Rebounding sales and the returns posted by REITs have brought pension fund investment back to retail.

Following a two- to three-year period of reluctant involvement with retail real estate, pension funds appear to be returning to the sector in strength. Investment advisers indicate the turnaround began in the second half of 1997 and has been building ever since, with the new year inaugurating an abrupt acceleration of interest. The really big push, they say, has yet to hit.

"I think retail values have fallen about to their lowest levels and are starting to build back up again," says Robert Welanetz, chief executive, Retail Group of Atlanta-based ERE Yarmouth.

The reason for the change, he adds, is simple: "Retail has been challenged in the past two to three years, not performing as positively as it had in the past primarily because of overbuilding. But it is rebounding. Sales are turning, and properties that shouldn't have been built are being converted to other uses, bringing total square footage back in line with reality."

At the same time, note several commentators, other sectors are showing signs of faltering. The dramatic resurgence in office markets has driven prices in that sector to the highest level this decade, while frenzied construction in the hotel industry has investors concerned about saturation. Meanwhile, intense competition for multifamily and industrial properties has turned those categories into battlefields. While their pricing is not out of line, landing deals is tough.

Despite retail's return to favor, few advisers think pension funds are likely to stage a land rush in the sector as happened in the mid to late 1980s due to uncertainty about both short- and long-term viability.

"I think some investors remain concerned about retail real estate," says Mary Ludgin, chief operating officer of Chicago-based Heitman Capital Management, which has $9 billion of funds under management, including one of the largest portfolios of regional malls in the nation.

"They see statistics showing consistent construction at a rate that's double the population growth rate," she says. "They see the growing popularity of competitors to standard retail, the Internet being a good example. For example, Egghead just announced it will be closing its outlets and doing business only over the Internet. Obviously, there will be other retailers thatfollow suit. That's going to create a lot of vacancies. The question is, will anyone be there to fill them up?"

In addition, retail sales are not growing at a rate consistent with overall economic and population growth, says Peter Korpacz, president of Frederick, Md.-based Korpacz Co. Inc. "It's not that pension funds aren't interested in retail, it's that their interest hasn't risen to the level of a few years ago," he says. "There have been a number of negative aspects to retail that haven't been resolved."

On the other hand, adds Ludgin, some observers see a different, more optimistic story. "They believe there is a very good future for key retail properties with the right kinds of tenants," she says. As a general rule, she continues, pension funds are buying properties on an initial cap rate of 7.5 percent to 14 percent, with the expectation of returns of 10 percent to 25 percent.

Kenneth Cooley, senior vice president of asset management for Dallas-based L&B Group, agrees that pension funds remain somewhat leery of retail. Nonetheless, given the alternatives, they are willing to invest. As he puts it, "A lot [of funds] are looking at retail because yields are falling in other sectors - not because retail is inherently that attractive."

Higher spending in 1998 Land rush or not, many investment advisers expect the majority of pension funds to increase the amount of money they spend on retail properties this year.

Tom Prendergast, president and CEO of Boston-based NET Properties Management Inc. - the company set up by the New England Teamsters and Truckers Pension Fund to handle its investments - says NET anticipates investing $150 million on retail properties this year, the highest level since 1991 or 1992. In February alone, he notes, the fund expects to close on $75 million in transactions, most of which were initiated in late 1997.

According to Prendergast, NET oversees more than $2 billion in assets, about one-fourth of which is invested in real estate. About 90 percent of that, amounting to about 7 million sq. ft., is retail, he says. "We've always been very bullish on retail," he says.

Although Welanetz speculates many pension funds will increase retail investment this year, he does not expect the funds advised by ERE Yarmouth to be among them. "We foresee a steady level of investment [by our clients] compared to the last few years," he says. The company, he adds, has $7 billion of retail under management, which represents approximately 80 regional malls and 25 community and small centers.

