When Prudential Real Estate Investors jumped into a joint- venture deal with Atlanta-based Cousins Properties late last year, it was both a sign of the times and a portent for things to come.

Prudential's $172.5 million, 50/50 joint venture with Cousins to build a new office tower called Terminus 200 in the heart of Atlanta's Buckhead office market reflected institutional investors' continued appetite for quality assets and showed the flexibility among the top investors in this group.

With their coffers full of pension fund money, institutional investors have decided to pump more cash into commercial real estate. And they are being far more creative in their strategies, favoring a mix of joint ventures and partial ownership structures for both development and existing assets.

Through November 2007, institutions invested $38.5 billion in office properties and $35 billion in apartments. That level of office investment was on par with the record volume of 2006, while apartment volume was 50% higher than in 2006, reports researcher Real Capital Analytics.

“Given the target returns institutions need to achieve actuarially, real estate makes a lot of sense,” says Greg Vorwaller, president of CB Richard Ellis' investment properties group in New York, which completed $60 billion in U.S. property sales in 2007. “You then add to that dynamic the continued volatility in the financial markets, and that clearly serves to support the view of real estate providing the anchor to values and income stability.”

According to data from the National Council of Real Estate Investment Fiduciaries (NCREIF), total investment returns in commercial real estate increased 16.6% in 2006 and were on track for the same increase in 2007. That compares favorably against declines in other investment indexes in 2007, including the Russell 2000 (-1.57%) and the S&P 500 (up 3.53%).

“The capital is still being allocated to real estate primarily for the portfolio diversification benefits,” says Bob White, president of real estate research firm Real Capital Analytics. “It is still a recent thing that real estate has become a legitimate asset class and not an ‘alternative’ investment strategy. Certainly the risk-adjusted returns have also been a draw as well.”

A pause that refreshes?

While most highly leveraged, under-capitalized investors are on the sidelines, increased allocations from institutional investors are not an automatic guarantee that the money will go into the ground right away. Institutions have tightened their underwriting standards and are focused on major markets with high barriers to entry.

Most observers believe the major players will sit on the sidelines for the first few months of 2008 while the Federal Reserve works its interest rate magic in helping the U.S. economy recover some of its steam. Because it's an election year, various economic stimulus packages floating around the halls of Congress may be enacted to stave off a recession later in 2008.

“Because of the debt markets, quite frankly the lenders are out of the market in the first couple of months of the year just checking the temperature,” says Steve Pumper, executive vice president with Houston-based Transwestern Commercial Services, which generated $5 billion in investment sales in 2007.

Last summer's credit crunch delayed many properties from hitting the for-sale market in 2007, but Pumper expects them to resurface early this year. “That will create a new pricing model that will determine whether or not deals get done based upon sellers' expectations. If the bid/ask spread is too great, many deals will not get done due to the fact that there are not many distressed sellers.”

When institutions do make direct investments today, what kind of leverage are they comfortable with? For value-add deals, the level of leverage is typically 50%, and that figure falls to 20% for transactions involving core assets, says Pumper.

Sizing up CalPERS

As bellwethers go, the California Public Employees Retirement System, or CalPERS, is the largest pension fund in the world and therefore a much-watched barometer of institutional investment trends. CalPERS announced in December it would pour an additional $5.2 billion into its $19.8 billion real estate portfolio, a 2% increase over its 2007 commitment level. Combined with other new alternative investment strategies, CalPERS expects its new asset mix to return 9.06% in 2008, up from 8.92% in 2007.

“The real estate unit is still understaffed and wrestling with an enormous workload during the current restructuring process,” says Clark McKinley, information officer for CalPERS. The CalPERS board has raised the allocation target for real estate from 8% to 10% of the total CalPERS portfolio, McKinley adds, with discretionary ranges for investment a few percentage points above or below those targets between now and 2010.

For its part, CalPERS is publicly coy about specifics. “It's a competitive market. We're looking to minimize the mortgage problem fallout, and looking for bargains,” says McKinley. CalPERS plans to split its real estate investment 50/50 between U.S. and international properties.

“By hitting the reset button every few years, we keep our portfolio balanced and diversified in a fluid market that never stands still,” says Charles Valdes, chair of the investment committee for CalPERS.

An informal survey of leading institutional investors and their advisors seems to support CalPERS' strategy, revealing nearly across-the-board increased funding for commercial real estate this year by an average of 1% in most cases.

