Head of the Class | Published in October 2010

Commercial Messages

Sponsors need to remember that real estate keeps a different schedule from most other asset classes

By John Keefe | October 2010
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Illustration by Chris Buzelli

Real estate is the oldest alternative investment for pension funds although, at many of the largest, it now takes second place to private equity. Portfolios are substantial nonetheless: $14.8 billion at CalPERS as of April 2010 (7% of assets); $13 billion at CalSTRS (June 2010, 10%); and $4 billion at the Pennsylvania Public School Employees’ Retirement System (March 2010, 9%). The average corporate fund is less enamored, says Greenwich Associates, allocating just 4% of assets to real estate at the end of 2009. Still, Towers Watson tabulates that, as of December 2009, the top 50 real estate advisers managed total assets of $439 billion for pension funds around the globe.

The pace of real estate investment quickened about five years ago, explains Heather Christopher, an Associate at consultants Hewitt EnnisKnupp in Chicago. “Real estate returns started rising after the tech wreck, which led investors to increase their allocations in 2005. All of a sudden, the managers had to put out money quickly, and that helped fuel the fire in returns.”

Real estate returns surged in 2005, 2006, and 2007, with performance for high-quality, full-leased core properties hitting the high teens in all three years, as measured by the National Property Index (NPI) and Open End Diversified Core Equity (ODCE) indexes of the National Council of Real Estate Investment Fiduciaries (NCREIF). The value of commercial real estate collapsed with everything else during the financial crisis when property ceased, for the time at least, to be an alternative, diversifying asset. The real estate measures fell in 2008, as did stocks, but fell again in 2009—a total of 23% for the NPI and 40% for the ODCE—reflecting the time lags inherent in real estate valuation, as well as the assets’ illiquidity and long deal-gestation periods.

Many institutions are seeing their property accounts fall further than the indexes. At CalPERS, for instance, real estate lost 43% for the one year ended March 2010, versus a drop of 19% for the median institution in the Trust Universe Comparison System. In addition to investing in conservative core properties, “the big funds often take on leasing and development risk and, today, the buildings built with all the capital that came in during 2005 are being delivered empty,” notes Christopher. Factor in leverage, and the markdowns become substantial.

Following the credit crisis, transaction volume in the real estate markets has fallen even further than property values. Real Capital Analytics, New York, reported properties changing hands to the tune of $130 billion to $150 billion in the U.S. during each quarter of 2007, falling off to a paltry $5 billion to $12 billion per quarter in 2009 and 2010.

The lack of transactions is not due to institutions turning away from real estate. “I’ve heard that some open-end funds now have queues of investors to put money in, which is an enormous change from 18 months ago, when there were very long queues to liquidate their holdings,” observes Jeff Kanne, a Managing Director of Real Estate Investment for the National Electrical Benefit Fund, and recently selected to be President and Chief Executive of its new subsidiary, National Real Estate Advisors, advising the Taft-Hartley market.

He explains that some investors see real estate as one of the best opportunities in today’s market. “The other options are not very enticing. Today, you get a 3% yield on a 10-year Treasury bond, and the risk of loss is huge. A quality real estate asset can yield 5% and has a hedge against inflation. For the first time in years,” he adds, “people are cold-calling to ask if I want to sell some property. Not specific properties—they’re just looking for anything for sale.”