When the California Public Employees’ Retirement System — America’s largest public pension fund — announced in February that it would radically change the way it invests in real estate, the news sent shock waves through the institutional investing community.

Known by its familiar shorthand as CalPERS, the fund has long been considered a leading barometer of major pension fund trends. Its movements are closely monitored, and for good reason. Sacramento-based CalPERS controls some $228 billion in total assets under management, with a real estate portfolio valued at more than $16.6 billion as of Sept. 30, 2010.

Under the direction of CalPERS’ chief investment officer Joseph Dear,the fund’s strategy is to reduce risk and focus on steadier and more predictable income streams from its future real estate investments.

While CalPERS is certainly the largest and most visible fund to adopt such a strategy, others are joining the movement. In November, the $34.3 billion Maryland State Retirement System announced its own plan to invest in more conservative real estate assets.

Power players

“There clearly is a measurable trend to deploy capital in the real estate sector that is seeking less risk,” says Michael McMenomy, global head of investor services with Los Angeles-based CB Richard Ellis Investors, which has $35.7 billion of assets under management across the world for institutional clients. “That means primary markets, not tertiary, lower levels of financing, and acquiring occupied buildings rather than developing them. The whole style has crawled back to that 8% to 10% return objective for a good swath of capital.”

That shift is the very antithesis of pension fund objectives during the height of the market from 2005-2007, when the search for ever-higher returns led many to stray into riskier commercial property investments.

According to research from Pensions & Investments magazine, the 1,000 largest U.S. retirement funds have total assets valued at $6.5 trillion. Pension funds have become one of the largest investors in commercial real estate.

Today’s pension funds are allocating an average of 10% of their total assets to the real estate sector, buying and owning properties directly, co-investing with other investors in commingled funds, and through the purchase of stocks in publicly traded real estate investment trusts (REITs).

That allocation level is up from the 6% to 8% range of just a decade ago, indicating the continued importance that real estate plays in their portfolios.

Their sheer size, however, also has made pension funds vulnerable to the recent market downturn in commercial real estate values. By many accounts, those values have fallen an estimated 50% over the past two years.

CalPERS’ own real estate portfolio saw an overall value decline of 5% for the 12-month period ending Sept. 30, 2010. And while the drop was the smallest since the beginning of the financial crisis, it comes on the heels of huge setbacks.

The CalPERS plan

One of the most recent hiccups was a land investment in the 12,000- acre residential development known as Newhall Ranch outside Los Angeles. The project went bust in June 2008 and is likely to cost CalPERS nearly $1 billion.

While pension funds remain committed to the real estate sector, how they are choosing to invest their capital is changing significantly. “They are in the process of rethinking their own expectations for how real estate fits into their broader portfolio,” notes Dr. Sam Chandan, global chief economist at New York-based researcher Real Capital Analytics. “They will just approach it with more caution.”

As a formal policy matter, CalPERS reviews its real estate investment strategy every five years. The last review was completed in September 2007. This time around, both CalPERS staff and its outside real estate consultant, Pension Consulting Alliance (PCA), developed the new strategy.

Specifically, CalPERS is shifting its real estate portfolio to less-risky “core” and income-producing properties in the United States run by managers in dedicated or separate accounts, as opposed to commingled funds that feature multiple investors. Core investments are characterized as high-quality assets in well-known major markets on the East and West Coasts, such as Washington, D.C. and San Francisco.

In a particularly dramatic move, CalPERS also is phasing out its investments in REIT stocks as part of its real estate portfolio over the next three years. Currently REITs make up about 7% of the CalPERS real estate portfolio, but their recent strong performance in 2010 has many analysts questioning their growth trajectory in the months ahead. The fund will continue to invest in REITs through its equity portfolio.

CalPERS will divide its real estate portfolio into two parts. A legacy division will include $6.8 billion of existing investments, which will be targeted for sale over the next five to seven years. A new portfolio will include $8.6 billion including stronger-performing existing assets as well as new investments managed by 15 to 30 new outside investment managers.

According to CalPERS spokesman Clark McKinley, it is in no hurry to hire those new managers, but the pension fund giant could make an additional $1.5 billion in new investments in the 2011 calendar year.

The new strategy also calls for reducing the portfolio’s overall risk profile by requiring a minimum of 75% of the portfolio to be in core investments, up from the recent 49% level.

CalPERS also expects to replace its existing performance benchmarks with an index from the National Council of Real Estate Investment Fiduciaries, the NCREIF Fund Index-Open End Diversified Core (ODCE).

