Pension funds look at how to marry the hard asset of real estate with cyberspace.
In today's investment climate, even pension funds have been unable to resist the temptation of technology investments, with their flirtatious promise of a higher return-on-investment. Some pension funds have entered into strategic alliances with Internet or telecommunications firms, while others have invested in real estate-related technology companies.
"Call it `dot.com envy,'" says Cordell Lietz, chairman of the Pension Real Estate Association and senior vice president of The Taubman Co., based in Bloomfield Hills, Mich. Lietz heads The Taubman Realty Group's newly formed technology and strategic investment group, which focuses on real estate-related technology investments.
Technology not only has changed the nature of real estate investments, but it also has altered the very definition of real estate, according to Lietz, who formerly was responsible for U.S. real estate investments by ABP, the Dutch pension with more than $150 billion in assets.
Are these real estate investments or venture capital? Should technology infrastructure be considered real estate? "As long as the bloom is still on the technology rose, nobody seems to care," says Lietz.
On the other hand, pension funds are shying away from REITs, the former darlings of Wall Street, even though publicly traded real estate funds have made a comeback in the past year. "The pendulum has swung back to pension funds wanting to control their own destinies, so they are making more direct investments in real estate," says Martin West, senior vice president of Bloomfield Hills, Mich.-based Acquest Realty Advisors Inc.
The real estate investments of the top 200 pension funds equaled just more than 3% of total assets, or $120 billion in real estate holdings last year, according to Brian Webb, managing director of UBS Realty Investors LLC, a division of Hartford, Conn.-based UBS Asset Management.
Though fairly conservative because of their fiduciary responsibility, pension funds are savvy real estate investors, relying more on professional real estate advisers than other investors, says Thomas Lydon, president of White Plains, N.Y.-based SSR Realty Advisors Inc.
"Pension funds operate on a more formalized basis than other parts of the real estate community," notes Lydon. "They're broad-based and diversified, with a fairly structured plan. That makes them a little different than the average institutional investor, and they're more cognizant about wanting to achieve balance in their portfolios."
Over the last five years, pension funds have taken a less conservative approach as they have allocated more of their real estate dollars to value-added and opportunity investments, says Bob Zerbst, president and CEO of Los Angeles-based CB Richard Ellis Investors LLC, which has 120 pension fund clients. "They're saying they want their real estate to be a contributor to the total return of the fund and not just a portfolio diversifier."
High-tech liaisons There is no question that, for pension funds, the line between real estate and technology investments is starting to blur. "It's unclear if plan sponsors want their real estate managers to be technology investors," says Lietz, who believes pension funds should be making technology investments as long as they understand the technology in which they are investing.
Real estate-related technologies not only can diversify portfolios and expand the income potential of buildings, but high-tech capabilities also provide better services to tenants. "All of this increases the value of their investment and enables them to become more competitive in the capital markets," says Lietz.
The capital markets now are heavily weighted toward technology rather than real estate investments, according to Lietz. "Even with the NASDAQ meltdown, it's still way ahead of where it was a year ago," he says. "How do pension funds compete for capital in this market?"
One way is to create smarter buildings equipped with high-technology capabilities, such as online leasing and procurement of supplies. To provide these services, pension funds are teaming up with high-tech companies.
For example, Sacramento, Calif.-basedPublic Employees' Retirement System (CalPERS) recently allocated $500 million for investments targeted at bringing together real estate and technology.
"The pension fund investment community is widening the definition of real estate investments," says Lietz.
A myriad of real estate-related technology companies are starting right now, adds Lietz. "They need capital but they also need a real estate company to incubate their business and be part of their initial client base. If [the real estate company] is going to help incubate these start-ups and make them successful, they also want an equity ownership stake in that [technology] company."
Such investments became more prevalent when REIT stocks were not faring well and they were searching for new return avenues, according to Lydon.
"Some of the public REITs have become active investors in start-up service companies in technology, and analysts have questioned why they've chosen to be a start-up investor," says Lydon. "Some people are questioning whether this is a real estate investment or a venture capital investment and whether management companies are qualified to do this kind of investing. It's the question everybody is asking."
A vast impact Technology has revolutionized the real estate industry to a great extent. It has changed the way business is conducted, and as a result investors must be wary of leasing to upstart tenants who often have no credit history and an intangible product. At the same time, they must invest in the technology infrastructure needed for their buildings to remain competitive.
"Investors are trying to determine how technology is going to impact them and how best to position themselves," says John McClellan, principal investment officer of real estate for the Los Angeles County Employees Retirement Association.
Rather than committing millions to technology-related real estate like CalPERS, the L.A. County pension fund is addressing the technology challenge in a different way, according to McClellan.
