Unnecessary scepticism about foreign real estate means that Swiss investors are limiting their own scope. And are they placing too much emphasis on liquidity? Richard Lowe reports

Pension funds in Switzerland are finding themselves under increasing pressure to reassess a long-standing investment philosophy - one that says their real estate investment objectives can be achieved sufficiently by investing directly in the Swiss market.
Swiss pension funds are for the most part investing in real estate for three reasons: to gain stable cash flows, hedge against inflation and generate returns that are not correlated with their equity and fixed income investments. Historically, property in Switzerland has served pension funds well in achieving these goals, but their reliance on the market is becoming unsustainable for a number of reasons.
For example, the internationalisation of real estate markets has made it increasingly difficult to justify investing in the Swiss market as though it exists in a vacuum and by not taking into consideration the broader European - or global - context. A more pressing driver is the dwindling number of investment opportunities in Switzerland for institutional investors which often find themselves in direct competition with each other for the same assets. Furthermore, the growth of cross-border capital threatens to exacerbate the situation, although for the time being foreign investors are not allowed to invest in Swiss residential property, which is the favoured sector among pension funds.
"In Switzerland it is very difficult to acquire real estate at the moment," says Jan Eckert, managing director at Sal. Oppenheim Real Estate. "The market is relatively expensive and there is simply not much around to buy."
According to Eckert, a number of pension funds were unable to purchase Swiss real estate in 2007 despite wanting to, "either because there were no transactions or they were too expensive or they were out of reach for the pension fund".
Indeed, Andres Haueter at Pensionskasse Post, the CHF13.5bn (€8.39bn) pension fund for Swiss postal employees, admits that the institution is below its target allocation (its current allocation is 10.6% versus a target allocation of 12.5%) because of a "lack of interesting investment opportunities in Switzerland". Meanwhile, the CHF2.8bn multi-employer pension fund Caisse Inter-Entreprises de Prévoyance Professionnelle (CIEPP) is also lagging its target allocation of 10% (it is currently at 6.1%) "as a result of a dilution due to a sharp increase in the fund's assets" and a "difficulty to find opportunities for direct investments in the region," according to fund director Marçal Decoppet.
There is pressure for change, therefore, and a growing number of pension funds are decreasing their overweight exposure to Swiss real estate and are beginning to diversify outside their home borders. Some have been doing so for some time, such as Pensionskasse Post, which has been investing in real estate markets outside Switzerland since 2003 and today invests 50% of its real estate allocation abroad.
However, this perceptible trend is taking place at a slow pace, with the vast majority of pension funds still relying on direct domestic portfolios. For the time being the expectation is for steady change and no sudden overhaul of the industry's long-standing approach to real estate investment.
Pension funds' appetite for overseas investment also depends on their attitudes and knowledge of investing on an indirect basis. The main shift from direct to indirect is actually taking place within the Swiss national borders, whereby pension funds transfer their directly held portfolios into tax-transparent investment vehicles known as Anlagestiftung (AST), They continue to supervise these but are able to relinquish their asset management duties. Between 2000 and 2008, the average volume in ASTs doubled.
As Eckert explains, these vehicles are unique to pension fund investors. "It is a very efficient way to invest in property in Switzerland for the pension funds," he says. However, "the next step" - ie, diversifying into European or global real estate - is "at the very beginning at the moment", he adds.
One might assume that embracing indirect investments at home would serve as a helpful stepping stone in progressing to overseas investment, which by its very nature requires an indirect approach. However, there are a still number of obstacles.
One might be currency risk - "pension funds are not used to dealing with different hedge strategies for foreign currency exposures in real estate and so on," says Eckert. But the biggest hurdle he believes is the fact that regardless of whether pension funds manage their domestic properties directly or via an investment foundation, they have "no knowledge or resources to invest indirectly in properties outside Switzerland".
He explains: "The equities are mandated usually with an asset manager, the alternatives are also often through fund of funds structures and other external asset managers. So if you go to a pension fund for an indirect investment outside Switzerland, it is basically a very difficult decision-making process.
"More and more pension funds in Switzerland have outsourced their asset management activity. They are basically supervising the external asset management. And so suddenly you have an investment decision which has to be taken in an environment where you don't have any expertise. That is a problem."
Another issue is that Swiss pension funds often target a certain degree of liquidity within their domestic real estate investments: in the direct market they prefer to invest in assets that can be sold within 12 months, should the need arise; when it comes to indirect investments in Switzerland they only have experience of open-ended vehicles. This demand for liquidity seriously limits the investment opportunities for those pension funds looking to invest across Europe or globally, because it discriminates against funds with defined investment durations.
"As they are used to being invested in open-ended structures here in Switzerland, they are absolutely inexperienced in investing in closed-ended structures," Eckert says. "In the global indirect real estate investment universe there are a lot of closed-ended real estate investment products and there is a reason for it. Swiss pension funds have difficulty in allocating money into such closed-end structures. They are rather looking for open-ended structures."
And as Eckert points out, Swiss pension funds that have ventured into open-ended funds outside Switzerland in recent years may well have been disappointed with the returns they are looking at today. "If you have invested in an open-ended structure in core property two years ago then you probably haven't had a good performance," he says.
