Spanish investors' property allocations have slumped while international interest in Spanish real estate has been active, as Gail Moss finds

While the construction industry dominates the national economy, Spanish pension funds invest very little in property, either directly or indirectly. And what little they do invest has declined in the past couple of years.

According to the Mercer asset allocation surveys, real estate holdings rose slowly from 0.9% of Spanish pension fund portfolios in 1996 to 2.9% in 2007. But this allocation has now collapsed, to 2.1% in 2008 and only 1% in 2009.

However, this can hardly be blamed on the regulatory framework, as pension schemes are allowed to invest up to 30% of their overall portfolios in real estate.

For those funds which do invest in property, the focus is still very much on the domestic market. "Spain is very traditional, so there is a culture among pension funds of concentrating on local real estate," says Max de Groot, head of institutional clients at ING Real Estate Investment Management Europe. "Furthermore, the Spanish construction industry was very strong, with really good returns until 2007. So there was no need to invest internationally."

With Spanish real estate companies performing at their peak in 2006-07, Spanish pension funds also started investing excess capital abroad, buying into listed property companies in countries such as the UK and France. Those very same funds are now battening down the hatches, says de Groot.

"Institutional equity is fleeing to the home markets, and pension funds are no longer diversifying abroad because they perceive it as more risky," he says. "They also now follow a safety-first strategy. If they have additional equity for real estate, they prefer to use it to safeguard an existing asset - for instance, to fend off the risk of repossession. Therefore ING REIM has no high expectations for equity inflow into their global products from Spanish pension funds over the next two years."

As for the Spanish property market itself, the past couple of years have seen a particularly bumpy ride.

Last year, capital values across the board slumped by 13.4%, according to the IPD Spain Annual Property Index. The retail and office sectors fell by 12.6% and 12.9% respectively, and the industrial sector by a whopping 18%.

Even with positive income returns averaging 4.6% across all sectors, the total return for the year was dire, at -9.4%.

Sabina Kalyan, European head of research at CB Richard Ellis, says: "Everyone pulled out from the end of 2008 through the first half of 2009. There was a freezing of the market. But now it's thawing."

She adds: "Some foreign investors have recently been making opportunistic deals, buying prime assets well-let to major multinationals at attractive yields."

James Preston, managing director of Rockspring Iberia, says: "Property has been one of the big casualties because so much of the economy depends on construction, which contributes 18% of GDP,"

But Kalyan says: "I'm relatively hopeful about Spain. Unlike the UK, during the boom years it ran budget surpluses, so while the current financing difficulties are severe, the underlying position is sound."

Vanessa Rossi, senior research fellow, international economics at Chatham House, agrees: "The recent consolidation in the government budget and efforts to restructure the banks may also improve the outlook for stability and growth, and this seems to be moving ahead strongly in Spain."

But she warns: "It is not clear how much these pension funds have already been able to invest outside their home markets in order to diversify and reduce risk. In principle, within the euro-zone this should be easy as it's the same currency, but rules for funds can be quite particular about types of investments. Certainly even if funds had not diversified before, then they may now seek opportunities abroad in order to avoid high single country exposure."