CEE pension fund allocations to real estate are still small compared with those of their western European counterparts as the region's pensions property patchwork gets to grips with the asset class. Krystyna Krzyzak reports

Pensions regimes vary across the central and eastern European (CEE) region, from countries such as Poland and Slovakia that expressly forbid direct real estate investment for both mandatory and voluntary pensions, through those such as Latvia that allow such investments only for the voluntary schemes but not the mandatory ones, to more liberal systems such as Hungary, Estonia and Bulgaria.
Within CEE, Hungary has the longest experience of pension fund investment into real estate. Its voluntary pensions system dates back to 1994, and in 1998 it became the first CEE country to launch a second pillar mandatory pensions system, now the second biggest in assets after Poland's. However, despite its relatively long history, the Hungarian pensions industry retains an inherently conservative approach.

The Hungarian Financial Supervisory Authority (HFSA), the local industry regulator, recently published an investigation on pension fund investment in real estate in 2007. According to Mihaly Erdos, deputy director general of the HFSA, the regulator wanted to determine how the funds administered the returns from direct real estate investment, whether the selection and decision-making were prudently managed, and what costs were involved. The HFSA found that only one - the €138m Evgyuruk Magannyugdijpenztar - of the 21 mandatory pension funds and seven of the 69 voluntary funds invested into this class. The amounts invested totalled HUF1.98bn (€8.3m) or 0.1% of total assets for the mandatory funds, compared with a regulatory maximum limit of 5%, and €22.9m or 0.7% against a limit of 10%.

Additionally, the voluntary schemes had some 0.5% of assets in real estate funds.
Erdos explains that the Hungarian real estate market does not operate transparently, and meanwhile it was essential for pension funds to invest prudently. The report found that generally pension funds followed the regulations established in 2003, including using a board-approved decision-making framework, appointing external advisers if the fund lacked internal expertise, and keeping the general assembly meeting informed. In the case of voluntary pensions, all outsourced real estate advisory tasks.

There were some cases of fund management companies using their own auditors for evaluating the real estate investment, which the HFSA concluded constituted a conflict of interest.Erdos adds that of the three different types of methods for evaluating real estate - benchmarking, cost base and cash flow analysis - "in most cases the evaluator used only one, mainly the benchmark, and did not check whether other methods would have produced a different figure. Although there are no regulatory requirements regarding evaluation, after this investigation we published guidelines for pension funds and their advisers on what we consider prudent management and procedure."

These included a stipulation that evaluators use all three methods and only then draw their conclusions.The study also revealed that the majority of Hungarian pension funds invested in office and residential property for rental income, in local or foreign currencies, although there were instances of investments for capital appreciation, which produced mixed results when it came to their expectations. The funds themselves reported that they did not expect a rapid growth in real estate investment because of a lack of professional expertise and liquidity.

The mandatory system changes next year: all the fund management companies will have to have switched from offering clients a single portfolio to one of three so-called lifestyle funds - conservative, balanced and dynamic - of different risk profiles depending on the client's time left to retirement. The direct real estate investment limits in the new scheme are zero for conservative, 10% for balanced and 20% for dynamic.

While the experience of countries such as Estonia and Slovakia, which kicked off with more than one portfolio, suggests that most pension funds opt for dynamic or growth funds, it is too early to say whether the Hungarians will follow suit given that only seven funds had completed the portfolio conversion as of mid-August. The HFSA is considering including indirect real estate investment into overall limits, and asking whether there should also be separate regulations for Hungarian funds investing in foreign property.

The pensions regime of Estonia, whose mandatory system started in 2002 and was modelled on the Hungarian system, has always encouraged real estate investment. Second pillar mandatory funds can invest up to 40% in real estate funds, of which 10% can be direct property (with a maximum 2% in any single project). For third pillar funds the respective limits are 70% and 20%, with a 5% single property cap.

Although Estonia has not experienced a US-style mortgage crisis, its property price boom came to a halt in 2007 and economic growth ground to a halt this year. "In 2005 to the first half of 2007 our property portfolio had double-digit returns, while this year it has barely shown any return," says Kristjan Tamla, portfolio manager at investment managers Hansa. "Yet, strange as it seems, we now see a lot of interest in new real estate funds. People seem to think that it's a good time to invest in the Baltics." Tamla says that while three years ago expected price rises were the biggest driver, investors are now focusing on rentals.

"It is possible to invest in a retail centre with a yield of 8-9%," he adds. Hansa, which manages most of the biggest pension funds in the country, had 5.4% of its K2 balanced mandatory pension fund invested into real estate as of the end of July 2008, amounting to EEK107m (€6.8m) and 4.3% or €11.7m in its higher-risk K3 fund. In both funds it has raised exposure, as a share of the total, by about 1.5% since the end of 2007. About 95% of the assets are in the Baltic region.

However, Vahur Madisson, fund manager at SEB Wealth Management Estonia, cautions: "We have done very little during this year regarding our real estate investments. There have been plentiful new opportunities around that have been presented to us but we can see upward pressure in property yields and lending standards have become tighter, which during a period of economic slowdown makes the real estate investment outlook rather challenging and we have been reluctant to make new investments.