At the opposite extreme, some funds have exited real estate entirely, according to Ludgin. Others, she adds, are keeping the percentage allocation constant, but because the strong economy is putting more money into the funds, their numerical outlays are growing.

Prendergast notes that although pension funds may want to increase investment, competition, especially from REITs, may prevent them from reaching their goals. NET's approach, he says, is likely to be typical of the industry as a whole.

"We'll buy only if we see the product there," he says. "Unlike REITs, we're not forced to buy. We're not pushed by Wall Street. We go at our own pace, and we're not going to buy just to buy. Every deal has to make sense."

Analysts agree that high prices, especially for regional malls, present the biggest obstacle to investment today. "The pricing [of regional malls] hasn't been favorable for the single-property buyer," explains Ludgin. "A couple years ago, regional malls were a buy, but that's not true any longer."

The primary reason for the high prices, advisers agree, is the aggressive acquisition stance of real estate investment trusts. If pension funds are not staging a retail land rush, the same cannot be said of REITs. Ludgin says most of the malls and large portfolios sold last year went to REITs.

"REITs are driving the industry. They're buying everything in sight," asserts Korpacz. "Pension funds are being overrun by the REITs."

But while competition from REITs has driven pension funds from the regional mall acquisition market, it has prompted them to become very active on the disposition side.

"Pension funds that own malls have been beneficiaries of the abounding interest by REITs. The high prices have not slowed interest in malls. It's just changed the lineup of buyers," says Ludgin. The upshot, she points out, is that pension funds find themselves with large amounts of capital for new investment.

REITs reshape investment landscape REITs have transformed the entire real estate market, according to most advisers. Whether for good or ill is not entirely clear at this point, but whichever, the situation is forcing pension funds to rethink their investment strategies and amend long-standing investment practices.

Besides exiting the regional mall market, pension funds have been prompted to dilute or abandon direct investment and benefit from the REITs' aggressiveness by investing in the REITs.

"A big trend is the whole the concept of investing in public securities, primarily through REITs," says Douglas Callantine, a senior managing director with Philadelphia-based Legg Mason Real Estate Services Inc. He says the liquidity of REITs is a major attraction. "It's easier to shift investments when you can sell stock rather than having to sell properties." He reports his company has $1 billion of pension fund assets under management, including both mortgages and equity, with retail representing about 30 percent of the portfolio.

Whereas two years ago pension funds shied away from REITs because of uncertainty over how they would perform, that is no longer the case, says Ludgin. "The REIT market has grown so rapidly and generated such strong returns that investors who were not investors when it was an emerging concept are now believers," she says.

Prendergast characterizes REITs as good investment vehicles for small to mid-size pension funds that do not have an internal investment and management unit, as does the Teamsters and Truckers fund. According to several advisers, most larger funds seem to be seeking a balance between direct ownership and investment in REITs as a way of hedging their bets.

Callantine says many pension funds use what he calls a four-quadrant strategy, in which they divvy up capital among direct ownership, issuance of private debt, purchase of commercial mortgage-backed securities and investment in REITs. Typically, he says, about 20 percent is allocated to REITs, 50 percent goes to private equity, and the balance is split between private and public debt.

Ludgin reports that many smaller funds have shifted entirely to REITs because they could not compete for properties with more powerful investors. It also enables them more opportunity to diversify, she adds, either by buying into REITs with diversified portfolios or by buying into a variety of REITs representing different property types.

Not all advisers believe REITs are necessarily a wise investment. Welanetz worries that REITs are paying too much for properties in order to build a large enough portfolio to interest Wall Street. "REITs are buying up everything," he says. "But when the acquisition opportunities dry up, they're going to have to rely on core assets for growth. If they have overpaid, those assets are not going to be able to produce the returns they were expecting and their values are going to drop."

Notes Cooley, "The big question on the REIT stocks is whether they will act like stocks or like real estate in the long run." He believes the question remains to be answered and recommends to his clients that they invest in REITs but at a limited level. That way, he says, they can take advantage of REITs' current big returns but not get stuck if the demand for REIT stock sours.

