The reputation of the Dutch real estate industry suffered another blow this year with the disclosure of a large fraud investigation. As Leen Preesman discovered, Dutch pension funds have other property-related matters to contend with

In May, the Dutch Internal Revenue Service (IRS) ordered 600 real estate companies to pay €330m in fees and back taxes after it investigated almost 1,300 firms in the industry. The evidence of fraud and fiscal irregularities was uncovered as part of an investigation dubbed ‘Operation Nokvorst'.

In addition to back taxes and fines, criminal procedures have been started in eight cases, including the notorious property fraud involving former directors at Philips pension fund and Rabo Bouwfonds. The investigation has made it clear that the real estate industry's transparency leaves much to be desired, the IRS said. According to Frans Weekers, under-secretary of finance, companies attempted to keep revenue off the books, mainly through middlemen and other structures.

However, according to Frank van Blokland, director of the Association of Institutional Property Investors Netherlands (IVBN), this has painted a wrong picture of the sector by implying that the entire Dutch real estate industry was being investigated. "Weekers failed to mention that the investigation was not at random, but based on suspicious transactions," he says.

The IRS said it would undertake follow-up investigations, collaborating with organisations, including Dutch pension funds. But there is also a sense from the pension fund community that the implications of the fraud investigation have been over-emphasised.

Karen Huizer, investor relations manager at Bouwinvest, which manages the assets of Dutch pension fund BPF Bouw, says it was not a wake-up call. "We think the issue has been exaggerated," she says. "The inland revenue has probably looked at many small and private companies."

Huizer adds that the largest part of the institutional real estate industry was already applying new transparency and integrity rules. IVBN had already taken the initiative for a sector-wide body to promote honest practices in the commercial property market, as well as jointly surveying the options to keep out unreliable players and employees. The Integrity Consultation Property Market (IOV), which has a contact point at government level, aims to improve internal supervision, increasing transparency, preventing conflicts of interest and tightening internal rules to prevent ABC transactions.

The IOV said it had expressed its worries to the national body dealing with property fraud about large-scale settlements with defendants. "As a settlement is not a conviction, the sector is facing the dilemma that the persons involved often want to continue a relationship or start new businesses," it explained.

The IVBN has further decided to establish a database of investment transactions, so professional market players can validate taxations based on actual transactions. The database must also provide more transparency of the institutional property market. "We expect that we can offer our members the first validated transactions later this year," says Van Blokland. He adds that other commercial players will be invited to provide input, and they will also get access to the database later.

In Huizer's opinion, initiatives already taken by IVBN are sufficient, and additional legal measures are not necessary at the moment. "However, fine-tuning of the rules will be a continuing process," she says.

Patrick Kanters, managing director global real estate at Dutch pension fund asset manager APG, says: "Key in our fraud-preventing policy are clear arrangements with the external managers about what information they provide and their frequency of reporting. We demand an extensive quarterly report on, for example, valuation, the composition of the portfolio as well as leverage. In addition, we have the assets valued by a third party every year.

"And by being represented in funds' investment committees and advisory boards, we
can monitor acquisitions, divestments and other management activities. A protocol indicates when we must be consulted about decisions. Moreover, we have arrangements with external managers in place to prevent conflicts of interest."

According to Kanters, the most important element of APG's internal process to prevent irregularities is that a broad variety of people in the organisation are involved in decisions on investments and divestments. "People from investment control, sustainability and governance, as well as from tax and legal, are directly involved in decision-making in following a clearly described process," he says.

More pressing issues to deal with
The Dutch real estate market recorded its first positive annual total returns in 2010, according to the IPD/ROZ Netherlands Annual Property Index. The 4.6% return was delivered mainly by improving income returns (5.4%), while capital values continued to fall, by 0.8%. More recently, IPD/ROZ's quarterly index showed that total returns were only 0.6% over the three months ending on 30 June 2011 (although when annualised, the quarterly results show an annual total return of 4.4%). Capital values continued to slide over the three-month period, by 0.6%, while an income return of 1.3% ensured the total return remained positive.

The market is therefore yet to undergo a strong recovery. IVBN estimates the vacancy rate in the Dutch office market to be more than 14%, although this falls to 8% when concentrating only on offices in institutional portfolios. To "cure the office market" IVBN has taken the initiative to tackle the vacancy rate together with local governments, focusing on the sustainability of the existing offices. "The offices market is a replacement market, with new buildings immediately leading to vacancies elsewhere," IVBN stated.

