Pension funds, which control 39% of all equity investments in the U.S. commercial real estate market, pulled back the reins in 2001. Private-equity investment dropped 21% over 2000 levels as the economy weakened and falling values in other investments forced funds to dial back on real estate to stay within their investment-policy guidelines.

Now, the economy is strengthening, valuations of other assets are rising and pension funds are ready to pump $15 billion into new, private-equity investments — up from $11 billion in 2001, according to Chicago-based LaSalle Investment Management.

“I think that we're coming out of a cyclical trough in terms of the amount of money invested by pension funds,” confirms Jacques Gordon, international director for research and strategy at LaSalle Investment Management.

Given their massive clout, pension funds' investment moves are tracked closely. And according to managers and advisors interviewed by NREI, pension funds are rebalancing their portfolios — moving away from the office sector to put more money into industrial, multifamily and even some retail properties, such as grocery-anchored strip malls.

One contributing factor: The national vacancy rate for non-CBD office properties stood at 17% as of fourth-quarter 2001, according to Cushman & Wakefield.

As of September 2001, the total real-estate equity market in the United States registered $372.7 billion, according to New York-based Lend Lease Real Estate Investments. Of that total, pension funds held $144 billion. That figure rose slightly over 2000, when pension funds accounted for $141.9 of the $378.7 billion real-estate equity market.

Meanwhile, on the debt side, pension funds accounted for $37.6 billion of the $1.67 trillion debt market, or 2.2%, virtually unchanged over the previous year.

Industry experts estimate that 75% to 80% of the total real estate assets are invested in private real estate, while REIT stocks comprise about 20% to 25% of a typical real estate portfolio.

Pension funds typically hold property for the long-term, perhaps seven to 10 years or longer. For core assets, they seek an internal rate of return (IRR) of between 10% and 12%. For core-plus assets, the IRR target is 14% to 16%, and for opportunistic plays, the IRR goal is more than 20%.

Pension funds regard real estate as attractive in the current economy, says Doug Poutasse, chief investment strategist for Boston-based AEW Capital Management, which manages a $10 billion portfolio, 90% of which is pension fund money.

“Today you can buy real estate with a going-in yield between 8% and 9%. If you buy a 10-year Treasury today, you're getting a going-in yield in the lows 5s. Ten years ago it was the other way around,” says Poutasse, who also serves as president of the Chicago-based National Council of Real Estate Investment Fiduciaries (NCREIF).

Office sector gets cold shoulder

During the latter half of the 1990s, pension funds went on an office-buying binge because of the solid returns in an era of strong demand and rising rents. That has left many funds with 40% of their real estate allocations in the office sector. With double-digit vacancy rates across office markets, a more acceptable range is 30% to 35%, Poutasse says.

“Pension funds will still consider office, but they still have to deal with the issue of terrorism insurance for CBD office,” says Carol Nichols, senior managing director at New York-based Insignia/ESG. “And they are choosy as to the market and location if they are dealing with suburban office.”

So, pension funds are bulking up on industrial and multifamily product. Industrial buildings, warehouses and multifamily housing are viewed favorably by institutional investors as the best hedge against a turbulent economy, according to Greg Hauser, CEO of Des Moines, Iowa-based Principal Real Estate Investors. The financial services firm manages a $20 billion real estate portfolio, including $3 billion in pension fund money invested in public real estate equities.

“Over the past 25 years, in terms of total return performance, apartments and warehouses tend to stack up pretty well compared with retail or office space,” explains Hauser.

The nation's largest pension fund apparently agrees. In October 2001, CalPERS entered into a joint venture with Chicago-based RREEF to purchase Boston-based Cabot Industrial Trust for $2.1 billion. The transaction added 360 industrial properties to CalPERS' real estate portfolio, including 41 million sq. ft. of warehouse, distribution and workspace in 19 major U.S. markets. It also raised CalPERS' industrial holdings to $3.5 billion.

User demand for new warehouse space has been on the rise as corporations consolidate distribution operations into buildings that are larger and more high-tech than ever, says Jeff Cavanaugh, a principal at PM Realty Advisors in Newport Beach, Calif. Many companies, for example, are shedding four 100,000 sq. ft. facilities in a region in favor of one 400,000 sq. ft. center.(Please see related story on the industrial sector on Page 46.) For tenants who seek the latest technology for warehousing and distribution, the lure of these facilities is efficiency in the supply chain, says Cavanaugh.

Karl Smith, managing director of the Frank Russell Co., a Tacoma, Wash.-based pension fund advisor, says that during the past 18 months he too has advised clients to shift the weighting of their real estate portfolios more toward multifamily and industrial. But he is quick to sound a note of caution.

