The financial crisis and the stability of the home market have made Swiss pension funds reluctant to invest internationally. But can the Swiss market satisfy the growing demand from local investors? Richard Lowe reports
International diversification began to gain traction with Swiss pension funds at the turn of this century. The movement was led by a handful of large institutions, including BVK, which has indirect investments across Europe, the US and Asia. But the majority of Swiss pension funds were either slow in making the move or still unconvinced that it was the best thing to do. Some commentators suggest these institutions now have a number of reasons to justify - rightly or wrongly - sticking with a purely domestic exposure.
"The Swiss world is very home biased," says Ulrich Kaluscha, managing director at 4IP Management, a fund of funds manager based in Switzerland. "From 2001, things opened up much more, but the crisis put some things on hold on the development of international real estate portfolios." In 2006, 4IP launched a fund of funds with capital raised from three insurance companies and two pension funds in Switzerland. "We had some good signs in Switzerland that this topic of indirect investment outside Switzerland was gaining speed, Kaluscha says. "But the crisis was a step back for this movement."
One of the main reasons has been the relative stability of the Swiss real estate market during a period when other European property markets have experienced severe volatility. In contrast to the significant capital depreciation and negative total returns seen across European markets, Switzerland has delivered consistent - albeit modest - capital growth and positive total returns since 2002, according to International Property Databank (IPD).
In its latest report on Swiss real estate, IPD explains how the market is unique in Europe. "Capital growth is also naturally stabilised by limited asset supply and a dominant local pension and insurance fund investor base which take long-term positions in the market, thereby creating genuine market stability."
Swiss pension funds will certainly have drawn reassurance from the positive performance of their domestic market while other foreign markets have fallen around them. BVK, for example, achieved a return of 7.2% from its domestic real estate investments in 2009. "The Swiss market is a stable market," says Stefan Schädle, head of real estate at BVK. "It is a good investment for a pension fund like ours. It is one of the best investments we've had over the last few years."
Alex Schärer, head of portfolio management for Swiss real estate at Migros Pensionskasse, is equally positive about the performance and relative stability of the domestic market. "There was no real crash, and there won't be one in my opinion," he says. "The rents went down, but on good macro and micro locations they are rising again. So the outlook for the real estate market in Switzerland was, is and will be good."
Those Swiss pension funds that did invest in foreign markets in recent years - predominantly through commitments to fund of funds managers - are likely to have suffered inferior performance compared with their domestic-only counterparts. Stephan Kloess, adviser to Swiss institutional investors and founder of KloessRealEstate, admits this picture has made pension funds more reluctant to invest outside their home borders."Overall, I assume that Swiss investors that were invested in foreign real estate did not perform better than the rest of the market," he says. "In future, they will try to avoid these kinds of negative experiences."
Pension funds that did invest in other European markets were somewhat unfortunate in their timing, investing into a rising market before the 2007 crash, Kloess adds. They will have learned a very difficult lesson as a result: timing is important in indirect non-listed real estate markets and that the diversification benefits of investing through fund of funds managers does not necessarily act as "a protective umbrella" during major downturns.
Kaluscha is concerned that the bad experiences of investing in foreign real estate, combined with the positive performance enjoyed in the domestic market, have given institutional investors a strong justification to maintain a Swiss-only exposure in the long term. "Whether it is true or not, you can easily use this as an argument for saying, I've done everything right staying in Switzerland," he says. "Some investors use the crisis as an example to say diversification didn't work in 2008 and 2009. If you want to stay in Switzerland you use this kind of argument to make the ground for being only a direct investor in Switzerland."
The issue of currency risk has also become more of a concern for pension funds, as currency swings between the Swiss franc and the euro have increased. "The general discussion about currency risk and how you manage the currency exposure is, in my experience, more intense than it was two or three years ago," Kaluscha says. "This always was an issue, but nevertheless it takes more space in investment discussions."
Schädle sums up the situation: "Traditionally most of the pension funds didn't invest in foreign real estate until a few years ago. Then they started to invest, but what has happened since the financial crisis is they are more prudent [when it comes to] foreign investments, because the performance was highly negative - especially in Swiss francs. Then there is the question how you assure your currency management with all the foreign currencies, because the Swiss franc is mostly stable and the insurance costs a lot of money."
