Icelandic pension funds' relationship to real estate has been tenuous partly due to lack of product. Things are now changing as Maha Khan Phillips reports

For Icelandic pension funds, investing in real estate is not necessarily an easy thing. Under current regulation, a pension fund is not allowed to invest directly in the asset class. As a result, many are investing in related asset classes that don't provide real estate-type characteristics to their portfolios. Pension funds say they would like to see this change, but that they have far too many battles on their hands already.

"I don't think the limitation of direct investment is one of our top priorities," explains Gylfi Jónasson, managing director at the Festa Pension Fund, the Western Province fund. "We have many constraints on investments, the main one being that we're limited in our investments in unlisted securities. The maximum allocation to unlisted securities we can have is 10%, which is quite constraining. So there are other issues that are more pressing."

Instead, pension funds get their exposure to real estate through other, much less direct, means. "Historically, we've been involved in the local real estate market through direct lending to participants," says Jónasson.

Pension funds buy bonds issued by the Housing Financing Fund, a Reykjavik-based agency 100% owned by the Republic of Iceland. Its main task is to provide loans to individuals, local authorities, companies, and non-governmental organisations for residential dwellings. Total lending by the Housing Financing Fund reached ISK5.6bn (€64m) in September, and reached ISK43.9bn in the first nine months of the year. 

In 1980, pension funds saw nearly 60% of their assets invested in bonds from the scheme. By the end of 2004, this had halved to approximately 30% of assets. "It's quite convenient for pension funds, because the rates take reference to government mortgage rates. Pension funds would offer rates that are competitive, but maybe 50bps above the government rate," says Jónasson.

When pension funds are not offering direct lending to members, they are buying bond issues from real estate companies. "Right now, we're talking about a very small fraction of our total portfolio. The loans we provide to participants amount to around 2% of the portfolio, while our bond exposure to Icelandic real estate companies would be somewhere around 1%," says Jónasson. This smaller allocation is partly a reflection of the fact that buying bonds and issuing mortgages, although they are long term in duration, don't necessarily provide the  investment characteristics of real estate.

Festa, alongside other schemes, are looking to invest overseas. The fund's allocation to European property funds stands at roughly 1%, although Jónasson says the scheme plans to diversify to other geographic areas as well. "Our strategic allocation to alternatives in general is 10% and we are nowhere near that goal. Altogether we've probably invested some 5% in private equity, hedge funds, and real estate in total. But slowly and gradually we'll get there," says Jónasson.

Other pension funds have similar ambitions. Tryggvi Tryggvason is chief investment officer of the Gildi pension fund, the product of a merger last year of the seamen's fund and the general workers' fund. He says that, while allocations to property are still at 1%, he hopes to see an expansion. "Real estate is a learning process, and we're doing our first investment. We have more or less looked at international markets, because there are not too many funds in Iceland," he says. The fund looks at value added and opportunistic funds and fund of funds. Tryggvason says alternatives will increase generally, with the fund allocating 5% of its portfolio to alternative asset classes.

Meanwhile LSR, the pension fund for state employees, made its first foray into real estate this year. However, the fund declines to comment on what type of product it has placed its asset in, or whether it is invested internationally or domestically.
Pension funds say there are limitations on the number of products on offer, but products are appearing. In 2006, Reykjavik-based investment manager Kaupthing Bunadarbanki launched an opportunistic private equity real estate fund, the International Real Estate Fund, which is a fund of funds vehicle, and worth approximately €60m. "We had an established relationship with a lot of private equity houses, and they were moving into real estate, and we decided to tap into that and explore what opportunities there were," explains Bjarni Gudlaugsson, chief investment officer. The fund has had one close, and Gudlaugsson says it has some promising assets. "We think it's going to give us a healthy return." Still, there is a dearth of information about real estate in the market that is limiting investors, both domestically and internationally, says Sölvi Blöndal, who is responsible for research at Kaupthing.

"Unfortunately, compared with other countries, Iceland has very limited data resources. There is some information about the residential house market, but as far as the occupational housing market is concerned, information is almost non-existent," he points out. Blöndal says that institutional investors are demanding increasing amounts of information. "We are trying our best to comply."

Kaupthing expects a cooling of the domestic real estate market in 2008, forecasting a 9% rise in property prices this year, followed by a slowdown on the market, with the 12-month increase bottoming out at 2.5% at nominal value.

The firm believes that instability of the exchange rate will put people off taking loans in foreign currencies. Also, the high interest premium on international capital markets following the sub-prime crisis has led to a deterioration of banks' credit terms. "The real estate market will embark on a new course at the beginning of 2009 as the economy starts to pick up and lower interest rates, easier to access to loan capital and higher household buying power will stimulate demand on the real estate market," says the firm.