Pension-Fund Changes
Could Affect Real Estate

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In 2001, pension funds saw solid appreciation in their real-estate holdings, even as the value of their other assets declined. Since each sector of a pension fund's investment portfolio is defined by an allocation limit, when one sector outstrips its asset percentage, what is called the "denominator effect" comes into play: The pension fund must either change its percentage allotment or sell assets in that class. That appears to be the big question facing the pension funds: Should their allocation percentages be left where they are or recalibrated to reflect real estate's enhanced performance?

A lot is riding on how this question is answered: In one sense, it might even be seen as a litmus test of the overall real-estate industry's health. Presently, pension funds account for close to 39%, or $144 billion, of the total U.S. equity real-estate (excluding debt) market, typically representing 3% of a fund's total overall asset allocation. Despite a general industry target of 5%, the percentage of equity investment, on average, went only as high as 4% in 1990. If pension funds do change the percentage of capital dedicated to real estate back to the 1990 level, the market would see an influx of over $45 billion into equity real estate: If they choose to retain their current allocation percentage, we can assume some divestment will occur.

To get a clearer picture of pension-fund status, trends and outlook, as well as get some fundamental advice on the asset classes which pension funds might target in the future, I spoke with Eugene Conway, President of Lend Lease's Real Estate Advisors. Mr. Conway is responsible for all equity real-estate operations, which include equity portfolios, regional operations, research, acquisitions, dispositions, financings and property sector groups. He also serves as co-portfolio manager of the Prime Property Fund, a $3 billion core real-estate flagship account for pension investors, and is president and CEO of Buckhead Industrial Properties REIT. In total, Mr. Conway manages about $17 billion of private equity, most of which, along with some offshore money, is with pension funds.

Sam Truitt: California State Teachers' Retirement Systems (CalSTERS), a Lend Lease client, recently decided to boost the real-estate segment of its $100 billion portfolio to 7% from 5%. Do you anticipate similar asset reallocations in favor of more real-estate holdings, from other funds, in the coming years?

Eugene Conway: Actually, we do see that as a potential trend, but it takes a fair amount of time for pension funds to decide to change their actuarial models because they are based on very long-term algorithms. Asset allocation is the most important decision, even before selecting individual managers and style. So it's not a change that takes place very easily or very frequently.

Truitt: And what do you feel is the rationale behind that shift? In other words, what's the driving force?

Conway: Well, I think it's pretty clear that as a fiduciary to the investors in the plan, solvency is important. Also -- whether it's a private or a public pension fund -- trying to ease the contributions from the organization to fund these benefits is key. You know, the trustees generally take a look at where the best risk/reward frontier is so that contribution costs from the employers can be minimized, while at the same time, retain a very sound pension fund that can pay out its benefits when required. The bond market has had a terrific run-up, but there's really no more room to grow. The current yield return on bonds is fairly low. And it's going to take a lot of out-of-pocket money for many of these pension funds to meet their obligations. So real estate looks to be an attractive area where, for the same amount of risk, they can get a supplemental reward, particularly on the income component.

Truitt: Bank of America's Lee Schalop writes that rising property prices over the past few years, combined with slipping returns in other financial investment sectors, have made many pension funds over-weighted in real estate. Due to allotment commitments, he suggests that pension funds may not be as active on the buying side in 2002. What are your thoughts on that?

Conway: He's correct. Many of the pension funds have hit their targets. They have had very good appreciation in their real-estate holdings and, with the decline in the value of their other assets, they find they are at their maximum allocation. That's called the denominator effect. But by opening the door to a new hurdle rate, I think you will find that the flow of money to real estate will once again be enhanced. I think this leads to the decision that CalSTERS has made.

Truitt: What about the pension funds that do not choose to raise the hurdle and are forced to sell assets to meet their allocation commitments, namely, those funds investing in REITs? Because of their higher liquidity, a pension fund's REIT holdings might be more apt to get sold off.

Conway: It really comes down to a case-by-case basis. We have seen that many of the pension funds may be exiting, lightening up on some areas, but they might be buying in the private real-estate sector in an enhanced form of investing. The money is not binary, in that it is either in real estate or out of real estate. There's really a lot of money that is moving among sectors in real estate. Then, we're also seeing a growth in 401(k) business, with the individual investor who is taking a look at REIT stocks as a very attractive area to capture a high dividend yield with prospects of appreciation. So there's a lot going on in the market place. While the pie may not be expanding, the size of the slices is changing.

Truitt: I guess the most recent big news (Dec. 7, 2001) in pension funds was the acquisition of Cabot Industrial Trust by Cal West, a joint venture between CalPERS (California Public Employees' Retirement System) and RREEF -- creating the largest privately-held industrial property company in the U.S., as well as the second largest overall [behind ProLogis Trust of Aurora, Colo.]. What further consolidations do you anticipate in the pension-fund real-estate market?

Conway: I think that certainly was an attention-grabbing headline, but over the years -- at least in my more than 20 years -- there have been a number of large entities that have been taken private. And, in some cases, they have been taken public again. I would say that anyone that is sitting on an amassed portfolio of high-quality real estate -- whether it happens to be industrial alone or retail, office, multi-family housing -- there is clearly a broad market demand for quality assets, particularly if there is an assembled strategy that engenders synergy.