Supermarket centers get highest marks Shut out of the enclosed-mall market, pension funds have turned to supermarket-anchored neighborhood and community centers as the prime vehicle for direct investment. Advisers say these properties' relative insulation from market ups and downs makes them very attractive investments for both the short and the long term.

"The collective judgment of investors we talk to is that neighborhood shopping centers are the least likely to become obsolete. I can't see myself getting on the Internet to get a carton of milk," says Korpacz.

The Teamsters and Truckers fund, which not only eschews the help of outside advisers but also manages all properties in its portfolio, concentrates almost exclusively on large strip centers in the 225,000 sq. ft. to 350,000 sq. ft. range, according to Prendergast. The projects feature supermarket anchors, or sometimes warehouse-grocer anchors, and a predominance of tenants serving day-to-day needs.

"We look for things like dry cleaners, video stores and pizza places," he explains. "There might also be a Target or Wal-Mart and a Home Depot or other home improvement tenant. Basically it's tenants that are going to do good business no matter what shape the economy is in."

Prendergast says the fund has followed this strategy for two decades, and it has clearly served the teamsters and truckers well. According to Pensions & Investments magazine, from 1986 to 1996, the fund's returns from real estate averaged 15.3 percent, compared to 4.5 percent for pension funds overall.

Ludgin also gives a favorable rating to the specialty center sector. "I include in that urban centers with a movie theater, theme restaurants, mid- to high-end retailers and sometimes a small department store," she says. "A variant is the suburban equivalent of this, the shopping center that substitutes for a downtown or that sits in the heart of a suburban downtown. These types of centers offers restaurants, small shops like Williams-Sonoma, Barnes & Noble, The Gap and Talbots. We're doing a number of these for pension fund clients."

Of less interest at the moment, according to Cooley, are entertainment centers because of concerns that heavy traffic and parking demands generated by movie theaters and restaurants will make it difficult for smaller shops to attract the customers they need to survive. Since the shops are the landlord's major source of revenue, this could prove disastrous for investors, he comments. Until such conflicts are resolved or demonstrated not problematic, these properties appear too risky for investors such as pension funds that want assurance of long-term value, he says.

Power centers, too, generally get low ratings from pension fund advisers. "Power centers as a category are less attractive than in the past due to concern about credit tenants," says Callantine.

Cooley advises his clients to stay away from this sector entirely, saying, "We believe there's going to be another consolidation. I'd be afraid to invest in those right now."

Another question mark for power centers, says Korpacz, is their future viability. "Ten years from now, will the Internet be the source for these goods? Certainly electronics dealers seem likely to lose customers to the Internet, but anything with a brand name that doesn't have to be tried on can be sold at a distance," he remarks.

Investors look to the three 'L's Regardless of category, advisers say, the old real estate dictum remains the most important: location, location, location. "There's no substitute for location," asserts Prendergast. "If you buy secondary and tertiary, you have a problem."

Cooley says L&B advises clients to take a close look at demographics. "Look at income, look at population, look at sales trends, look at psychographics, that is, what people like to do and how they like to spend their money - all the consumer characteristics you can think of. With those, you may find properties that are much better, or much worse, buys than they seem," he says.

According to Korpacz, tenant mix is more important than location. "The real ticket for success is to buy or build centers that contain in each category those tenants that do better on sales per square foot than any other tenant in that category," he says.

Few advisers rank one region better than others right now, saying all regions have good opportunities. Within regions, however, some markets are stronger than others based on the amount of sales activity the area has already seen. In some SMSAs, prices appear to have peaked.

On the other hand, Cooley points out, even in markets that look risky, good deals can be found. "There are pockets[of opportunity] in almost every city that would be a good buy," he says. "Retail is not like the office market, where properties are clustered together in one or two places. With offices you can look at overall vacancy rates and know whether the market makes sense. Retail is everywhere, and even if a city is doing so bad it's falling off the map, there's at least one neighborhood that's doing well."

