Pension funds are as diverse as the properties they buy, but investors share a common bond in their search for value-added opportunities. A "flight to quality" characterized investments in 1999, and that focus is expected to continue in 2000.

"Institutional investors moved up in the spectrum to look at the best-quality projects out there vs. a couple years ago when they signed onto anything that moved," says Jerrold Barag, CIO for Atlanta-based Lend Lease Real Estate Investments Inc.

That flight to quality is partly due to the long expansion of the economy. Investors are starting to become wary of a downturn and are buying defensively, says Barag.

Most pension clients maintain a real estate allocation of 5% to 10% of total fund assets. Types of investments are typically defined by yields. Core investments typically produce a return rate of 10% to 11%, core-plus 11% to 13%, value-added 13% to 18% and opportunistic more than 20%.

The most significant trend sweeping the pension-fund industry during the past year has been the shift to value-added and core investments vs. opportunistic property buys. "I think that's demonstrative of where we are in the cycle," says Hugh Zwieg, executive vice president of Chicago-based CMD Realty Investors Inc.

The shift to the more conservative core investments indicates that most real estate markets are at or near peak levels.

"We're seeing a lot of pension funds focusing domestically with a renewed emphasis on value-added strategies," says Stephen R. Quazzo, director of Transwestern Group LLC and co-founder and CEO of Transwestern Investment Company LLC, a real estate principal investment firm in Chicago.

Pension funds are asking themselves how to incorporate real estate in their broader investment strategy, and the answer is still shaking out, Zwieg says. Some might decide to commit to real estate for the long term, while others may decide that - given the high returns in sectors such as technology - they may not want to dabble in real estate at all.

Others might shift from the higher-risk opportunistic investments to more conservative income buys by targeting core property acquisitions.

CMD Realty Investors focuses on value investments with its CMD Real Estate Investment Fund IV, a $290 million fund. "Based on where we are in the market, it will be tough to find those opportunistic buys," says Zwieg. "To get that high return, you're going to have to walk more out on the risk spectrum to get it." Many pension funds are averse to that risk.

Opportunistic plays Chicago-based Walton Street Capital LLC is in the midst of raising $600 million for Walton Street Real Estate Fund III LP, an opportunity fund. The fund has raised $300 million, and it expects to complete its fund raising in second quarter 2000. The fund already has $75 million specified in three investments and another $100 million in investments under contract. The firm's investment prototype is a single, complex transaction, a type that is largely out of favor with other institutional investors.

"In light of what's happened with the capital markets and REITs, there are good opportunities in larger transactions," says Eric Mogentale, a principal at Walton Street Capital. "Our strategy is removing those complexities and then selling a stable, well-capitalized investment that is more attractive to institutional investors."

For example, the fund purchased the Houston Galleria in November. The investment package included office, hotel and retail components with 891 hotel rooms, 1.1 million sq. ft. of office space and a 1.6 million sq. ft. shopping mall.

Because capital markets are still sluggish for real estate, and REITs are clearly wounded, that opens up new opportunities for pension-fund investors to target such large deals, says Mogentale. Because there were not four to five REITs competing for the Houston Galleria, Walton Street Capital was able to buy the property at an attractive rate.

"It was a value investment because we had the ability to buy way below market and below replacement cost," he says. The office and hotel portion was about 50% below replacement cost, while the retail portion was purchased at better than market cap rate.

The Houston Galleria also presents opportunities for repositioning. Walton Street Capital plans to add value to the project by renovating the office and hotel portions, as well as expanding the retail center by 800,000 sq. ft.

Shifting momentum Office and industrial buys continue to be popular choices. Lend Lease's transactions had a gross value of $4 billion in 1999, and about 70% of those transactions involved office properties. Availability of properties is one reason for that activity. However, the momentum is shifting from suburban office acquisitions to CBD investments. The perception among investors is that there is higher rent potential in downtown buildings because construction for the most part has been limited, notes Barag.