New investors come out to play

One investor jumping back into the real estate game is TCW Group, an international asset-management firm with more than $150 billion in assets. Late last year, the company purchased a majority interest in Newport Beach, Calif.-based Buchanan Street Partners. The national real estate investment manager and advisor has $1 billion in committed capital across several funds on behalf of large institutional clients. Buchanan led some $3.8 billion in transactions in 2007.

TCW is no stranger to the real estate game. Up until 1995, the firm co-managed TCW Realty Advisors, a $3 billion joint venture with Westmark Realty Advisors, but it sold the business to CB Richard Ellis in 1996.

Now TCW is back with an aggressive five-year commercial real estate investment plan, starting with the Buchanan Street acquisition. “It was something glaring that we were not in U.S. real estate,” says Robert Beyer, TCW's CEO.

While Beyer would not elaborate on the exact funding commitment, Buchanan Street is reporting increased demand from its institutional clients. “We've seen more investment appetite than ever before,” says Robert Dougherty, senior vice president and head of principal investment with Buchanan Street Partners. “TCW views real estate as a viable asset class and it is not really concerned about whether it's the right time in the cycle. TCW is viewing it more from a portfolio of products and overall wealth management standpoint.”

Another new entrant is Chicago-based financial services firm Mesirow Financial, which announced in January the startup of its own institutional real estate investment unit. Mesirow hits the ground running after raiding its Chicago neighbor, institutional investment advisor Capri Capital, hiring three ex-Capri executives, Alasdair R.J. Cripps, Guy Chairiello and Charles L. Kendrick.

Portfolio deals dwindle

Institutions were instrumental in driving the record volume of mergers and acquisitions in 2007. In August, Morgan Stanley Real Estate took Crescent Real Estate Equities in Fort Worth private in a $6.5 billion deal. Morgan Stanley currently manages a $55.6 billion portfolio of assets on behalf of its clients.

In October, a venture formed by New York-based Lehman Brothers and Tishman Speyer closed on the $22.2 billion purchase of Denver-based multifamily REIT Archstone-Smith. That deal alone accounted for more than 60% of the total institutional investment in the apartment sector in 2007.

But privatization activity is likely to wane in 2008, given the continued credit crunch and economic slowdown. “A big part of the fallout in 2008 is a huge slowdown of the public to private component, a huge drop-off in portfolio sales, and a significant drop-off in single asset sales in excess of $100 million,” says Pumper of Transwestern.

Where to invest?

Institutional investors continue to favor office and apartment properties in markets with high barriers to entry, due to their strong real estate fundamentals in recent years. With consumer spending slowing — retail sales dropped 0.4% in December — the retail sector is generally less favored among major institutions. But well-capitalized investors are keeping a hand in the game.

For example, The Oregon Public Employees Retirement Fund has entered into a partnership with Jacksonville, Fla.-based Regency Centers Corp., to purchase seven grocery-anchored shopping centers for $76.6 million. A major part of the draw is the diversification of the properties, which are located in Florida, South Carolina, Atlanta, Sacramento, Houston and Charlotte.

International markets are also drawing investors. In January, First Industrial Realty Trust formed a 10-year joint venture with the California State Teachers' Retirement System to invest $475 million in industrial land and buildings in overseas markets. CalSTRS is contributing $150 million in the venture and First Industrial has a $17 million equity stake.

Mezzanine debt also is becoming a more attractive opportunity for institutional players. Investment managers continue to source deals that drive double-digit returns, and since banks and hedge funds have shut down their debt financing operations, mezzanine debt is drawing much attention. According to Private Equity Intelligence in London, 36 funds are now in the market raising $28 billion to invest in mezzanine debt.

As of June 30 last year, CalPERS had created a $186 million equity mezzanine portfolio. And a variety of pension funds, including the Seattle City Employees' Retirement System, the Los Angeles City Employees' Retirement System and the North Dakota State Investment Fund are making commitments in this sector.

Big names in the real estate finance world, including Apollo Real Estate Advisors, Shorenstein Properties LLC, The Blackstone Group, Lehman Brothers Private Equity and Babson Capital Management LLC have all struck mezzanine deals in the past and are focusing on capturing new opportunities in the area.

Despite the choppy property waters ahead, mezzanine investors are willing to take the short-term risk, even if borrowers stumble. “The returns are strong in the mezzanine area,” says Pumper, “and you can underwrite it nearly like equity and structure it as such.”

Ben Johnson is a Dallas-based writer.