"We're making sure our properties are technologically advanced enough to provide essential services to tenants," he says. "That's critical to maintaining the competitive status of our properties. We're making what investments we deem necessary to have those services available to tenants."
From a product standpoint, the pension fund considers itself somewhat conservative and fundamentalist, focusing on appropriately located, functional properties, according to McClellan. "We're not to the point where we think technology has caused location not to matter," he says. "We still think it's probably the most important factor."
Many office and retail developers have begun to wire buildings for high-speed Internet access, notes Lietz. "Instead of landlords being passive, they're offering additional services to tenants," he says. "They view the landlord as one-stop shopping."
Investment strategies In the late '80s and early '90s, pension funds had to reconsider their exposure to real estate investments, says Dr. Jeff Fisher, director of the Center for Real Estate Studies at Indiana University. "For a long time, people talked about the 15% as the appropriate level," he says. "I think a lot of pension funds were moving in that direction, but with the turmoil we had in late '80s and early '90s they backed off. Now, because the stock market has gone up so much, their allocations to real estate are even less. Now's a good time to increase that allocation."
The percentage has moved toward 10% for some pension funds, or 15% when combined with REITs, according to Fisher. "The reason real estate makes sense as an investment is that it's not highly correlated with stocks and bonds, so it provides diversification as well as a hedge against inflation," he says.
Though many pension funds invest between 5% and 10% of their assets in real estate, the average last year for the top 200 pension funds was 3.2%, a small decline from the 3.8% average in 1996, according to UBS Real Estate Research. The percentage peaked in 1985 when the average was 5.3%, but has decreased primarily as a result of the skyrocketing stock market.
The Los Angeles County Employees Retirement Association aims to invest 10% of its portfolio in real estate, which equates to a current investment of $3 billion in properties, says McClellan. "Achieving that 10% balance has been an uphill battle because equity markets have been doing so well," he adds.
McClellan's fund chooses not to invest in REITs. "For the most part, it's direct, wholly owned investments," he says. "Our fund does tend to stay fairly conservatively positioned. We require at least 70% of real estate be invested in core assets, which means built, existing, leased and operational properties in the United States."
More pension funds are looking at international real estate, according to McClellan. "They put [international investments] in the high-return, high-risk part of their portfolio," says McClellan.
Though pension funds tend to be conservative because of their responsibility, they do have more flexibility and less pressure than banks or Wall Street vehicles, says Acquest's West. "Pension funds are allowed to be a little more creative in how they invest and don't have as much pressure to sell," he says, citing an example of an apartment complex built by trade union pension funds in the early 1990s.
"We built beautiful luxury apartments when there was no money to be found elsewhere," he says. "It's among our best performers to date."
The apartments were operational and ready to take advantage of the improving economy. "We weren't under pressure to sell," says West. "We held them and they cash-flowed quite nicely. We caught the market at the right time and sold them in 1997 and 1998 to apartment REITs. You'd be hard-pressed to find someone who invested in new construction projects in 1990 and held them for eight or nine years and had ultimately a return in the low teens."
Banks, S&Ls and even life insurance companies suffered more in the real estate downturn than pension funds, according to West. "Publicly traded entities were being beaten up by stock analysts because they were holding on to underperforming loans," he says. "Pension funds are a little more self-regulated. They have the ability to weather downturn much better than an entity that's publicly traded."
Zerbst has detected a recent slowdown in pension contributions to real estate. "In part, the slowdown in growth in the stock market has slowed growth in overall portfolios and therefore the amount that gets allocated to real estate," he says. "A number of our clients are approaching their full allocations for real estate, whether it's 5% or 10% of their overall portfolio."
He also has noticed a higher percentage of pension fund assets being allocated to higher-yielding type vehicles such as value-added and opportunity investments. "There's been a shift on the part of a number of pension funds primarily for diversification to one more heavily weighted toward yield and returns," he says. "They're migrating up the risk-return graph."
Pension funds are cognizant of the fact that the real estate investment arena is operating at a high plateau in terms of both occupancy and rent levels, according to Lydon, who has noticed a shift away from making major new investments in the office sector, especially suburban projects.
"They feel their allocation is at the level they'd like it to be," he says. "They're taking a breather from new building and likely will lower their office allocation for 12 to 24 months."
Retail's lag continues Recently, Lydon has observed more pension funds investing in multifamily and industrial properties. "What continues to lag is the retail sector," he says. "It's been a sector that's been difficult to judge long-term risks and rewards, partly because of the impact of the Internet and regional malls. There's been an outflow of capital."
While REITs are a permanent part of many pension funds' portfolios, Lydon doesn't expect the allocation to be as high as was originally thought. "The allocation for REITs might be 15% to 20% of the total real estate portfolio, but a few years ago people thought it would go higher," he says.
