Resilient and highly diversified, but also management intensive and with a reputational risk, pension fund attitudes to residential housing vary worldwide. Christine Senior reports

Pension funds take very different attitudes to the residential real estate market sector, depending on their home base. US pension funds have historically been regular investors in housing, as have the Dutch in Europe, but elsewhere investment has been more limited. UK pension funds, for example, have next to no involvement.

Often historical factors play a role. In the Netherlands it has been seen almost as a moral obligation to use pension fund money to provide housing. In the UK by contrast the institutional rental housing sector hardly exists, maybe in part because of a lack of suitable properties - the large apartment blocks that are attractive to institutional investor landlords. The UK residential investment market is dominated by buy-to-rent individuals, often themselves using it as an investment to fund their retirement.

Calum Mackenzie, senior investment analyst at Aon Consulting UK, lists a roll-call of negative factors associated with residential property investments. "With regard to UK pension plans, residential property has historically not featured highly either in the UK or Europe. I think that mainly it's perceived as being low yielding, management intensive and legislatively burdensome, and there are reputational risks. You also have an issue of small lot sizes." Reputation risks include the being held responsible for evicting people if they build up rent arrears.

Furthermore residential property is management intensive, with the burden of maintenance costs eating away at yields. Part of this is due, particularly in the UK, but also to some extent elsewhere, to the costs that fall on the shoulders of the landlord.

"With residential property gross to net is quite big," says Alan Patterson, head of European research and strategy at AXA REIM. "The reason is that the landlord is typically responsible for a lot of maintenance work, whereas in commercial property the tenant is responsible. The loss gross to net isn't so great in commercial property. You have to factor that in."

Setting aside the negatives, residential property does offer opportunities for institutional investors, mostly by way of diversification. It is driven by different factors from the office or retail market and is more stable.

"By definition, residential is highly diversified and resilient as an investment," says Dana Hamilton, managing director of Archstone BV, which runs a fund of German residential property. "Unlike an office, a large portion of which could sit vacant for some time waiting for a tenant to fill that space, housing is a function of pricing because at the right price people would always prefer more space rather than less space. People are more mobile than companies. In addition to that if any one of those customers decided to leave it doesn't have a huge impact."

The office sector is more cyclical, more linked to economic conditions, whereas housing is a necessity, so demand is more constant. The result is that volatility in residential is far lower than in office.

Private equity property company Benson Elliot's managing director, Marc Mogull, has a broad view of European property. He regards the rental residential market as an opportunity for pension fund investors. "There is no question that it's the right arena for the pension funds to have exposure.

"In the Netherlands institutions have been involved in the market for a very long time. In markets like Sweden rental housing is a very established rental product. In Germany there is a tradition of home rental rather than ownership, and a large supply of rental housing offering stable cash flows. For institutions that have very long-term liabilities, ie, pension obligations, it's an asset class that should be taken seriously."

The Dutch housing market has a strong, longstanding level of participation by its domestic pension funds. The market is unique in the way it operates: the high level of regulation distorts the market, hampering the normal forces of supply and demand.

Supply is restricted through a labyrinthine set of planning rules from both the government and local authorities. And rents are regulated. Only 5% of rental agreements are open to free negotiation between landlord and tenant, the rest is limited by government rules, with maximum rents set and increases linked to CPI.

"The market is heavily regulated, which is a plus and a minus," says Onno Breur, director of Dutch residential developer Vesteda. "It's very difficult to develop projects because of central government and local municipality regulations. It can take four to five years from the moment you have a project to the time you deliver it to market. Development periods of up to 10 years are not an exception. But it means it's virtually impossible to overbuild."

Because of the scarcity factor property values have increased continuously over the last 10 years, but increases in value have started to stall a little, which has much to do with the rising cost of borrowing.

"We are approaching levels where people can't afford to buy houses any more, and the value of rental properties is linked to the sales market, obviously," says Breur. "For the next couple of years a substantial increase in value is less likely but the downside is very limited. Cash returns are lower than in the office market, or a bit lower than retail but the risk in the cash return is almost zero. Because of the rental contracts we have there is virtually no downside in that. It's an attractive market but it's definitely for the longer haul."

For investors looking for stable cash flows linked to inflation, the target of pension funds, Dutch residential presents a good match.
"It's a good hedge against inflation because of the structure of lease contracts," says Breur. "And downside is limited because of the scarcity of property and scarcity of development."

Luigi Leo, head of implementation at Watson Wyatt, says Dutch funds normally weight residential in their portfolio in line with its weighting in the total Dutch market, and over- or underweight according to their view. "This is a deep market," he said. "It's the largest sector within real estate in the Netherlands. That is different from other countries where the market is not that deep."