Still focused on the long term Regardless of what is happening in the marketplace or what kinds of investment vehicles are available, pension funds remain conservative, with a focus on the long rather than the short term. The major difference between now and the past, says Cooley, is that long-term today often means five to seven years rather than 10 years.

"They felt the longer-term strategy may have worked to their disadvantage," he says. "They can extend beyond five to seven years if they choose, but they want the opportunity to get out sooner if necessary in order to avoid getting caught like they did in the early '90s."

David Rosen, a principal with Jericho, N.Y.-based Rosen Associates Management Corp., says pension funds rarely make strictly opportunistic plays.

"Traditionally, pension funds are advisory funds that to some extent may be discretionary, but they always have, or should have, a great deal of oversight," he says. "The intent is to preserve capital and make a nice return, which means minimizing risk. We've seen where some pension funds have some capital set aside for higher risk deals, but it's never a large percentage."

As Rosen puts it, "[Pension funds] like to make safe investments that have the ability to have added value. They're looking for properties that are less management-intensive, with conservative underwriting and aggressive cap rates. They're concerned with the nature of tenancies and the mix of tenancies. They like expansion possibilities, and they're looking for long and mid-term leases rather than shorter."

And, says Rosen, that description of pension funds applies as aptly today as it did 20 years ago.

Today's low interest rates have prompted pension funds to ease up on mortgage lending. "The rates are so low now, it's not that attractive for us," says Tom Prendergast, president and CEO of Boston-based NET Properties Management Inc., noting that the Teamsters and Truckers fund has a portfolio of about $250 million in commercial mortgages.

According to Prendergast, most of the big pension funds -- including the California Public Employees' Retirement System and the Ohio and New York state teachers' retirement funds -- have mortgage lending programs. His understanding is that most are reducing the amount of money loaned.

Douglas Callantine, a senior managing director with Philadelphia-based Legg Mason Real Estate Services Inc., agrees with Prendergast. Callantine remarks that the debt side recently has been of relatively low interest to the pension fund community. "Interest rates are 7 to 7.5 percent on conventional A- quality properties. Pension funds want returns of 8 percent or higher," he explains.

He says some pension funds are looking at involvement with unrated commercial mortgage-backed securities, but most, including those advised by Legg Mason, are still shying away from this option. "We don't feel comfortable with the CMBS market," Callantine says, "because we haven't had enough time to evaluate it and understand how it works. We feel its newness makes it too high a risk right now. If it proves itself out over time, then we will reconsider."

Shopping Center World presents the Leading Pension Fund Managers as ranked by Nelson Information Inc., Port Chester, N.Y. The ranking is based on the total assets invested in shopping centers only, reported by investment managers to Nelson as of Feb. 5, 1998.

1 ERE Yarmouth (Independent) Shop. Ctr. Assets ($ Mil.): 7170.8 3424 Peachtree Road N.E., Atlanta, GA 30326 Douglas A. Tibbetts, President

2 General Growth Properties (Independent) Shop. Ctr. Assets ($ Mil.): 6700 Year Founded: 1993 55 West Monroe, Suite 3100, Chicago IL 60603 Matthew Bucksbaum, CEO

3 CIGNA Investment Management, Real Estate (Insurance Co. Affiliate) Shop. Ctr. Assets ($ Mil): 5528 Year Founded: 1967 S-314, Hartford, CT 06152-2314 William A. Taylor, Managing Director/Commercial Mortgage

4 Heitman Capital Management (Independent) Shop. Ctr. Assets ($ Mil.): 4319 Year Founded: 1966 180 North LaSalle St., Chicago, IL 60601-3100 Charles Wurtzebach, CEO

