The high price of risk

The real estate business needs a cash injection and it could 
not be said that pension funds 
in the CEE region do not have the means to do this. Nevertheless, the funds are 
in no hurry to splash out. 
And there are no signs that 
this is about to change

Mladen Petrov

The National Pension Service, the biggest pension fund in South Korea, has been on a shopping spree. The last purchase by the investor was the Sony Center building in the centre of Berlin. The price paid for the well-known office building was USD 768 mln. The Berlin purchase was not the first European investment of the fund, which already owns the HSBC headquarters in London and a 12 pct share in London Gatwick airport.

Foreign pension funds are not hiding their interest in the European real estate market. They are one of the most active types of investor on the property market in Western Europe, and at the same time they are looking for new possibilities in the east of Europe. With the recent legislative changes that have been made, players looking for real estate might be joined by Chinese pension funds in the long run. Since the end of 2009, the funds can invest directly in the local real estate sector. According to DTZ’s estimates, assuming that in the beginning pension funds will conservatively invest up to 5 pct of their assets in properties on the Chinese market, there will be app. USD 28 bln available in the following 3 to 5 years. Eventually, according to analysts, the funds will switch their interest to European markets, and to Central Europe in particular.

Long distance investment

All this sounds interesting, but so far that is all. Developers and investors are not concealing their hopes for financing projects with the funds’ money. Some of them are already managing to do this in some countries. Doverie, the biggest pension fund in Bulgaria, is one of the biggest investors on the real estate market. In Poland, pension funds’ involvement in the real estate sector ends with the purchase of construction and development companies’ shares on the Warsaw Stock Exchange.

Polish pension funds had nearly 15 mln accounts in total in Q4 last year, and over PLN 179 bln in their portfolios. The biggest share of the investment portfolio instruments belonged to companies registered on the prime market of the Warsaw Stock Exchange (over PLN 53 bln) and treasury bonds with fixed interest rates (over PLN 85 bln).

Grzegorz Chłopek, vice-president of ING PTE, the second biggest pension fund in the country in terms of asset size (with a portfolio worth over PLN 43 bln at the end of last year), views the market with some interest, but at the same time with caution. Why? “There are a number of reasons. The first is the fact that our fund needs a daily market estimation of its portfolio, which is not very realistic in regard to direct investment. Real estate is a better opportunity for closed funds in this respect. Another hurdle is the fact that development projects are usually based on the interest rate of the euro, which is much lower than the interest rates for the local currency. With no possibility to use derivatives freely in order to change the reference curve and secure the risk, development projects are an additional risk. With the limited profitability of the product, the cost of portfolio management also becomes important, if it eats up a significant part of the expected premium for the risk,” Grzegorz Chłopek explains.

Maciej Kiełbicki, managing director of development company Mayland Real Estate, is on the other side of the market. He emphasizes that the development business is trying to draw attention to the fact that the stock exchange is not necessarily the only right solution. “Obviously, money for future pensions should not be invested in risky projects, so is the stock exchange the only secure place? Indeed, the Warsaw floor has been developing, but the assets available remain limited. By their very nature, stock exchanges involve an element of speculation and emotion. In addition, we have a relatively large share of individual investors in Warsaw, which amplifies this feature. This is normal and there is nothing wrong with it; however, it constitutes an additional element of portfolio diversification. Foreign funds have appreciated the advantages of owning products with a constant cash flow, e.g. real estate. If foreign funds work for higher pensions in Poland, why can’t local funds do the same?” wonders Maciej Kiełbicki.

Who’s not afraid of risk?

Direct investment in real estate is not on the agenda of alternative investment instruments in Poland. A similar situation exists in the Czech Republic. However, there are exceptions in the CEE region. Open pension funds in Bulgaria can invest up to 10 pct of their assets in development projects. After a six-year debate in parliament, the Bulgarian legislature took one more step forward by allowing pension funds to invest in infrastructure projects. According to the amended act on social insurance, pension funds will be able to spend 10 pct of their assets on infrastructure bonds issued by the banks with Bulgarian capital of more than 50 pct. In addition, funds will be able to invest in similar bonds issued by the national banks of EU member countries.

Despite the continuing crisis on the real estate market in Bulgaria, most pension funds are sticking with taking the option of investing in development projects. This is made possible through REITs (real estate investment trusts) – funds established in order to carry out concrete development projects. There are 60 such funds registered on the Sofia Stock Exchange. In reality, the number of active funds is two thirds lower. Moreover, some funds focus only on creating land banks without going ahead with development activity. According to the law, pension funds can possess up to 10 pct of the shares in such a company. Sometimes it happens though that one fund owns more shares via a number of sub-funds. For example, Doverie is the owner of a 30 pct stake in Prime Property BG REIT. The fund is currently investing in office and residential projects in Sofia, Plovdiv and Sveti Vlas on the Black Sea. Last year, the Doverie fund increased its involvement in development projects by investing an additional EUR 4.5 mln, constituting a 50 pct growth in investment per annum. The fund’s investment in real estate amounted to nearly EUR 14 mln at the end of last year, with the profit from real estate investment reaching app. EUR 600,000 in 2009.

