Some Icelandic investors are looking to real estate to help them improve performance, but in the wake of the country's financial collapse prospects are limited. Gail Moss reports

The pension funds of Iceland are still recovering from the seismic shocks that have hit the national economy over the past year, when average inflation hit over 16% and the value of the Icelandic króna fell by over 80%.

This time last year, the world looked on at a scenario of economic meltdown, with the big banks going to the wall, severe deleveraging in the financial system, and fire sales of assets held abroad by Icelandic investors.

However, Iceland has come out on the other side, but with economic statistics that still make grim reading. And its pension funds have been bruised, if not as badly as some other institutions.

The real rate of return for Icelandic pension funds over the 12 months to 31 December 2008 was -21.78%, according to the latest figures from the Icelandic Financial Supervisory Authority. Meanwhile, the value of net assets dropped by 6% over the course of the year to ISK1.6trn (then worth €8.8bn).

But at least pension funds have started looking to the future again, including plans for real estate investing. "Our intention is to build up our real estate holding to a slightly bigger percentage of our portfolio," says Kari Arnor Karason, managing director, Stapi Lifeyrissjodur, a regional pension fund. "We are probably through the worst in terms of real estate in most markets, although some pension schemes are still facing difficult times. Obviously things have been tough, and most of the funds are still struggling to make positive returns this year, but it's normalising, and in the third quarter of this year we have seen a slight pick-up."

Iceland's Pension Fund Act says pension funds cannot invest in real estate directly except to the extent that such investments are necessary for the funds' activities - for instance, owning their own offices. However, pension funds may invest indirectly through real estate mutual funds, REITs or specialised real estate companies.

At present, Stapi's property assets are worth €14m, or 2% in value of its €700m total assets and include holdings in pan-European funds. Stapi does not invest in the US at present, for tax reasons.

"At the moment, capital restrictions are limiting what we can do abroad," says Karason. "However, we will probably carry on investing in property next year, and may look at domestic real estate, in sectors such as local government and healthcare."

But in spite of some stabilisation over the past year, the economy is still troubled.

"We have seen a sharp reduction in Iceland's GDP - a year-on-year decline of 6.5% at the end of the second quarter this year," says Nadja Savic de Jager, senior analyst, research, at CB Richard Ellis Investors. "Private consumption has fallen by 17% in the same period and this is proving a big drag on GDP."

Savic de Jager's remarks are tempered by the fact that most big property agents are not represented in Iceland, as the market is so small.

She says: "Imports have now fallen off a cliff, although exports have gone up. But there are further complications because imports are now so expensive, and some companies, such as McDonald's, are moving out of the country."

"As far as I know, there is little or no interest in real estate at the moment," says Hrafn Magnusson, managing director of The Icelandic Pension Funds Association. Magnusson continues: "Pension funds view real estate as part of their foreign assets and as a long-term investment. But there are currency controls in place, which do not allow us to make any new investments abroad. And very few opportunities are available locally."

Magnusson says that at present the expectation of future return from real estate funds is between 8-15%, depending on the sector and type of investment.

However, a feature of Icelandic pension fund portfolios is the inclusion of assets related to the domestic residential market.

First, pension funds buy bonds which have been created to finance the state housing loan system. These are issued by the Housing Financing Fund, and at the end of August this year, made up just over 19% of Icelandic pension funds' net assets of ISK1,738bn when aggregated with smaller amounts of other housing bonds, according to the Central Bank of Iceland.

This is a sizeable increase over the 13% share which these bonds represented as at end-August 2008.

Second, pension funds make mortgages available to their members, secured against residential housing. By the end of August, these were equal to just under 10% of net assets, compared with 8% as at the end of August 2008.

But domestic property is no longer the gilt-edged asset it once seemed to be. Magnusson observes: "There is a price decline in all real estate sectors because of oversupply, and inflation has been burning up any capital gain through increase in asset prices. Nearly all mortgage loans are inflation-linked." He continues: "The financial crisis has lowered prices, and people and companies have moved from owning to renting. Housing prices have gone down significantly in real terms, but less in nominal terms."
Gildi Lifeyrissjodur has no direct property investments, just a small amount in funds of funds invested on a pan-European basis.

But like many other Icelandic pension funds, it has made mortgage loans to its members, which it does not regard as property investments. The mortgages make up around 5% of the pension fund's €1.2bn portfolio.

"However, the economic situation is not exerting a big influence at the moment, as the loans are all well secured," says Tryggvi Tryggvason, chief investment officer at Gildi.

At a wider level, things may not be so stable. "All the recent economic developments will of course affect the property market," says Savic de Jager. "The economy will expand, but at very low rates below the long-term trend." She says that achieving a good healthy occupier market means that GDP needs to grow by at least the long-term average.
"In the next five years, it is very unlikely that we'll see these rates of growth," she says. "This means occupier markets will be very weak."