Truitt: Are there any specific consolidations that you are anticipating?

Conway: Not specific consolidations... There are always going to be a few... There have been consolidations, but I won't say it's a sea change, but more "business as usual."

Truitt: CalPERS recently launched an ambitious initiative to channel investments into underserved urban and rural markets in California. Traditionally, CRE investors shy away from these areas -- those termed by the Clinton administration as "domestic emerging markets" -- due to their perceived high-risk rate and the lack of data substantiating their potential value. How would such investments be justified as sound?

Conway: I think, first off, that various forms of capital, principally from private investors, have served the underserved in rural and urban markets. CalPERS has been in the ownership of real-estate equities for a long time, has a very good track record and has the scope, scale and strategic alliances that I feel are very capable of making a win/win situation, deriving adequate return while contributing to public good.

Truitt: Do you see CalPERS setting a trend in this?

Conway: That's a challenging statement. Is there a public policy of using pension-fund money for anything other than its mandate, which is to maximize return and create risk diversification for annuitants of the fund? Having come from the life-insurance industry, I would say that in the insurance industry, it was an important initiative 25 years ago to take some of our premium dollars that we took out of communities and reinvest back into those communities. I think the landscape is just chockfull of urban revitalization that took place in the late '60s and early '70s, with large, well-capitalized institutions playing a public/private role.

CalPERS has always done a certain amount of focused investing in its own backyard. There is a political will to do that sort of thing in California. Yes, they have been a bellwether, but sometimes without other pension funds necessarily following suit.

Truitt: How do you see the real-estate portfolios of pension funds evolving over the next two to three years?

Conway: Core investing will continue to dominate the landscape. There will be a significant number of investors that will take a look at enhanced or opportunistic situations, but -- realizing that the real-estate markets were in a relative supply/demand imbalance prior to the recession -- I don't think there's going to be a plethora of those opportunities, unlike the big returns made in the mid-1990s. They'll gravitate toward the solid, day-in/day-out core returns that are going to beat the bond market and be competitive with stock equities.

Truitt: How do you define "core investing"?

Conway: To our way of thinking, a core investment is an existing, established property that has a diversified rent roll, with approximately 75% of the total return coming from the income component: If there were a total target return of 10% to 12%, you'd expect 7.5% to 9% to come from income and the balance to come from an appreciation component. The property would also possess generally acceptable physical characteristics; it would be in a large-to-middle market; and it would be a property, which if taken to market, could be sold in a reasonable amount of time.

Truitt: What other trends do you see in pension-fund investing?

Conway: This is not a major trend, but I would say that 10 years ago, a core investor typically bought properties and managed a portfolio on an all-cash basis. As property values continue to increase, what we are now seeing is a strategy of portfolio diversification that puts moderate leverage of between 20% to 30% on the portfolio, which is a way to diversify holdings without creating excessive volatility in the returns.

Truitt: Where do you see the emerging real-estate markets in the next 10 years?

Conway: Geographically, we at Lend Lease tend to favor the top 25 markets. We also like to think of diversification by the different economies, as opposed to just where they are physically. Frankly, we see very good growth opportunities in multi-family housing. We also see growth in solid, bread-and-butter distribution centers; strip retail; trophy, regional malls; the 24/7 downtown office sector; the suburban/urban, ring city commercial business districts; and the very selective, full-service hotels.

Truitt: In this vein, what economic/demographic trends are you zeroing in on?

Conway: The economy has become more and more knowledge based. We as a company are very bullish on choosing those property types and markets that have a high basis in intellectual capital. Those markets -- whether they are banking, insurance services, medical research, telecommunications or communications -- will also have a close affiliation with major research universities, think tanks… It's very important to us that we are near a highly educated portion of the population. Also, when you take a look 20 or 30 years down the road, we are going to be a nation of many types of people, and we are very in tune with diversity in terms of looking at demographic trends. But, again, with an eye toward where that region of the country lies that has the potential for the highest intellectual-capital base, regardless of the background of the people. We see this as a huge driver over the long term.

Truitt: What do you see as the big issues pension funds need to address in the near future?

Conway: I would say it is a time to choose very carefully and very wisely. As we go into a pause in the economy, the highest quality properties -- those with the best rent rolls in the best long-term locations -- should continue to do well. With marginal investment properties -- those in the second-tier cities and those properties that have a lot of near-term rollover with rent rolls that don't have a high degree of credit -- I would be careful.

Truitt: In other words, again, returning to the core investments?

Conway: Correct.

Truitt: Is there anything else you would like to add?

Conway: I would just say that the objective of maximizing the overall pension-fund portfolio return while minimizing the risk should play well for core real estate and certain forms of enhanced real estate over the next one to five years. Additionally, it would be an unfortunate lost opportunity that while other asset classes are swooning, real estate is ruled out because of the denominator effect.

Truitt: Meaning that pension funds should be raising the real-estate allocation hurdle if need be.

Conway: It's an interesting conundrum that you have with real estate: When the stock market is terrific, people say it is so easy to make money in stocks, why bother [investing in real estate]. On the other hand, when real estate does well, and stocks have done poorly and maybe it's time to buy in and dollar-cost average...the denominator effect in real estate kicks in. Consequently, real estate seems to be on the short end of the stick, in many real-estate programs, no matter what.

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