5 Corporate Property Investors (Independent) Shop. Ctr. Assets ($ Mil.): 3810 Year Founded: 1971 Three Dag Hammarskjold Plaza, 305 East 47th St., New York, NY 10017 Mark S. Ticotin, President

6 Taubman Centers (Independent) Shop. Ctr. Assets ($ Mil.): 3178.7 Year Founded: 1992 200 East Long Lake Road, P.O. Box 200, Bloomfield Hills, MI 48303-0200 Robert S. Taubman, CEO

7 Clarion Partners (Independent) Shop. Ctr. Assets ($ Mil.): 2523.6 Year Founded: 1982 355 Madison Ave., New York, NY 10017 Frank L. Sullivan Jr., Managing Director

8 The O'Connor Group (Independent) Shop. Ctr. Assets ($ Mil.): 2451 Year Founded: 1983 399 Park Ave., 25th Floor, New York, NY 10022-4614 Jeremiah W. O'Connor Jr., CEO

9 RREEF (Independent) Shop. Ctr. Assets ($ Mil.): 2413 Year Founded: 1975 101 California St., 26th Floor, San Francisco, CA 94111 Stephen M. Steppe, Partner/Client Relations

10 LaSalle Advisors Limited (Independent) Shop. Ctr. Assets ($ Mil.): 2055.5 Year Founded: 1968 200 East Randolph, Chicago, IL 60601 Jacques N. Gordon, Managing Director

11 AMP Investments Australia Ltd. (Insurance Co. Affiliate) Shop. Ctr. Assets ($ Mil.): 1766.4 Year Founded: 1849 GPO Box 4134, Sydney, 2001, Australia Leigh Hall, Deputy Managing Director

12 AEW Capital Management Independent) Shop. Ctr. Assets ($ Mil.): 1642 Year Founded: 1981 225 Franklin St., Boston, MA 02110-2803 Joseph F. Azrack, CEO & President

13 Healey & Baker (Independent) Shop. Ctr. Assets ($ Mil.): 1600 Year Founded: 1820 29 St. George St., Hanover Square, London, W1A 3BG, England Tim Weale, Investment Partner

14 AEGON USA Realty Advisors (Insurance Co. Affiliate) Shop. Ctr. Assets ($ Mil.): 1417 4333 Edgewood Road N.E., Cedar Rapids, IA 52499-0001 Paul Johnson, Director of Marketing

15 Westmark Realty Advisors L.L.C. (Independent) Shop. Ctr. Assets ($ Mil): 1162.2 Year Founded: 1971 865 South Figueroa St., Suite 3500, Los Angeles, CA 90017 Richard C. Clotfelter, CEO

16 Schroders Australia Property Management Ltd. (Bank Affiliate) Shop. Ctr. Assets ($ Mil.): 1047.1 Year Founded: 1972 225 George St., GPO Box 5059, Sydney, 2001, Australia Turi Condon, Assoc. Dir./Mkting

17 CBL & Associates Properties (Independent) Shop. Ctr. Assets ($ Mil.): 1025.9 One Park Place, 6148 Lee Highway, Chattanooga TN 37241-0001 Charles B. Lebovitz, CEO

18 L&B Real Estate Counsel (Independent) Shop. Ctr. Assets ($ Mil.): 996.1 Year Founded: 1983 8750 North Central Expressway, Suite 800, Dallas, TX 75231-6437 M. Thomas Lardner, CEO

19 AMB Institutional Realty Advisors (Independent) Shop. Ctr. Assets ($ Mil.): 833 Year Founded: 1983 505 Montgomery St., 5th Floor, San Francisco, CA 94111-2552 Hamid R. Moghadam, President & CEO

20 J.P. Morgan Investment Mgt. Co.- (Real Estate) (Bank Affiliate) Shop. Ctr. Assets ($ Mil.): 829 522 Fifth Ave., New York, NY 10036-7601 Harold J. Murray, Dir. of Marketing