Southern European investors stuck in an economic hole are likely to stop digging and hold on until the worst is over, as Shayla Walmsley reports

When the financial crisis struck, mature European investors headed for home, moving out of markets and sectors they perceived as particularly risky to retrench within their own regional borders. Investors from southern European economies smacked with home-grown deficit mountains did the same. So why didn't they head for the hills - or German retail? In fact, they did not do much of anything.

The sit-and-wait approach is largely all these markets have in common. "You have to be very careful to distinguish between Portugal and Greece, which have already gone to the IMF for help, and Spain," says Sabina Kalyan, European head of research at CB Richard Ellis. "You see opportunistic private equity players going into the Spanish market looking for distressed assets, while domestic investors look for core."

Spain's is a complex market made up of two segments. The first comprises single buildings and little groups of two or three buildings. These appeal to family offices and German funds with less than €25m to invest. Buildings whose value exceeds €50m - the second segment - are comparatively scarce.

"The reality is that there is not a widespread trend towards divestment because many think it sub-optimal to divest at this moment in the cycle," says Ismail Clemente, head of RREEF in Spain. "Spain and other markets are caught in the middle of nowhere. It will take time for them to come back. In the meantime, the market is anticipating a greater level of distress."

But this is not solely about the property market; nor is it just about macroeconomics; what pension schemes might invest in depends on how all those pension schemes invest. No two European countries' pension systems work in the same way, and neither does how pension schemes invest in real estate. In some cases, the constraints on investment are regulatory, but reforming tendencies that would have made investing in real estate easier - or even possible in some markets - have effectively been put on hold with the financial crisis.

Greek pension funds are only just beginning to invest in real estate. The government last autumn changed the law to enable pension funds better to manage real estate assets. Under the new law, pension funds looking to invest directly will be able to select only from developers and asset managers listed by a single firm, EDEKT. CEO Nicholas Tessaromatis told IPE at the time that much of the real estate held by pension funds directly had been on their books "for decades".

One positive indication for future progress in real estate investing has been the removal of the dual pricing system, where property could be valued at this market price and the price based on the (usually lower) official state square-metre price.

For most Portuguese schemes there is no regulatory limit on real estate investments, although personal pension allocations are capped at 20%. The average allocation to real estate is 15% - not surprisingly, given its recent outperformance. Commercial real estate last year delivered a strong performance - 5.8%, largely the result of income returns - after two years of negative returns. It outperformed both bonds and equities.

A January Economist Intelligence Unit forecast for the Portuguese asset management industry claimed that pension funds, as long-term investors, were less likely than other investors to suffer as a result of domestic and global economic uncertainty. But the pension system is itself uncertain - and seemingly regressing. In December, Portugal Telecom cut a deal with the government to transfer €2.8bn in pension assets from its three schemes to the state social security system. The transfer of Portugal Telecom's pension fund amounted to a boost of 1.6% of GDP to the national coffers.

As if Spain's three-pillar system weren't sufficiently dominated by the public pension scheme, in January 2007 the government reduced tax incentives for occupational pensions. According to Allianz, only around 7% of companies offer a retirement plan, 25% of them reserved for executives. Jaime Nieto-Márquez, deputy practice leader of benefits consulting at Towers Watson Spain, earlier this year argued that the introduction of a private pension system in Spain would "take a genera tion".

The more troubled the Spanish economy, the less likely it is to diversify away from domestic debt. Pre-crisis debate that mooted diversification of the €58bn Fondo de Reserva de la Seguridad Social (Social Security Reserve Fund) into private bonds and equities seems to have stalled. The reserve fund has diversified - but only part of its allocation away from Spanish public debt into other countries'. The most recent full-year figures for the fund reveal that it holds 87.9% in Spanish public debt and 12.1% in French, Dutch, and German public debt.

The constraints on pension schemes are obvious from what they don't invest in, as well as what they do. Hans Meissner, managing partner of the UK-based EISER infrastructure fund, recently suggested that overseas pension schemes - and other bidders, including EISER - would team up with local Spanish pension funds in joint ventures to acquire privatised airports in Madrid and Barcelona.

You can see why these assets would be attractive to pension schemes, not just in general terms because of the inflation link and the income yield, but because both these specific assets have high traffic volumes and capacity. The problem is that Spanish pension schemes do not really do infrastructure - or at least not enough of them to give an overseas investor much of a choice.

Viva Italia
The regional exception is Italy. Not only does it have a larger and more sophisticated pension fund community than its neighbours, it also has a long tradition of investing in real estate. Mercer senior associate Armando Piccinno points out that the investment patterns of Italian pension funds are influenced by tradition. Rental yields and relative price stability have helped.