Credit Suisse's Pensionskassenindex revealed earlier this year that the average total returns for Swiss pension funds (in this case, those that specifically employ the Swiss banking group as their custodian) in 2007 was 2.04% - a disappointing figure that is below the minimum Pension Fund Act basic rate of return of 2.5% for 2007.
Ironically, pension funds' direct real estate outperformed (averaging a 4% return) most of their other investments, according to Credit Suisse, including overseas property. For instance, the Sulzer Vorsorgeeinrichtung pension fund recorded a return on its direct real estate of 4.31% in 2007, but its indirect investments were negative at -3.10%. And while the CHF50bn Pensionskasse Freelance, the industry-wide pension fund for freelance journalists and photographers, posted a return of close to 0% on its domestic real estate assets in 2007, it suffered a negative return of -10% from its international property investments.
And so for those who have ventured outside their national borders, many may feel as though they are nursing burnt fingers. As Eckert suggests, it would be specious to suggest that the relative outperformance of Swiss real estate in 2007 is a justification to eschew global real estate per se. But he admits that, along with the general volatility in the real estate markets at the moment, it does make it harder to convince pension funds to diversify internationally for the first time.
"Today we have the situation where most of the foreign property markets - but not the Swiss market - have suffered, so the ones having no exposure outside Switzerland are on the good side. So, there is a challenge to convince a pension fund about global diversification needs.
"Due to the fact that we have a financial crisis and the Swiss real estate market was not affected at all you need a lot of energy to convince them that they should right now invest in Asia, Europe or the US. In the early 1990s it was exactly the other way around.
"At the moment there is no dramatic need to shift this strategy. There are a number of pension funds that simply say: ‘we won't change anything; we don't have a reason to address the real estate side, so we simply run it as it is'."
Pension funds will be even less pleased with the recent performance of listed real estate. And with listed real estate offering even more liquidity than open-ended non-listed funds, many pension funds have gone down this route.
For example, the first pillar pension fund Ausgleichsfonds der AHV (Swiss Federal Social Security Fund) has yet to invest in non-listed real estate, but has been investing in property securities since 2000-01. AHV pension fund manager Eric Breval reveals that the fund is "keeping an eye open for all different forms of real estate", including non-listed, which it has yet to invest in "for various reasons". Breval admits that the recent volatility of the listed sector makes is it a more pressing issue.
Swiss pension funds currently allocate more capital to international listed real estate (15-20% of their real estate assets) over non-listed funds (10-12%). But Stephan Kloess, founder of Kloess Real Estate advisory business, expects a preference for the non-listed funds to emerge as pension funds begin to realise that the price of greater liquidity of listed real estate is caused by a higher volatility. "Listed real estate behaves in a short- and mid-term perspective like equities and not like real estate and this fact reduce the diversification effect."
He explains that pension funds are often trying to achieve a level of liquidity that allows them to exit investments in less than 12 months. "Often they try to harmonise it with their thinking in the direct market, whereby you are able to sell an object in a one-year period," he says. "At this stage they are not used to the 10- or 12-year investment period of non-listed funds and their advantages."
But Kloess expects pension funds are under increasing pressure to reassess their approach, not least when it comes to investing in listed real estate. "If we look at the last half-year, listed real estate came from premiums of 30% to discounts of 30% in six months. This is not the risk they want to take with real estate."
In addition, Swiss pension funds begin to feel an increasing specification on attainable returns in conjunction with a strong cost pressure in their direct investments. So, Kloess expects an ongoing shift from direct investments into non-listed indirect Swiss-based funds, indirect non listed foreign funds and funds of funds.
However, Swiss pension funds are possibly targeting what can be described as "emotional liquidity" or the knowledge that they can exit from investments if things go wrong.
Ulrich Kaluscha, managing director of Sal. Oppenheim's indirect real estate investment platform 4IP, believes this might be the nub of the problem. "From my experience here in Switzerland," he says, "they try to at least have the impression that if something went wrong you can run away."
This aversion to being tied up to new investments, particularly those that are new and unfamiliar for the investor, is an understandable one. However, with the case of open-ended funds, the logic of seeking liquidity in case you want to back out of an investment begins to fall down. Normally if ‘something goes wrong' - there is a sudden correction in the market, for example - the majority of investors in an open-ended fund will also be looking to exit. It is precisely at these times that liquidity in open-ended vehicles dries up.
"The fact is that if something is going wrong, in the fund or in the market, everybody wants to run away," says Kaluscha. "In the situation that you need the liquidity, it is not there, because everybody wants to get out."
Despite this, Swiss pension funds are still by and large demanding liquidity in their real estate investments and this is something that Kaluscha experienced first hand when raising capital for the 4IP European Real Estate Fund of Funds, which was launched in 2007 to invest in non-listed European funds, and which itself has closed-ended structure.
"I hardly understand this issue about liquidity," he says. "We had a lot of talks with Swiss pension funds and they just said no because of not having the liquidity feature. Obviously, they still want to have some kind of escape route, at least mentally."
One explanation Kaluscha has arrived at is that many pension funds are working with investment regulations and strategies that require them to "tick the liquidity box" when searching for new investment opportunities.
He concludes: "To a certain extent the investment strategies or regulations in the funds are sometimes two or three years old and perhaps were formed when these kind of investment opportunities were not in the focus."