“Cap rates (the expected rate of return of an investment as it relates to the purchase price) have fallen for apartments,” Smith says. “They're a good place to be strategically, but you've got to make sure that you're not overpaying for apartments. All property types have been impacted by the slowdown in the economy,” adds Smith, whose clients include both private and public pension plans with a combined total of $38 billion invested in real estate.

Russell Dixon, national managing director of multifamily properties at Insignia/ESG, says one of his top priorities is to help institutional clients such as pension funds funnel more money into multifamily. “Pension funds and insurers were going into office investments, not multifamily,” he says. “As a result, most institutional funds are far under-weighted in multifamily.”

Over the past year, Chicago-based RREEF has executed several multifamily deals on behalf of pension fund clients. In May 2001, the pension fund advisor purchased Winridge, a 364-unit apartment complex in Aurora, Colo., for $24.7 million. In October, RREEF purchased Taylor Place Apartments, a 410-unit complex located just outside the Chicago Loop, for $38.5 million. In December, RREEF purchased Bay Court at Harbor Point, a 420-unit complex in Mukilteo, Wash., for $34.9 million.

Despite the ever-growing popularity of apartments among investors, Gordon of LaSalle Investment Management takes a more neutral stance on what's hot and what's not. “My advice to clients is that I don't see any screaming buys out there right now by property type. There is no single property type that's so attractive that I'd say, ‘Go over-weight in it.’”

Some pension funds are comfortable having office comprise 40% to 50% of their real estate portfolios, says Gordon, while others prefer to have 25% allocated to each of the four primary sectors: office, industrial, retail and multifamily.

“Moving a pension fund's weightings is a bit like steering an aircraft carrier,” says Gordon. “It's a multi-year process in many cases.”

Grocery-anchored retail favored

As pension funds readjust holdings within their real estate portfolios, they also are focusing on grocery-anchored strip centers. For example, The New York State Teachers' Retirement System and J.P. Morgan Investment Management are major investors in Edens & Avant, one of the nation's leading owners and operators of grocery-anchored centers, which has successfully trademarked the phrase “necessity retail.” In September 2000, the two entities teamed up to infuse the company with $250 million of growth capital. At the time, the investment represented a 30% ownership interest in Edens & Avant of Columbia, S.C.

But fund managers are notoriously selective about which strip centers to invest in, says Gordon. “Is it the No. 1 or No. 2 dominant grocer in a region? Can it demonstrate that it's in an infill location that isn't going to have a Wal-Mart moving in next to it?” adds Gordon. If the answers aren't “yes,” chances are the investment decision will be “no.”

Nichols of Insignia/ESG suggests that pension funds may want to consider some hotel opportunities, too. “You could cherry-pick your investment opportunity and get surprisingly strong yields, and you can do this with a small portion of your program.”

Gordon agrees, but says only those pension plans that can stomach the risk should be invested in hotels, a sector that is part real estate and part business operation, which can make returns less predictable.

Poutasse says hotel product doesn't match up well with the long-term needs of pension funds. “If you're trying to invest to hold for a relatively long period of time and get a consistent income stream, you are not going to buy a hotel.”

Pension fund managers prefer properties located in the nation's 20 largest metropolitan areas. Big cities are perceived to be stronger than smaller markets because they offer greater and more diverse economic activity, according to Mike Acton, director of research at AEW Capital Management.

Nichols says that opportunities are not limited exclusively to top-tier markets. Columbus, Ohio, has strong financial underpinnings and offers suburban office product that has the potential to provide investors with attractive returns, she points out.

The ‘denominator effect’

Pension funds are constrained by how much they can put into real estate overall — no matter how promising the returns are relative to other asset classes. As was demonstrated last year, when real estate rises in value relative to other asset classes, such as equities, pension funds may actually be forced to sell real estate.

Why? Because pension funds are administered by investment committees that set strict guidelines about how much of the overall portfolio can be held in each asset class. So, last year when real estate values began to rise and equities fell, the real estate portion of the total portfolio approached or even exceeded limits set by the various plans.

Take CalPERS, for example. The total market value of the CalPERS fund fell to $156 billion for the fiscal year ended June 30, 2001, a 7.2% drop from the previous year, attributed mainly to falling stock prices.

Meanwhile, CalPERS' real estate investments went the other way, chalking up a 14.4% return for the year ended June 30. By year-end 2001, CalPERS' total assets had dipped to $151.8 billion. That left the pension fund with 8.6% of its assets in real estate, vs. the 8% target allocation.

