When Carmel Partners Inc. marketed an apartment complex in Costa Mesa, Calif., last year, three pension funds were among the bidders. But the highest offer came from Essex Property Trust, a real estate investment trust (REIT) that paid $74 million for the 468-unit Villa Venetia Apartments.

The sale was hardly unusual. “A lot of times pensions just can't match what other people will pay,” says John Williams, COO of Carmel Partners, a San Francisco-based investment firm.

Pensions and other institutions are famously disciplined investors that must answer to conservative boards of directors. When prices climb, these cautious buyers typically hold back.

That's why last year was a frustrating time for pensions, life insurance companies and other conservative institutional investors. All too often, they bid on properties only to lose out to foreigners or private investors who paid higher prices than had been expected.

Feeling a ‘Sense of Urgency’

Indeed, pension funds accounted for only 10% of institutional real estate purchases in 2003, about half their normal share, estimates Peter Schaff, CEO of U.S. Private Equity for Chicago-based LaSalle Investment Management, which manages $20.5 billion for institutions, corporations and individual investors.

That pent-up demand could pave the way for a stronger showing by institutions in 2004. “The pensions have a lot of available capital, and they have an increased sense of urgency to make up for their slow pace last year,” Schaff says.

Institutions that once focused on the top 20 cities are now looking at secondary markets with healthy economies, such as Austin, Texas. In addition, some pensions are increasing their use of leverage. In the past, institutions rarely used leverage for their core holdings, properties designed to provide conservative income streams.

In the 1990s, pensions typically paid all cash for such holdings. But now many institutions are borrowing in order to boost returns and stretch equity dollars further. While many institutions would prefer owning 100% of a project with no debt, they are increasingly taking on partners as a way to win deals. Some pensions participate in leveraged deals in order to satisfy partners who borrow for all their acquisitions.

“We do predominately cash deals, but if we have a partner who needs the ability to use debt, then we will put on conservative debt of 50%,” says Joseph W. Luik, senior managing director of TIAA-CREF, a New York-based teachers' pension fund.

That's not to say all pension funds are keen on debt. Some fear that leverage adds risk. Still, a growing number of pensions are inclined to boost returns with leverage. Those pensions that do use leverage are strictly limiting its use. Individual core properties rarely have more than 60% debt, and total portfolios typically have less than 30% leverage.

Some institutions put 75% leverage on opportunistic investments. But these may be viewed as alternative investments, a category that includes venture capital and other choices that are supposed to produce higher results in return for greater risks.

According to the Pension Real Estate Association (PREA), pensions continue to focus on core holdings, keeping 66.5% of assets in that bucket (see chart). But in their search for deals, some institutions are looking harder at value-added or opportunistic deals. Carmel Partners reports strong demand from university endowments and foundations for a $215 million fund that focuses on buying under-performing apartment complexes. Using leverage, the fund hopes to buy $700 million worth of properties and deliver returns to investors in the mid-teens.

Last year, the Carmel fund paid $90 million for Riata at Bel Mar Park, a 1,120-unit apartment complex in Lakewood, Colo., near Denver. At the time of the purchase in July 2003, the complex was plagued with an 82% vacancy rate, according to Williams of Carmel. The owners now plan to renovate apartments and build four state-of-the-art health clubs. The complex had a cap rate of about 7% when it was acquired. Carmel hopes to achieve a total return on the project in the mid-teens.

The aim will be to divide the huge complex into four divisions, each aimed at a different market segment. By selling each division separately in a few years, Carmel hopes to boost its returns. “There are a limited number of buyers who can afford a huge development, but a lot of people can bid on a project with 400 apartments,” says Williams.

A Seller's Paradise

Though they did not plan to lower their real estate allocations, many institutions decided to take advantage of strong markets and sell properties in 2003. In some cases, the owners were approached by aggressive buyers who offered prices that the institutions could not refuse. TIAA-CREF sold $800 million worth of real estate last year. “A lot of pensions have been selling,” confirms Luik of TIAA-CREF. “If you are in the right markets, it is the time to sell because the demand is so strong.”

The average pension had 5.3% of its assets in real estate at the end of 2002, according to PREA, but that figure could be lower today because of asset sales. To boost real estate positions, many institutions now are aiming to increase purchases.

Some boards of directors are pushing to increase real estate allocations. For pensions, real estate now seems particularly appealing. While stocks rose and fell during the past decade, real estate stayed in the black every year, yielding an average annual return of about 10%, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). Meanwhile, the National Association of Real Estate Investment Trusts (NAREIT) reports a 10-year annualized return of 12.1% as of Jan. 31.

Clearly, real estate produces a solid income stream, an important consideration for boards that are responsible for sending monthly checks to retirees. So far, the allocation shifts of individual pensions have been minor, but they could have a big impact on overall demand. “We see cases where someone has a target allocation of 6% or 8%, and they are moving that up fully 1 percentage point,” says Schaff of LaSalle.

Prices Begin to Stabilize

Many pensions were caught by surprise in 2002 when a wave of aggressive bidding began. After being burned in the stock markets, private investors and foreigners raced to buy real estate. At the same time, interest rates on 10-year Treasuries dropped from above 6.5% in January 2000 to a low of 3.13% in June 2003. That lowered the cost of financing and made bonds look unappealing compared with real estate. Then in the summer of 2003, interest rates began to rise and bidding became less heated. “Prices have stabilized, and we aren't seeing prime offices and other properties trade for more than people expected,” says William Maher, director of North American Investment Strategy for LaSalle Investment Management.

While a stable investment climate could enable institutions to make additional purchases, they must still contend with prices that remain at high levels. Price increases have been particularly steep for apartments. For high-quality properties in major cities, capitalization rates have dipped to as low as 5.5%, says Patrick Halter, CEO of Des Moines-based Principal Real Estate Investors, which manages $25 billion worth of equity and debt investments for institutions and corporations.