"In our opinion, only new property should be added on top locations if there is a real demand, and new developments should be combined with the removal of ageing property," says Van Blokland. He believes it will take at least five years before the sector-wide action plan delivers results. "There will be quite a lot of pain, in particular among the many small and private investors in the lower segment who might need to demolish property," he says.

According to the IVBN, the retail market is performing well, although differences between A, B and C locations are still growing. It also indicated that it is anticipating a strong decrease in the number of outlets. At the same time, it is expecting a considerable rise of retail surface during the next 10 years, following a trend towards more chain stores and up-scaling, as well as the additional effect of population ageing and internet shopping.

To prevent a surplus of retail surface, IVBN has called for consultation between investors, the retail sector and local governments. In its opinion, the focus must be on reinforcing inner cities and shopping malls in retail core areas, as well as on modernising existing retail centres. "Peripheral and large-scale extensions should be prevented," it stressed.

All of these developments in the domestic real estate market are important for Dutch pension funds. The established trend among the investor community is to replace directly-held real estate portfolios with non-listed fund investments, although there is still a widespread intention to retain a significant exposure to the domestic property market. But whether the trend will endure is another matter.

According to Peter van Gool, head of property investments at pension provider SPF Beheer and professor of property economics at Amsterdam University, directly-held Dutch real estate comes the closest to being the ideal real estate investment. It delivers real, stable returns, acts as a shock absorber and can also offer an inflation hedge through long-term rental contracts. "The returns of the increased investments in indirect property have been disappointing," he says. "In particular, highly leveraged indirect real estate has caused problems."

Henk Jagersma, chief executive at real estate investment manager Syntrus Achmea Vastgoed, agrees: "Our surveys show that a property portfolio of mainly Dutch direct real estate is ideal indeed," he says. According to Jagersma, pension funds are increasingly establishing joint venture direct property funds. "These are generating better net returns than indirect real estate," he says. In his opinion, Dutch direct property is the best protection against inflation and interest risk for pension funds.

In the years following the onset of the financial crisis, a large volume of high quality real estate has come to the market, at the same time that foreign buyers have left. Jagersma says that several Dutch pension funds have raised their property allocations during this time (the average is estimated to be close to 10%), particularly those with smaller real estate holdings. "Following our own surveys, as well as research from consultant Ortec, we advise our clients to switch to a stake of between 20% and 25%, as the optimal allocation," he says.

There has been a flight to quality in recent years across Europe. Dutch pension funds have been part of this trend. "We are focusing on rental income for a steady return," says Maarten van der Spek, senior strategist and researcher for private real estate at PGGM, the investment manager for pension fund PFZW. "As the development of property value is highly uncertain, it is unlikely that capital growth will contribute to strong returns on real estate investments for the time being."

PGGM is targeting a global real estate exposure through both listed and non-listed fund investments, allocating 33% to North America, 28% to Europe, 34% to Asia and 5% to emerging markets. "We have solely invested in property funds, rather than in direct property, because it offers the advantage of diversification," Van der Spek says. "And by picking specialised niche managers, the diversification is still effective during hard times."

Van der Spek is convinced that the main challenge is to find high quality property, "as everybody is looking for it". Determining the investment strategy has also become more complicated because of the current financial turmoil. There is much financial and economic uncertainty, with interest risk and inflation risk, as well as market sentiment, playing a growing role, he says.

Any ‘flight to quality' cannot be made without giving due consideration to sustainability and energy efficiency of buildings. Earlier this year, PGGM, together with APG, Denmark's ATP Real Estate and the UK's Universities Superannuation Scheme (USS), launched a sustainable real estate benchmark. The Global Real Estate Sustainability Benchmark (GRESB) aims to enable the assessment of the sustainable performance of real estate investment managers.

"We haven't only started the initiative for idealistic reasons," Van der Spek says. "We also believe that sustainable management delivers better returns ultimately."

"The trend to sustainability is irreversible," agrees Cor Worms, manager, research and development at Syntrus Achmea Vastgoed. "It is one of our key targets, and we don't have any doubt that the most sustainable objects are performing better."

According to Worms, population ageing will also become an important issue in the property market during the coming decades. "It will have consequences for residential and retail properties, as well as the use of buildings," he says. Anticipating this shift, Syntrus Achmea has established a fund for care property, aiming at combined residential and care facilities.

The investor's focus on care property follows the tendency in Europe of governments withdrawing from the economic process, through deregulation and cutting expenses, Worms explains. "We are expecting an increasingly important role for the private sector in developing social property, such as community and educational buildings as well as cultural facilities," he says.