Apart from a few exceptions, the crisis last year in Bulgaria was not dominated by significant changes in investment portfolios, at least not with regard to development companies, confirms Snezhana Yotinska, who is responsible for relations with investors in FairPlay Properties, another developer whose shareholders include Bulgarian pension funds. The company, the biggest REIT registered on the Sofia stock exchange with a market share of 13 pct, is currently working on eight projects across the country. More than half of the fund’s portfolio (58 pct) is accounted for by investment in luxury apartments. Ten pension funds owned 8 pct of the shares in the company at the end of April. “We have increased our capital four times, it is worth nearly EUR 28 mln at this point and we have enjoyed the interest of pension funds every time. Even today, when the real estate market is in crisis and there are no new institutional investors, we have not noticed considerable changes in the shareholders. Funds are focused on long-term profits and perfectly understand that periods in the doldrums are inevitable,” argues Snezhana Yotinska.

Wait till the crunch ends

Nevertheless, Bulgarian funds, which can also invest abroad, have not hesitated in taking this option. According to data prepared by the Bulgarian Financial Supervision Commission, 34 pct of funds’ assets were invested abroad in 2009, which is 8 pct more than in 2008. Funds involvement in the Sofia bourse is considerably less: shares in registered companies amounted to 15 pct of funds’ portfolios in 2009, which constitutes an annual drop of over 30 pct. “The crazy times of limitless growth have finished for good. Funds are looking for other profitable projects, but nowadays the concepts for what constitutes profitability are different. Funds are satisfied with normal growth rates and do not trust promises of 100 pct growth within 2-3 years, as used to be the case with residential investment. A few years ago, even a cautious and conservative player believed that the market would continue to develop forever,” comments Veselin Genchev, managing director of BenchMark Fund Estates REIT. Approximately 30 pct of the Sofia fund is currently in the hands of pension funds. The fund is currently focusing all its energies on the development of two office buildings in Sofia and has frozen the construction of the Exclusive Ski & Spa Resort project in Borovetz. It has also given up on plans for a residential estate in Kjustendil. According to Veselin Genchev, the Bulgarian real estate market needs at least a year in order to bounce back. The market capitalization of BenchMark fell to EUR 5 mln at the end of last year, and according to analysts the company remains much undervalued. This is a source of problems for many registered development companies. “Funds remain on the market, but we are not seeing a growth in interest. According to my best estimates, the funds can invest up to app. EUR 125 mln on development projects.”

High hopes vs. harsh reality

Because of the size of the market there is much more available to developers operating in Poland. Nevertheless, discussions on how development companies can use the capital of development funds are only theoretical. Maciej Kiełbicki, managing director of Mayland Real Estate, points out that capital should be freed gradually for a number of reasons. He estimates that a reasonable level of resources that funds could invest in real estate would be 15 to 25 pct of their assets. Of course, to be safe the parameters of project quality and purchase process assessment should be imposed top-down on entities managing the portfolios. “One could of course ask why developers do not introduce finished projects on the stock exchange to make them available for funds. In fact they do this, but because of the above-mentioned characteristics of the stock exchange, a certain mix is created: finished, cash-producing facilities and ‘promises’ of less secure facilities in the future, and this is a type of activity which carries a substantial risk,” explains Maciej Kiełbicki.

Pension funds themselves admit that portfolio diversification is what they need. Grzegorz Chłopek of ING PTE goes so far as to use the word ‘pressure’ when he compares the available capital to the investment channels on offer, but he emphasizes that “alternative solutions can also create a bubble”. Being among of the main players on the Warsaw floor, funds can also contribute to unwarranted growth in registered companies’ values. With this in mind, funds should take a look at some of the more successful projects on the real estate market, according to developers. “Funds of this type in the West buy finished products at a slightly higher price, but with the guarantee of stable revenue. The element of stability is crucial for them,” claims Maciej Kiełbicki, who goes on to add that the development business is somewhat sceptical towards the possibility of quickly freeing up these funds due to the high level of public debt.

It is a similar story on the funds’ side. “We can still see a lot of potential in the stock exchange. Around 360 national companies, including many from the construction and development industries, offer investment possibilities in the real estate sector without the necessity of involving, for example, closed funds. Moreover, the free floating of shares is improving due to the fact that the state is lowering its shareholding in companies. From our point of view, it is better to buy assets in development companies than to get directly involved in the real estate market,” asserts the vice-president of ING PTE.

Pension funds are also one of the regulators of the capital market, thanks to the obligations which have been imposed on them in terms of the sale of shares in the case of a sudden growth of quotations to 40 pct. Funds usually start selling earlier, which is supposed to protect the market against bubbles. Cautiousness is one of the reasons why funds are in no hurry to change the regulations. For them, direct involvement in the real estate market is connected with a bigger, undesirable risk. “The rate of return does not provide a satisfactory premium for the risk. A pension fund usually invests with a long-term view and has too short a history on the Polish market to be able to forecast trends for the whole investment period. Moreover, higher transparency on the market is required. We will know the actual risk connected with a transaction that is only an indirect one in our case via closed investment funds after a year at the earliest. So is it worth taking this risk on ourselves with current expected premiums? The direction of pension fund development is clear: multi-funds, paying out pensions, and changes in investment policy. However, I must admit that after the latest legal changes which impose limits on administration charges, risk control will gain more and more importance, limiting the readiness to take bigger risks,” Grzegorz Chłopek concludes.

It looks like developers, even though they are closer to Warsaw, will have to go to Seoul among other places to obtain financing. Meanwhile, the National Pension Service is announcing further European shopping sprees. ν