The CBD investments have focused on vibrant, "24-hour cities" such as New York, Boston, San Francisco and Washington, D.C. "In 2000, we will see further growth in acquisition of CBD office buildings, with even less than 24-hour cities being considered," says Douglas Callantine, senior managing director for Legg Mason Real Estate Services in Philadelphia, noting that markets such as Dallas, Chicago, Denver, and Atlanta will be in greater demand this year. Fewer suburban investments are expected in 2000 due to the perception that significant construction may lead to weaknesses in rents and occupancy levels, he says.

Both CBD and suburban office buyers continue to search for value opportunities. For example, Transwestern recently acquired the 450,000 sq. ft. Corporate Center in northwest Phoenix. The property has a significant rollover risk due to the upcoming lease expiration of a major tenant. However, Transwestern views the buy as a value opportunity because of the potential to either renew the existing tenant at a higher rate or reposition the asset if the tenant relocates, says Quazzo.

Industrial properties continue to be a favorite buy for pension-fund investors, but the biggest challenge is finding available properties.

It can be difficult for pension funds to place larger chunks of money in industrial investments due to the smaller value of the transactions compared with an office tower or apartment high-rise, says Barag. As with other property types, the focus is on high-quality product.

"New, well-located property is in great demand, and I think that trend is only going to accelerate," says Barag. The product of choice among pension funds is bulk, high-cube industrial facilities with 30 ft. clear ceiling heights, EFSR sprinklers and flat floors, he notes.

Other ideal industrial buys include buildings with 28 ft. to 32 ft. clear ceiling heights, planned industrial park settings and good tenant rosters with varying lease expirations.

Growing interest in multifamily Pension-fund asset allocation models increasingly include multifamily holdings. "We're very enthusiastic about multifamily over the long term, and over the next couple of years," says James W. O'Keefe Jr., president and CEO of Hartford, Conn.-based UBS Brinson Realty Investors LLC. In the early 1990s, pension funds typically had an exposure below 10%. Now pension funds are looking at allocating 18% of their real estate assets to multifamily, and that figure is likely to increase to 25% to 30% in the near future, says O'Keefe.

Historically, pension funds considered office, industrial and retail properties as comparatively safer investments. "Time has proven that is not necessarily the case," says Brian Webb, a managing director and head of research in the Dallas office of UBS Brinson Realty Investors.

Through the mid-1980s, apartments were targeted primarily by investors seeking tax advantages due to accelerated depreciation. During that era, apartments were targeted by syndicators or other investors seeking tax shelters, not by cash-flow investors.

The smaller size of some properties also influenced the perception that apartments were not effective investments. The reality is that apartments have risk-return characteristics that are very attractive to pension-fund investors.

Rising interest rates also bode well for multifamily investors. The single-family and multifamily markets are typically very competitive. However, rising interest rates often tip the scales in favor of rental multifamily properties vs. home mortgages.

UBS Brinson is targeting value buys - primarily apartments that were built in the 1970s that require renovation work. One of the advantages of the older properties is that they often feature more square footage than comparable buildings built in the 1980s and early 1990s.

Expect a mild rebound for hotels The fundamentals in the hotel market are still good, particularly among the full-service sector. However, overdevelopment among the limited-service sector did create a scare in the entire hotel investment market in 1999, which led to a drop in both values and investor interest, says Barag.

In addition, when financing became less available in 1998, it had a chilling effect on hotel acquisitions. After a turbulent period in the capital markets at the end of 1998, most sectors rebounded in 1999. The hotel market did not, he says. However, the hotel market is expecting a mild rebound in 2000.

Early on in the hotel development cycle, there was considerable value to be had in acquiring under-performing hotels. "As we move through the cycle, those properties are not as available," says Webb. Full employment and a strong economy have produced a strong market for hotels. But since it is late in the development cycle, investors are selective in their investments, he adds.

In short, pension-fund investors are changing and examining their investment strategies. Expecting an economic downturn, many are focusing on value-added and core investments.

They also are grappling with the issue of their level of commitment to real estate vs. technology and other sectors. These developments signal a decrease in the appeal of the opportunistic property buy.