"The vehicles we are investing in have strategies that have resulted in less downside than general equity markets during the same time, which means real estate has contributed relatively positively to our pension fund returns in terms of equity market returns," Madisson adds. These include closed-end investment funds, certificates, private equity funds, and also public and private shares.

"It is the valuation methods that create pricing differences. Public shares listed in exchanges have, of course, daily repricings but private equity type of vehicles have NAV appraisal methods that are not affected by public equity market volatility. So, as public real estate stocks have come down from NAV premium to NAV discount, the price has come down much more than private equity investments that are still priced around NAV. Therefore public real estate equities have fallen more than private equity," he explains.

For direct investment the situation is more risky. Estonia's GDP growth has contracted severely in 2008 and banks have cut lending. "It's currently next to impossible to get a bank loan if you are a developer. In my opinion, if you are good at property selection, this is the time to enter at a low price, because many developers are cash hungry," says Tamla.

Unlike Estonia's, Latvia's pension legislation allows only the voluntary funds to invest in real estate. This investment remains relatively small and stable - at LVL1.1m (€1.5m) or 1.5% of the total portfolio as of the end of the first quarter of 2008. Roberts Idelsons, president and CEO at Parex Asset Management, says that Parex's fund has a relatively small exposure, accounting for 2.5-3% of pension plan assets, in the form of land for development acquired a year ago. "Given the current situation in Latvia we will hold it for at least five years," he forecasts.

As in Estonia, the economic growth has decelerated sharply this year along with economic sentiment and bank lending, and as in Estonia Idelsons believes that this is throwing up market opportunities. "We believe that our pension plan and others in the region will be increasing their real estate exposure in the coming months," he predicts.
Latvia's mandatory pension funds are currently not allowed to invest in real estate. However, the second pillar law is currently under review and Idelsons says that possibly next year their scope of investment may be changed to incorporate such assets.

Czech Republic

The Czech Republic has bucked the trend of CEE countries by not introducing a second pillar system. It does run a long-established defined contributions third pillar pensions system that receives state subsidies and tax advantages. Czech pension funds can invest up to 10% of assets into direct real estate. As of the end of June 2008, according to data of the 10 members of the Association of Pension Funds of the Czech Republic, the amount invested totalled CZK1.3bn (€60.5m) or 0.9% of the total.

The bulk of that, €53m, is accounted for by one fund, AXA PF, a fact that Kamila Horackova, CIO at AXA Czech Republic and Slovakia, finds curious at the very least. She adds: "We focus only on the most conservative investments - major city-centre offices, fully built and occupied, in Prague, Brno and most recently Bratislava," reports Horackova, adding that yields have come down from close to 8% net when AXA PF made its first investments to 6% currently for prime property. "There is nevertheless low volatility and fortunately our market has not been affected, at least yet, by the overall situation in global markets," she says.

Bulgaria's pension funds, while among the smallest in the CEE region, probably have the most diverse real estate investment. As of the end of June 2008, the second pillar general pension funds had BGN27.7m (€14m) or 2.1% of the total portfolio invested directly in real estate and a further €22m or 3.3% in REITs, according to data from the Bulgarian Financial Supervision Commission. The professional pension funds - second pillar funds for occupations with a short life - had €6m (2.8%) in direct real estate and €7m (3.5%) in REITs, and the voluntary third pillar funds BGN44m (7.5%) and BGN33.5m (5.7%) in property and REITs respectively.

Bulgarian REITs, which date back to 2004 and which include agricultural land trusts and property, are unique to CEE. They are typically development start-ups that subsequently rent or sell on to other funds. According to Miroslav Marinov, CFO of Doverie, Bulgaria's biggest group of pension funds, while REITs prices on the Bulgarian Stock Exchange have fallen since July, some have started to distribute profits, benefiting from the land and property appreciation. As elsewhere, Bulgarian REITs must distribute 90% of their realised profits to shareholders.

Doverie's REIT investment focuses on diversified portfolios of rented office and commercial properties, with some residential, while avoiding those solely invested in ski and sea resort vacation villages. "We prefer REITs where the management has an understanding of the property business, not just fund management," says Marinov. He also sees potential in logistics and industrial. Doverie also invests in agricultural REITs, where the yields are high by local standards.

The value and income of these are based both on the rising price of Bulgarian agricultural land and rents from agricultural producers, especially those that qualify for EU subsidies. By European standards, Bulgarian agricultural land prices are low but rising, from €100 per 1,000 m2 in 2007 to €150-200 this year. In the future agricultural REITs expect to exchange and consolidate their holdings.

In the case of direct real estate, with the pension fund approaching its 5% legal limit, Marinov says that Doverie is focusing more on benefiting from capital appreciation than diversification. Because they start from a low base, Bulgarian property prices have generally bucked the European trend over the past two years. Building costs are also significantly lower, while the country's geographical location has high logistics potential. However, development land is already becoming expensive.

"In the future, when development margins slow down, we will switch to finished projects to benefit from rents," he explains. Other future investment trends, according to Marinov, include the peaking of the residential market, a more focused approach to retail and office property and exceptionally high selectivity in the case of the overdeveloped vacation property sector - what he describes as first line or no less than 100 metres from the Black Sea. This market has suffered from a pull-out by British and Irish investors, although there is now interest from Russian, Ukrainian, Romanian and Scandinavian investors.