Pension funds in this tiny country are not allowed to invest abroad at present but distress in the domestic market is opening up new opportunities, as Gail Moss reports

There may not yet be a flurry of pension fund activity as far as real estate investing is concerned, but with the economic situation in Iceland stabilising, bricks and mortar are slightly less of the unlikely investment they appeared to be this time last year.

The country's GDP is still expected to fall by 2.2% over 2010, according to the OECD, but that is an improvement on last year's whopping 6.5% slump. Next year's forecast is a much rosier 2.3% growth.

And while unemployment will peak this year at around 8.7% according to the same figures, it should level off to 8.4% in 2011.

Meanwhile, Icelandic pension funds recorded a 0.34% net real return in 2009, compared with a real terms loss of 22% in 2008, says the Iceland Financial Supervisory Authority.
But in terms of real estate, pension funds are still faced with two major obstacles.

First, the domestic market is relatively small, and there is a ban on direct investing, except to the extent that the property is necessary for the fund's activities - for example, owning its own building. Secondly, currency controls mean that new real estate investment outside Iceland is not allowed.

Outside Iceland, pension fund money is invested generally indirectly, focusing on UK and pan-European funds.

In the years before Iceland's spectacular financial meltdown large institutional investors were driven abroad because of the relatively few real estate opportunities in Iceland itself. In 2006 and 2007 particularly, investors were pursuing higher-risk strategies.

"Icelandic pension funds have to invest abroad because there is relatively little stock in Iceland, as many buildings are owner-occupied, so there is no investment property available to hold," says Tony Key, professor, real estate economics at Cass Business School in London.

"The stock market is very small, so it's a good idea to invest in property overseas, using pooled funds to get good diversification across several countries, and providing a steady income."

While some pension funds have always had small real estate allocations, others have seen their plans intended to increase allocations put on hold. This time last year, Stapi Lifeyrissjodur, a regional pension fund, and one of Iceland's 10 biggest, was planning to build up its real estate holding to a slightly bigger percentage of its portfolio.

But that is now unlikely to happen for some time, says Kari Arnor Karason, Stapi's managing director. "When you have a collapse, the first thing people invest in is government-secured assets," he says.

"After that, however, physical assets are attractive because the fact that they are tangible means they cannot disappear, whatever happens to the markets. So the larger pension funds including ourselves will start investing, but it will not happen until next year."

At present, Stapi's real estate assets make up 2% in value of its €800m total assets and include shares in pan-European funds. "Most of these have done relatively well, and we're holding on to them," says Karason.

But of course, further foreign investment cannot take place for the moment. However, Karason says that there are some property investment products in the pipeline within Iceland itself.

"People are trying to put together a number of real estate projects," he says. "There are many distressed assets in the Icelandic non-residential property market with their owners in negative equity territory - prices have gone down over 30% since 2008. The companies which own them are either restructuring or facing bankruptcy, and some of these properties are now coming on to the market. So the banks are putting together packages which they can sell on to investors via funds or real estate companies."

Like many other Icelandic pension funds, Stapi also invests in residential-type securities - mortgage loans to its pension fund members, and Housing Finance Fund (HFF) bonds - which together make up 23% of its portfolio at present. The HFF is a state-owned fund which makes loans to homeowners who have problems paying their mortgages.

With more and more homeowners experiencing negative equity alongside financial hardship, the HFF has been responding to increased demand for loans.

Earlier this year, Stapi was one of two dozen pension funds which agreed to buy additional index-linked HFF bonds from the Central Bank. These were foreign-owned bonds, and the funds had to pay for them in foreign currency, which further limits their ability to invest abroad.

The rationale behind this is to reduce the pressure on the domestic currency when it is floated again, and speed up the process of lifting the controls.

It is likely that there will be an increase in securitisation and asset-backed financing of financial institutions in future, says Karason.

"But it will all happen at a very slow pace," he says. "There is a big debate here about debt relief and who will fund it - people with the claim on assets, or the taxpayer. This increases uncertainty and slows down the restructuring process."

Gildi, another of Iceland's biggest funds, still has a holding in a pan-European real estate fund of funds, but it is undecided as to whether to make more overseas investments even when the currency controls are lifted.

On a wider scale, however, Vanessa Rossi, senior research fellow, international economics, at Chatham House, says that Iceland's currency controls could have a long-term detrimental effect on its pensions industry.

"In the modern financial world, little Iceland would expect to diversify its institutional savings into global markets, as otherwise they are creating a high level of dependency on a small island investment market with restricted options," says Rossi.
"But Iceland seems to be bringing all these funds back home."

She says: "To put it starkly, the position of Iceland's pensioners can be likened to Robinson Crusoe staying on his island with his family, with their living dependent on their small fishing, farming and hospitality business."

In this economy, the elderly (equivalent to the pension funds) own the property, earning rent from the next generation, which runs the business and earns a wage.

"Iceland has been forced back into that kind of self-invested pension system which, like my stylised analogy, depends heavily on a generational model," says Rossi. "As long as this cycle continues satisfactorily, then it can be self-sustaining.

"But will working people stay?" she asks. "Unlike the Crusoes, they don't have to. And what ‘business' is there to employ enough people and at a decent wage? If there is not enough work and people leave, then pensioners will suffer, as ‘rents' will fall."

Rossi says it is not clear why there should be restrictions on assets held abroad, especially as she believes pension funds holding most of the government debt could pose a high risk.

"Pension funds need to have secure investments and cash flow: is it prudent to hold all their assets in Iceland?" she asks. "It will be interesting to see how they resolve all these issues, and how pension payments can be guaranteed to make the system work."