PropertyReturns: Pension funds are looking abroad or upgrading because of competition, writes Gretchen Friemann.

Ten years ago, the institutional funds were the financial heavyweights in Ireland's commercial property market.

Today fund managers acknowledge that the market stimuli of record low interest rates and rising capital values means private investors are now calling the shots.

For developers it's a win-win situation. But as the pension funds are increasingly outbid on deals by private investors, fund managers are now faced with the vexed question of how to reduce unusually high cash weightings in a market where demand far outstrips supply.

Over the last few years some institutions have diversified into the UK market to overcome the dearth of available investments at home but the increased competition for British property is forcing risk-averse pension funds to move even further abroad. Irish Life, which has a portfolio totalling €1.8 billion, is set to diversify into the European market later this year according to its head of property fund management, Paul King.

He claims the shortage of supply here - together with the lack of good value investment opportunities - are key factors behind the company's decision to branch into European property.

Ten years ago Irish Life held one of the largest European property portfolios in Ireland but sold it to concentrate on the booming domestic market, which has recorded total returns of 16 per cent per annum over the past decade.

Last year Irish equities did even better, showing a return of 29 per cent.

However, Mercer Investment Consulting, which advises institutional pension funds, claims that the upward curve peaked in the late 1990s and, over the last few years, the firm has consistently advised fund managers to trim back their weightings in property following more moderate growth forecasts for the sector.

According to the company's latest research, the average pension fund weighting in property at the end of last year was 4.9 per cent, a drop of 1.3 per cent from two years previously.

Noel Collins, senior investment consultant at Mercer, said: "Although this figure is clearly not evidence of a wholesale sell-off of property among the institutions I do think it's a recognition that the strong run of recent years is not likely to be repeated to the same extent in the near future." The company is now advising institutions to diversify into European property and take advantage of better values in a market that is large enough to withstand a sudden shock to the economy.

Mr Collins said: "The Irish market is very small so there is always the risk of an outside shock that could potentially damage the entire portfolio. That's why we believe it's best practice to spread the risk across a diverse market."

However, Mr Collins acknowledges that expanding into external markets is not a "straightforward exercise" for pension funds. He said: "Institutions must maintain a far more risk-averse position than the private investors and, because Europe is further away than the UK and a very different marketplace, it can be difficult for fund managers to know what acquisitions to make."

The Irish Pension Unit Trust (IPUT), which manages a fund of €685.1 million, the largest in the state, has resisted the trend into UK property and concentrates solely on the Irish market.

Niall Gaffney, IPUT's investment manager, claims many of the problems facing the Irish market, such as inflated values and low yields, are now prevalent in the UK market and he claims the company achieves good returns for its investors by concentrating on domestic property. But he acknowledges the commercial sector in Ireland has changed radically over the last five years due to the huge numbers of private investors.

He said: "It's making it much harder for us to acquire good investments - but the private investor is really a function of low interest rates.

"Because they can leverage their acquisitions they're able to create large portfolios. That in turn creates aggressive yields as demand exceeds supply."

Despite modest yields, particularly in the retail sector, pension funds are still returning relatively robust returns - Mercer claims total pension fund property returns last year were 10.5 per cent. According to Mr Gaffney, the low yields are a function of increasing rental value and reflective of the strength of Irish property. He said IPUT has committed €40 million of its funds to acquisitions over the last year and continues to actively seek investments.

Hibernian Life is also looking to spend significant amounts of money in the commercial sector and to reduce its 20 per cent cash weighting. Hugh Linehan, the institution's property fund manager, said the supply crunch was not solely due to the rise of the private investor.

"Low interest rates have also persuaded developers not to sell on a scheme immediately. Many now hold onto them in the expectation the asset will significantly increase in value."

Faced with such a shortage of investment product, institutions are upgrading their current properties in search of higher portfolio returns.

Irish Life is spending €30 million upgrading the Ilac centre with its co-owners, British Land, while Hibernian Life expects to generate a further €170,000 in rental income from the Earlsfort centre following its decision to add another floor to the building.

According to Mr Gaffney the "illiquidity squeeze" in the market is not expected to ease this year. So for many institutions upgrading existing assets or diversifying into overseas markets may be the only option.