It was thought for a time that REITs would be a substitute for investing directly in real estate, says Fisher. "Initially, it was thought to be an easy way to solve real estate problems. It's more difficult to invest in private real estate. Some hoped REITs would help that problem, but it's pretty clear that REITs take on characteristics of the stock market."
When REITs became popular, some pension funds and life companies literally sold all their portfolios and invested in REITs because they thought it would provide more liquidity, says West. "But pension funds found out you couldn't liquidate your position in a REIT as quickly as they thought they could; it would create too much of a sell-off. It didn't provide as much liquidity as they thought."
REITs again have become active buyers in the market, according to Zerbst. "We have sold a number of buildings this year and it's interesting we've seen more REITs as buyers than pension funds. The pendulum is swinging back."
Making a difference Corporate Woods, a 294-acre office park in Kansas City's affluent Johnson County, has flourished since being purchased in 1996 by the New York State Teachers Retirement System, according to Bob Cattanach, vice president of Kansas City, Mo.-based MC Real Estate Services Inc., which handles leasing for Corporate Woods. New York-based Clarion Partners is asset manager for the pension fund.
"Not only have they made one of the largest real estate purchases in the Kansas City market - maybe in the history of this market - but they've increased their investment," says Cattanach.
The pension fund bought the prime property for a reported $170 million in 1996 and has increased its investment by constructing more office buildings and purchasing an adjacent one. "They increased their investment substantially," says Cattanach.
So far this year, 17 existing tenants in Corporate Woods have expanded in the 2 million sq. ft. office park. Corporate Woods has about 250 tenants in more than 20 buildings. The master plan for the park calls for four additional buildings.
While many pension funds invest nationally, a few prefer to invest in their own communities. Because of the preference of pension-fund clients, Acquest handles investments primarily in Michigan. One client, the Operating Engineers' Local 324, a construction trade union, has chosen to invest in the redevelopment of the downtown area of its hometown Detroit. Not only does this benefit the CBD and provide a good return, but it also supports work done by the skilled building trades, says West.
The pension fund is renovating and retenanting 1001 Woodward Plaza, a landmark high-rise building that is a cornerstone of the master plan development of downtown Detroit. The project is totally funded by Local 324, organized as 1001 Woodward Partners LLC.
The pension fund wanted to invest within the city of Detroit to help spur the turnaround, according to West. The pension fund will spend upwards of $40 million in renovating the 21-story high-rise building and build a parking structure, he says.
"Suburban Detroit has been gangbusters," says West. "It's a lot easier for a life company headquartered in another state with no presence in the city to come in and naturally gravitate toward lower-risk parameters. Since we're based in Michigan and we know the inside and out of the metropolitan market, we're able to bring and find deals, and monitor them through the life of the investment."
The city's downtown master plan includes a new baseball stadium for the Detroit Tigers that opened this year and a new football stadium for the Detroit Lions, which will open in 2002.
The trade union pension funds invest between 5% and 10% of their portfolios in real estate, according to West.
"Since the pension funds we represent are Michigan-based and the pensioners are Michigan residents, we invest solely for those funds in Michigan," adds West.
Even with all the questions about technology on the horizon, there is no doubt that pension funds will continue to view real estate as a viable investment, according to Zerbst. "Certainly, pension funds are going to be a long-term player in real estate investments."
San Francisco conference to be heavy on technology When pension-fund real estate professionals converge on San Francisco this month for the Pension Real Estate Association 's (PREA) 11th Annual Plan Sponsor Real Estate Conference, the talk most likely will turn to the issue of technology, according to Cordell Lietz, chairman of PREA's board.
Technology has revolutionized the real estate industry to an even greater extent than many other businesses, he notes. Therefore, conference sessions will focus on investing wisely in today's technology-driven economy.
Guest speakers will include Harry Dent Jr., author of the best-selling books The Great Boom Ahead and The Roaring 2000s Investor.
Glastonbury, Conn.-based PREA was formed 21 years ago to help promote and enhance the investment in real estate by public and private investment funds nationwide. The organization has 1,200 individual members representing 368 corporate members, including 82 pension funds.
This conference was planned and developed by PREA's pension fund members and will focus on the issues most important to that constituency, says Gail Haynes, PREA president.
About 650 attendees are expected at this year's conference, which represents the country's largest gathering of pension funds, according to Haynes.
Pension fund representatives will have a two-hour closed session of their own at the conference to discuss pertinent issues. A lunch session led by 40 pension funds is also planned, says Haynes.
PREA's 2000 Plan Sponsor Real Estate Conference will be Oct. 22-24 at The Palace Hotel in San Francisco.
For more information on attending this event, call PREA at 860-657-2612 or register online at www.prea.org.