The problem for Italy is that pension fund investing in real estate is strictly regulated. Mostly defined benefit (DB) schemes that existed before 1993, which are now closed to new members, can hold real estate directly or indirectly. Mostly defined contribution (DC)schemes created under legislation introduced in 1993 to replace the earlier DB schemes can invest in real estate only indirectly - with no alternatives and no shorting. The Pension Funds Supervisory Authority (COVIP) has recommended a 20% cap on allocations to real estate by May 2012.

"Historically, allocations to direct local properties from the so called pre-existent pension funds and cassa have been high. In the past few years these allocation had been reduced, even though in some cases properties still play an important role in the asset allocation," says Piccinno.

Allocations vary significantly. The engineering pension scheme has more than 30% of its overall portfolio allocated to real estate. In contrast, the €4bn lawyers' fund allocates €0.5bn. "There is no clear pattern. If you're an engineer, real estate looks like a good thing. But if you're a lawyer….," says an asset manager with knowledge of both schemes.

Italian pension schemes tend to be more innovative in how they invest in real estate
than their southern European neighbours.

The Social Security agency (Istituto Nazionale Previdenza Sociale - INPS), for example, announced in April that it would set up a property management company and a fund management arm to own and manage its property assets. The rumoured €2bn fund will hold residential and land.

All Italian pension funds sign a Società Gestione Risparmio (SGR) agreement with an external asset manager. The Fondi Immobiliari Italiani (Fimit), for example, in January linked up with First Atlantic Real Estate to create an €8bn AUM property management company with 19 managed funds, five of them listed. The National Insurance Institute for Public Administration Employees (INPDAP), which owns 30.7% of FIMIT, will have a 18.33% stake in the new firm and the National Insurance Institute for Workers in the Entertainment Business (ENPALS) will hold 11.34%.

Pension funds also manage funds for other investors. In April INPDAP opened its €630m Aristotele property fund to other pension schemes, and extended its life for 10 years. The fund invests in student accommodation and nursing homes. It already holds 1,500 student homes in Rome, with another 550 scheduled for delivery this year. It has invested €180m in the sub-sector since 2005, not only in Rome but also in Milan and Bari.

Recent transaction activity has been robust. As it announced that it would open its student accommodation fund, Inpdap also announced that it would sell a portfolio of 75 office properties valued at €400m. Meanwhile, Ippocrate, a fund owned mainly by Enpam, the private-sector scheme for doctors and dentists, acquired Milan's Rinascente building for €472m from fund manager Prelios.

Yet, even amid this activity, reforms have stalled. Industry body EIRE has in recent months criticised the Italian government's indecision over legislation mooted last year on funds, especially new tax rules. Although pension funds are still exempt from withholding tax, much of the draft presented to the industry has not survived government intervention. Fimit managing director Massimo Caputi claims the industry's views on the reforms have been "totally ignored". Cometa, Italy's largest private-sector pension scheme, has likewise been outspoken about restrictions on pension scheme investment. The €6bn scheme, which covers the engineering industry, is second in size only to INPS and INPDAP.

In the meantime, the DC schemes that are gradually replacing DB schemes are largely invested in pooled balanced funds, with 80% of their portfolios invested in equities and bonds. They could do with alternatives, especially real estate, but the tide is against them.

If regulatory and other constraints are stopping southern European investors from maximising their property allocations, there is still less chance that they'll diversify outside their domestic markets. The exception, once again, is Italy.

The more respectable real estate becomes as an asset class, the more likely Italian investors are to go outside their home market. It's a move that will be driven not by economic crisis, but by a natural process of toe-dipping diversification. But it will take a while.

"The drivers that led to real estate investing were not entirely linked to the economic performance of Italy," says Piccinno. "Some players are now becoming conscious of the anaemic future growth of Italy and we are starting to see with some favour a more global exposure."

But for pension funds in other southern European markets, there is sense in staying home and holding tight. Kalyan points out that in Spain and Italy tax treatment of investors is up for change. "If you can afford to weather a two-year period, in the long run it will have an income stream, if not a massive income. Compare property with equities and bonds. It offers a nice, reliable, inflation-linked income. Combine that with low-yield bonds and property with a real yield of 5%. Index-linked is even better."

The rich are different
So what does all this tell us about southern European pension fund investors in real estate? It is clear that how they change their investment in an economic crisis depends on what they had before - not only in the real estate market, but in their own structures. Greece, which had barely allowed pension schemes to invest in real estate, is unlikely to bite the bullet now. Spain is years away from credible pension reform and its pension schemes are years away from being significant investors in real estate.

That Italy is an exception tells us something not only about the Italian real estate market - that it is more open, more innovative, and more vibrant than its neighbours' - but also something about its parlous economic situation. Kalyan has described Italy vis-à-vis its public debt as "a serial offender", but she also points out that it is the most sophisticated public debt markets in the world after the US and the UK. Some regions, such as Lombardy, are remarkably wealthy. "If domestic investors look at that market, I wouldn't be surprised," she says.

Italy has not gone to the IMF. Thus far has it fudged, and thus far has it worked. That is a significant difference.