According to the ROZ/IPD index weighting, last year residential accounted for 43.5% of the market, compared with 30.8% for retail and 21.6% for office.
Leo says Dutch pension funds are now spreading their residential investments beyond the domestic sphere. "You see them going more down the fund of funds route in which they don't have so much influence on the allocation."

Another European residential market considered to have good investment opportunities is Germany. This is the focus of Archstone BV, whose Luxembourg-based FCP, set up last year, had just under €1bn in assets at the end of 2007. Targeting a return of 9-11%, the fund has attracted pension fund investors from the UK, the Netherlands, Denmark and Finland.

As in the Netherlands, German residential property is heavily regulated, which limits new supply of housing - a plus for investors. Rents are controlled, with increases limited to 20% in any three-year period, and they can only be increased once every 15 months, and increases have to be in line with other rents in the same area. Vacant units, though, can be let at market prices.

Germany also benefits from a strong culture of renting, with owner occupation accounting for just 43% of housing, though that figure is gradually on the rise. Rental costs that are low compared with income offer the prospect of future increases.

"New rents can be significantly higher than in-place rents," says Hamilton. "When you have new rents they feed into the backward looking rental average called Mietspiegel against which you can move up existing rents. That creates positive momentum going forward. It moves slowly but it moves steadily, and the risk of rents going down is very low. It's a bit like an inflation-linked bond - you get a bit each year but never a huge amount."

Hamilton is disappointed that residential property was excluded from German REITs, arguing that all types of real estate should benefit equally from tax advantages. But she is philosophical about it: "It would have been nice to have that option," she says. "The German structure might have been more successful if it had allowed residential to take advantage of it. But it's a new structure. We hope and expect it will change over time."

Recent research from PricewaterhouseCoopers (PwC), ‘Emerging Trends in Real Estate Europe 2008', which reflects the views of real estate professionals, shows prospects for residential rental property slipping from last year. PwC attributes this partly to the extra management resources the sector demands.

Survey respondents rank Turkey top for investment prospects due to rising population and rising incomes, with Moscow in second place and Germany third, particularly the major cities of Munich, Berlin, Hamburg and Frankfurt. At the other end of the scale, Spain was singled out as the country to avoid.

Long-term prospects are good for the new EU entrants in eastern Europe, though some markets have suffered through development coming on-line too quickly. But this is likely to be a temporary blip.

"For institutions taking a long-term investment view the key thing is demographic drivers in eastern Europe - the increasing middle class," says John Forbes, UK real estate industry leader at PwC. "For both rental property and property for sale it creates demand."

On the Mediterranean coast of Spain housing development for many years was driven by demand for second homes, which recently dried up. The recent tribulations of the
second-home market have opened up opportunities for private equity investors like Benson Elliot. The company has been able to buy up prime building land from house builders that are struggling, often because of second-home market ventures.

Managing director Marc Mogull commented: "If we can buy high-quality primary housing land at a significant discount to the price in the last few years we can sit on it and hold it. We know Spain's economy over the next 10 or 20 years is going to grow faster than the EU overall. It has a population that is growing faster than the EU overall, therefore houses will be built. They will be built first on the best land. We are interested in finding opportunities where we can sweep that up and wait. That strategy only works if you have pretty deep pockets."

US pension funds have a tradition of investing in residential real estate. The US public sector fund CalPERS has an allocation to residential of 10-15% of its total real estate portfolio, mostly in its non-core sector. As well as investing in the domestic housing market, it has also made forays into international residential, one example being its allocation to the Hines Spain fund.

Dutch pension investment company Mn Services has investments both directly in its domestic residential market and via funds in the German market. It has around €50m invested in residential funds in Germany, in a programme initiated three years ago.

Over the period the portfolio has returned well over 20% on an annualised basis.
Senior real estate manager Bas van den IJssel says returns in Germany are attractive and prices keen. "You can buy on very attractive yields. You can buy a portfolio, put some leverage in it and the cash returns were very attractive already but you can add to that. The acquisition price was well below rebuilding costs, that puts a big brake on development. Why develop if you can buy for less than the rebuilding costs?"

Van den IJssel says the company has targeted Germany because suitable investment vehicles exist there, which is not the case elsewhere. "Not a lot of managers present funds for residential, and the ones that exist are normally core or core plus. Internationally we invest opportunistically for value creation and higher returns. You don't normally find that in residential portfolios."

But Danish pension fund ATP avoids residential. It would present a conflict of interest, says head of real estate Michael Nielsen. "We have all Danes as members of ATP. We don't want to invest in residential because we will have a conflict of who we should rent these residential units to. Furthermore, on a long-term perspective we don't see the same return potential in that real estate as in other asset classes."

Nielsen thinks that many Danish pension funds have invested in residential but have sold off their residential investment over the last couple of years. "It's mainly because they have been able to realise substantial gains," he says.