Larger pension funds like CalPERS and its upstate cousin, the California State Teachers’ Retirement System (CalSTRS), also are expected to commit more capital to separate accounts.

Oh, the irony

For its part, CBRE Investors has revamped its fund offerings to include lower-risk investments, and more than half of its assets under management are fashioned in a separate account structure. However, a separate account strategy is likely within the purview of only the largest funds that can command enough capital to make it worthwhile for outside managers.

“I sense that the pension fund investor world may be heading toward a bifurcated structure,” says Ted Leary, president of Los Angeles-based Crosswater Realty Advisors, an institutional investment consultancy. “I think we are going to see these big dogs create a new, improved version of separate accounts with very large commitments. At the same time small and mid-sized investors will likely continue to utilize a commingled fund structure.”

Over the past few years, pension funds have been buoyed by the performance of REIT stocks. In fact, in 2010, REITs gained 28% on a total return basis, easily beating the S&P 500 return of 14.8%, according to the National Association of Real Estate Investment Trusts (NAREIT).

In January 2011, NAREIT released a new report, the Real Estate Optimizer, directed to pension funds extolling the virtues of combining one-third part REIT stocks with two-thirds real property in their portfolios to produce optimal returns.

All of which makes CalPERS’ new strategy of trimming down future investments in REIT stocks particularly ironic.

Turning the Titanic

“Certainly there is the potential for higher returns with greater exposure to REIT stocks, but there are concerns over the appropriateness of the timing given the appreciation we’ve seen in REIT stocks over the last year,” says Chandan.

“Also, there is the desire on the part of a number of pension funds to insulate themselves against the vagaries of the stock market, since many REIT stocks demonstrate a strong correlation with overall market returns,” adds Chandan.

While the ink is still drying on CalPERS’ plan on paper, it will take time to fully implement. According to its schedule, the fund intends to roll out most of its strategic moves by the third quarter of this year. Other pension funds are expected to follow suit, but the industry will not shift its course overnight.

“There is more confidence in real estate in general, but that confidence won’t be expressed in a markedly different allocation of capital to real estate in 2011 because a lot of the capital earmarked for real estate has yet to be deployed,” says McMenomy of CB Richard Ellis Investors.

Chasing the assets

In other words, there is already a backlog of capital that pension funds have previously committed to their real estate managers, but has yet to be invested. Fund managers continue to be selective in their hunt for property investments, waiting for the right opportunities to come along as markets across the country continue their slow economic recovery.

Despite the backlog, according to McMenomy, pension funds do have the capacity to pump even more money into real estate in the months ahead. “Their target is about 10% of assets, and their current position is 8% to 8.5%,” he notes.

While pension funds are favoring core investments in major markets where they believe the risk is mitigated, they face increasing competition for these assets. Other investors, most notably the publicly registered non-traded REITs and international investment funds, have been the most active buyers.

One recent example was the February sale of the former headquarters of the Mortgage Bankers Association at 1331 L Street NW in downtown Washington, D.C. CoStar Group purchased the building in 2010 for $41 million and sold it one year later for $101 million to an affiliate of Munich, Germany-based GLL Real Estate Partners.

New challenges ahead

“Capital remains significantly concentrated in major markets, and that will present challenges to the funds in executing on a core strategy,” says Chandan.

Some observers see little change in the mindset of pension funds, however. “They are not going to be the ones out there leading the charge into secondary markets,” says Robert Bach, senior vice president and chief economist with Grubb & Ellis. “They are going to stick to their knitting for a long time, and right now class-A properties in core markets is the most risk-averse slice of the market. That’s where they will be.”

Due to their ties to cash-strapped cities and states, public pension funds in particular face a great many obstacles to overcome in the years ahead. Arizona, California and Washington in February proposed drastic reforms to cut statefunded obligations to their public pension systems.

States are struggling under the weight of reduced tax revenue, and the proposed measures would reduce the capital the pension funds could invest on behalf of their members.

Among the specific measures proposed are repealing cost-of-living raises for retired public employees, increasing the age to be eligible for retirement and even a cap on pension benefits for all new employees.

Such moves would add pressure on pension funds to produce steady returns over the long term without significant losses such as they have incurred in recent years. Given that mandate, their new way of thinking about real estate may serve them well, says Chandan.

“They remain committed to the sector, but will select assets and investment opportunities that are more clearly focused on a steady income stream as opposed to asset appreciation.”

Ben Johnson is a Dallas-based writer.