Bob Zerbst, president of Los Angeles-based CB Richard Ellis Investors, a $10 billion investment management firm, says that large pension funds increasingly are placing 25% to 40% debt on their core real estate portfolios. Using leverage frees up capital for additional real estate investment and avoids the problem of pension funds exceeding their target allocations.

The acceptance of REITs

Pension funds do not fund real estate only through direct investment, and over the past five years there has been a dramatic increase in the percentage of pension real estate assets invested in REITs. Today, REITs account for 25% or less of real estate assets for most funds. But that percentage is still huge, considering that almost all investment took place in the private sector a decade ago.

REITs outperformed other equities for a second consecutive year in 2001, with the NAREIT Composite Index posting a total return of 15.5%.

Smith of The Frank Russell Co. advises clients to limit investment in the REIT market to 20% or 25% of the total real estate allocation.

“The reason is the public market is more volatile than the private market. The private, core real estate is a better diversifier than the public market,” emphasizes Smith.

Jack McAllister, vice president for institutional investment affairs at the National Association of Real Estate Investment Trusts (NAREIT), says that the private and public markets value real estate assets differently. “There are times when opportunities arise to arbitrage the difference.” For example, it may be cheaper to buy apartments in the public market than in the private sector.

By having a portion of their real estate investments in daily-traded securities, institutional investors can swap real estate assets in a more timely fashion, says McAllister. Conversely, one of the challenges of direct real estate investing is that it takes anywhere from 90 to 180 days to buy or sell a piece of property.

Last July, the City of New York announced plans to set up a $1 billion real estate equity securities portfolio on behalf of the city's retirement accounts. The city comptroller issued a request for proposals seeking one or more investment advisers to create and manage the portfolio. Those proposals are still under review.

Cash flow is king

Landmark Realty Advisors of Simsbury, Conn., specializes exclusively in what's known as the real estate secondary market. Since 1996, the firm has launched four real estate funds, the latest of which is Landmark Real Estate Fund IV, which has committed $270 million of capital, the majority of which stems from public and private pensions, institutions and high net-worth individuals. Landmark will invest 1% to 3% of its own money in each fund.

Among the pension funds participating in Real Estate Fund IV is the New York State Teachers' Retirement System. In January, the pension's board authorized the system to invest up to $50 million in the fund.

Here's how the fund works: If, for example, a primary investor in a commingled or opportunity fund chooses to opt out, Landmark will become a replacement partner by buying out the interests of that particular investor. Because these interests are held in private real estate, they are considered to be illiquid. Presumably Landmark would serve as replacement partner at a price discount.

“We're buying an illiquid interest, and by definition we should be realizing a liquidity discount when we buy,” says Bob Harvey, a partner with Landmark.

The $270 million in Landmark Real Estate Fund IV will be invested over a three-year period and will be carved up in about 25 separate investment transactions, says Harvey. “By investing our money in lots of small interests, we're building a very diversified pool of assets.”

Why is Landmark Real Estate Fund IV a good bet for pension funds? The ability to assume the role as replacement partner three or four years after a fund has been launched is significant because by that time the fund should be distributing cash, explains Harvey. Typically, funds don't distribute much cash in the first few years.

Harvey says that pension funds are zeroing in on operating income in this soft economy. “While I think investors are always looking to get the highest return they can and understand the risks involved, they're looking at how much of that total return is coming from operating income.”

Since 1990, Landmark Partners has invested $3.1 billion in its 11 venture funds and four real estate funds, principally in the secondary markets.

Thinking outside the box

Contrary to the theory that all pension funds operate in herd-like fashion, Zerbst of CB Richard Ellis emphasizes that some pension funds are willing to experiment with a small percentage of their real estate allocation. “They're looking for investment companies to come up with strategies, support those ideas with research and do the risk evaluation,” says Zerbst.

Strategic Partners II is a $300 million fund launched by CB Richard Ellis Investors to purchase, reposition, develop and sell institutional-grade properties in the United States. The fund, supported by equity commitments from U.S. and international investors, targets multifamily, office, industrial and retail properties in select markets. Zerbst describes the Strategic Partners fund as a low-risk, opportunity fund.

Like Zerbst, Gordon believes that the pension fund world is heterogeneous when it come to risk tolerance. “They're doing investments all the way up and down the real estate risk/return spectrum, from triple-net, very safe, unleveraged core deals, all the way on up to development and opportunity fund investing.”

Charles Davidson, an Atlanta-based writer, contributed to this report.