T he Swiss real estate market has been one of the best investments for Swiss pension funds in recent years and it remains an attractive opportunity for them. Perhaps then many are right in taking the decision to stick to what they know best: investing directly in the domestic market. Why should they necessarily be looking to invest internationally when it involves wider risks and they can't even rely on diversification protecting you from downturns?
To start with, there are signs that diversification is returning. European markets have recovered at different speeds, with the UK leading the pack. But the big incentive for Swiss pension funds to look abroad is the shrinking body of investment opportunities at home.
As institutional investors across Europe retreat to their domestic markets in search of core, secure income-oriented investments, it is no surprise that Swiss pension funds are focused intently on their home market. They have been particularly focused on the residential sector. The problem is that in such a small market a lot of institutional money is chasing limited investment opportunities. Residential prices in particular have continued to climb and yields fallen to 4%, or even lower.
"The price level in the Swiss market, especially for residential, is quite high," says Kloess. "Institutional investors are looking for a net cash flow return of about 4.5-5% and they are looking for a total return of between 5% and 6%. Given the current market situation, this is quite difficult to reach in the Swiss market. The options are to develop only on their own book or to buy developments, and there are other risks involved in developments."
Schädle confirms this. "The problem in Switzerland is the availability of investments," he says. "We undertake many project developments ourselves. That is the way you have to do it in Switzerland, otherwise you cannot get the good investments." BVK plans to continue investing in the Swiss residential sector. Schädle says the pension fund has approximately CH500m (€350m) worth of developments in the pipeline.
Migros Pensionskasse has invested in a number of new projects over the past two years, mostly residential, each worth in the region of CH15-50m. Its strategic allocation to Swiss property means it needs to invest CH200m in the market each year. "We examine every opportunity we hear of, but often the macro-location or other risks are too high for us," Schärer says. "We only want to invest in core properties, so at the moment it is not easy to acquire a bigger project. When they exist they are too expensive, because of the demand side and because of the yield compression in the last years."
Schärer says rent levels for Swiss apartments have reached a limit in the large cities of Geneva and Zurich and he believes yields will not fall any further. Inflation was negative (-0.5%) he says, and next year this will rise, making it easier to acquire properties with 100% equity, as Migros does.
"There are not many opportunities to invest in core real estate for pension funds," he says. "At the moment it is too expensive. We can wait till this changes. Also we have the opportunity to invest in our own buildings. We can develop our own properties."
But Kloess says many pension funds are faced with a difficult decision: their home market is overbought, but those who did invest internationally saw negative performance. He believes that certain pension funds were struggling under these challenging circumstances as they had not experienced this kind of situation before. He says that three points are key to avoid such negative experiences: right timing, a broad and deep manager selection and professional management. Compared with the Anglo-Saxon market, where usually external investment advisers are involved, most Swiss institutional investors prefer to solve problems internally, he says.
The next 12-24 months are critical. One possible scenario is that European real estate markets suffer a double-dip recession in 2011. Alternatively, there could be a sustained, if modest, recovery. Either way, Kloess hopes that pension funds do not hesitate to improve their investment processes, take advantage of the investment expertise available to them and invest at the bottom of the cycle. If prices in the Swiss market do reach a level where pension funds cannot justify investing, they could be pushed into investing abroad despite their concerns over volatility - exactly at the wrong time in the cycle.
"Investors are facing a similar situation to the one we had in 2006 and 2007," Kloess says. "They need to make sure that they are not too late in stepping into the markets, and identify the right windows of opportunities - depending on the different markets."
BVK, the largest pension fund in Switzerland, has already capitalised on the recent market downturn across Europe to invest in core real estate at low prices. Strategic Capital Management runs a global multi-manager mandate for the pension fund, investing 4% of its CH20bn-worth of total assets.
The pension fund, along with a number of other Swiss institutions, is a shareholder in global investment company AFIAA. In November 2009, AFIAA launched a new strategy to invest in secure, prime real estate in European countries outside Switzerland. "We did invest with AFIAA, particularly in London," Schädle says. "Last year you had good opportunities to get a yield of 7-8% for class-A properties."
But for most Swiss pension funds, Kaluscha agrees with Kloess's sentiments. "If this big amount of money chasing few properties is pushing up prices, when do we come to a point where it is not sustainable anymore," he says. "I hope that part of the money that is available now is diverted into a more international investment approach again."