Less sought-after multifamily projects have rates of 6.5% to 7%. During the past three years, rates have dropped by 200 basis points, Halter says. The prices have been pushed up by demand from pensions as well as private investors. That is a far cry from a decade ago when many institutions steered away from multifamily properties because of concerns about the short leases of tenants.

Apartments Get the Nod

Most institutions prefer holding a diverse array of property types. According to PREA, the average portfolio has 35.3% of its private real estate holdings in office product, followed by retail (19.3%), multifamily (17.3%) industrial (15.1%), and hotels (3.2%).

Advisors have been urging clients to consider acquiring more apartments and second-tier office buildings, which have been strong performers that can diversify portfolios. But rather than raise their bids to satisfy allocations, many institutions are sitting on the sidelines and only buying properties that fit within their price range. Because of their long time horizons, pensions can afford to wait for years.

In recent years, apartments have emerged as the least volatile property type. While offices and retail properties suffer from occasional periods of weak demand, apartments have rarely faced high vacancy rates. Demographics suggest that apartments can continue to thrive. The number of immigrants — prime apartment customers — remains high.

And a growing class of so-called echo boomers, children of the baby boomers, are reaching their 20s and seeking apartments. Lately, apartment vacancy rates have climbed because of overbuilding and low interest rates, which made it possible for young people to buy their own homes. But institutions have shrugged off the difficulties and continued shopping for apartments. “Investors figure that the problems are a temporary speed bump, and demand will be strong for a long time,” says Halter of Principal Real Estate Investors.

Apartments account for 19% of the investment-grade properties included in the NCREIF Index. But many institutions hold less than that figure. Participants in the PREA survey had 17.3% of assets in multifamily investments. Some advisors have suggested increasing the allocation, but with pensions reluctant to pay high prices, it may be hard for institutions to raise their stakes this year.

Don't Count Out the Office Market

Betting on a revival in downtown Chicago, LaSalle Income & Growth Fund III, an institutional portfolio, recently purchased an office property at 55 West Monroe for $90 million. Although the building has a prime location in Chicago's Loop, it comes with leasing risks because about 20% of its tenants are about to vacate.

According to Schaff of LaSalle Investment Management, any vacancies in the Class-A building should be filled as soon as the economy improves. “This is a solid investment for our value-added fund, and it should produce nice results with an internal rate of return in the mid-teens.”

Cap rates on top office buildings in major cities have dipped about a percentage point to 7% in the past year. With Germans and private investors pushing up prices, pensions have had little success in contests for the trophy properties.

Institutions have had better luck buying in the suburbs. And in order to capture more deals, some institutions have begun purchasing buildings with vacancies. Such properties don't necessarily inspire heated bidding. If the economy improves this year, the vacancy levels could drop, and the buildings could produce handsome returns. Strong appreciation could cause pensions to raise their allocations to the sector.

What are the prospects for buying retail product? Fully leased retail and industrial properties post cap rates as low as 6%, down a percentage point in the past two years. Because they control strong franchises, regional malls are particularly difficult to buy, and running a mall requires expertise and strong relationships with national chains.

In order to remain active in the retail arena, some institutions are turning to joint ventures with experienced operators. In December 2003, Principal Real Estate Investors joined with Madison Marquette, a veteran mall developer, to purchase MarketFair Shopping Center in West Windsor, N.J., for $70 million. The 240,000 sq. ft. center is anchored by Barnes & Noble and a United Artists theater.

REITs, CMBS Hold Attraction

Unable to find real estate at bargain prices, some institutions have bought public shares of REITs. Pensions have 9.2% of their real estate holdings in public REITs, according to PREA. Although stocks are more volatile than owning buildings outright, REIT shares are highly liquid, and it is easy to achieve diversification across property types and regions.

In recent years, many of the stocks paid attractive yields of more than 6%, and total returns have been strong. According to NAREIT, for the 12-month period ending Jan. 27, REITs returned 38.5%, and 18.9% annually for the past three years. Now some institutions worry that prices have gotten too rich. The price of many REIT shares exceeds the value of the underlying assets.

Led by insurance companies, institutions also have been boosting their holdings of commercial mortgage-backed securities (CMBS). Mortgage securities offer attractive yields compared with bonds. CMBS yield about 5%, an appealing rate at a time when 10-year Treasuries yield 4.1%.

With many investors worried about the safety of stocks and bonds, mortgage securities hold a special appeal. Even securities rated below investment grade have performed well and enjoyed strong demand. “There has been very little default experience, and that has encouraged a lot of capital to flow into mortgages,” says Halter of Principal Real Estate Investors.

The reliable performance of real estate in recent years stands in stark contrast to the stock and bond markets where investors have been plagued by concerns about fraud and defaults. More institutional boards are taking notice and gravitating to real estate as a source of transparent cash flows. The strong confidence in the sector should ensure that institutions will maintain their real estate allocations this year and beyond, indicates Schaff of LaSalle Investment Management.

“Lately, real estate has delivered good returns, and there have been virtually no scandals or foreclosures.”

A PENCHANT FOR CORE PROPERTIES

By historical standards pension funds prefer well-stabilized, or core, properties, but they are not completely averse to risk as this chart shows.

Distribution of Private Real Estate Investments by Strategy
ALL FUNDS
$ Millions % of Private Real Estate Equity
Core 49,662 66.5%
Value-Added 11,900 15.9%
Opportunistic 13,086 17.5%
Total 74,648 100%
Source: Pension Real Estate Association survey conducted between June and December 2002 of 46 pension funds with an aggregate of $90 billion of real estate-related investments.