add North American funds to these holdings.
However, the more domestic-biased trend within the pension fund sector has been counterbalanced by a continuing lack of interest in Sweden from outside.

John Routledge, partner head of capital markets, Nordic region, at Cushman & Wakefield in Stockholm, says. "During the last few years, the property market was shared approximately 50: 50 between Swedish and foreign investors. But the international buyers have been out of the market for 18 months."

Partly as a result of this trend, transaction activity is down by around 85% from its peak, says Routledge, who also blames sluggish sales and low trading volumes on the expectation gap between buyers and sellers, as well as a lack of available finance.

"Pension funds want to buy core product at 6% plus, but while owners realise that the market has changed substantially, few if any owners are willing to sell at below 5.75%," he says. "And the owners of core assets have no distress, as most are long-term investors."

Existing landlords are facing a softening market, according to Routledge. Supply is increasing because of new developments, but demand is shrinking.

"Until last Christmas, tenants were telling our leasing team that they needed more space," he says. "Now the same groups are saying they may reduce their current headcount further, so they need less space. Even if the underlying business is doing well today, many corporates still lack the courage to commit to a new lease, as it is not clear what the future holds."

He says the vacancy rate in Stockholm's central business district has risen from 6% to 10%. "But for Stockholm as a whole, it has gone from 10% to above 12%, and will probably reach 16% next year."

While Cushman & Wakefield expects the overall vacancy rate to increase over the next year or so, Routledge says it still sees healthy occupier demand for good-quality and well-located product.

But he also says rental levels fell by around 10% in Stockholm's central business district in 2009.

"And the real figure could be more than that, if you include the incentives being offered by landlords to hang on to tenants," he adds. "Standard rent frees used to amount to below 10% of the total value of the lease contract (ie, be for two or three months rent free). Now, you might get 15-20% of the total value of the lease contract - ie, six to nine months - often including a free fit-out. And tenants are not rushing to conclude deals, as things may be even cheaper in a few months' time."

Good premises still attract buyers. "From the pension funds' point of view, the challenge will be to find enough product to meet their allocation targets," says Charlotte Stromberg, chief executive officer, Nordic region, at Jones Lang LaSalle. "Everyone is looking for core prime product in Stockholm, and to a lesser extent Malmö and Gothenburg."

Stromberg says that indirect investing is increasing in importance, even in the domestic market. "Those institutions which have invested for years have traditionally gone direct and managed their properties in-house. But new pension funds are taking the indirect route, because of the flexibility and liquidity it offers. It is difficult to achieve a target allocation of, for example, 7-10% from scratch by buying assets piecemeal. Smaller funds can also do joint ventures through funds, which is a good match for a 20-year horizon."

Another factor making indirect real estate funds attractive at present is that Swedish pension funds follow IFRS, so have to mark to market asset valuations each year, including bricks and mortar.

"These funds have seen capital values falling, which gave them a negative total return last year of about 3%," says Stromberg. "But when the market starts to improve, indirect investments will be quicker to react, as they are valued more frequently."

Strihagen sees some light at the end of the tunnel for direct investment. "Over the past year it has been almost impossible to get financing for property acquisition," he says. "Now, after the summer, banks are in better shape and are starting to lend money again for commercial real estate, so the sector is picking up." And he says that Swedish pension funds are already preparing to re-enter markets abroad.

"We are now seeing some funds starting to screen for the UK property market," he says. "Values in the UK have fallen 45% so it has become very attractive, as well as from a diversification point of view. The US is also top of the agenda because of similar falls, and because the economic outlook there suggests that now would be a good time to step back into the market."