As institutional dollars continue to flood the commercial real estate market, large pension funds that have been in the game for some time are seizing the opportunity to sell some of their core properties. But reinvesting those proceeds into trophy office, retail and apartment buildings remains a challenge as intense demand for product has sent prices soaring. The result is that institutions and pension funds are increasingly eyeing non-traditional real estate investments, such as senior housing communities and even distressed office buildings.

This fundamental shift in investing strategy is strikingly apparent at CalPERS (The California Public Employees' Retirement System), the largest U.S. pension fund. In December 2004, CalPERS stirred waves in the real estate industry by announcing its intention to decrease its real estate allocation from 9% to 8% — a shift which amounts to roughly $1.7 billion. CalPERS, a longtime player in the market, had $12.1 billion invested in real estate as of late 2004.

“We are in a seller's real estate market and there are opportunities for us to prune our portfolios and take some profits,” said then-CalPERS president Sean Harrigan. Since the summer of 2004, CalPERS has been marketing 13 office properties it jointly owns with Hines in Washington, D.C., Seattle, San Francisco, and other markets.

Handsome profits

In December, TIAA-CREF bought several of the properties from the CalPERS/Hines joint venture, one of which was 1900 K Street, N.W., a 342,884 sq. ft. trophy office building in the CBD of downtown Washington, D.C. TIAA-CREF purchased the property for $633 per sq. ft. The cap rate on the purchase was 6%, according to market sources. CalPERS/Hines bought the property for $397 per sq. ft. at a cap rate of 8% in November 2000, according to CoStar Group.

CalPERS has emphasized that the pension fund behemoth is not looking to withdraw from real estate, but instead engage in some profit taking and plow those dollars into other investments, such as a rebounding stock market. As a result, CalPERS also widened its real estate allocation range from 7-11% to 4-12%, giving the fund the flexibility to adapt to future changes in the real estate market.

Bruce Schonbraun, managing partner with real estate consulting group Schonbraun Safris McCann Bekritsky & Co. LLC, is seeing many institutional investors follow CalPERS' lead and become net sellers. “Despite the fact that fundamentals are decent but not great, the investment side of the business over the last few years has been nothing short of terrific, and pricing has been going up and up,” says Schonbraun. “A lot of funds have found themselves in the enviable position of having substantial value appreciation, and are taking advantage of that.”

In the late 1990s through 2001, institutions were largely net buyers. But from 2002 to 2004, they reversed course and became net sellers. In 2004, institutions sold $4.7 billion more then they purchased, according to Real Capital Analytics, which tracks deals $5 million and higher.

Russ Appel, president of the Praedium Group, a New York City real estate firm that invests money on behalf of institutional investors, says institutions have lost some of their competitive advantage in the marketplace because of the flood of new capital. “In general, our feeling is that institutional-quality, Class-A assets of almost every property type are difficult to buy because there has been a surge of institutional liquidity chasing those properties,” Appel says.

New opportunities emerge

Since pricing remains high for core, or stabilized properties, institutions are looking to invest in more specialized properties such as senior housing. “Given the scarcity of product — low supply and great demand — pension funds are looking harder and harder into real estate products that they never looked at before,” Schonbraun says. “Trophy assets in major cities continue to be a prized product for institutional investors, but in today's environment where product is scarce, we've seen pension funds look at more and more types of properties.”

CalPERS, whose portfolio largely consists of office, retail, industrial and apartment assets, is increasingly investing in senior housing and other specialty properties. It's easy to understand why. For its fiscal year ending June 30, 2004, CalPERS reported that its investments in housing, timber, and other specialty real estate assets posted a 23.5% return — led by senior housing, which returned 47%. CalPERS' investments in traditional commercial real estate, such as office, retail, industrial and apartments, netted just a 12% return.

In late November 2004, CalPERS invested another $200 million into senior housing, teaming up with Shea Homes, a Walnut Creek, Calif.-based residential developer, to build master-planned communities for “active adults over the age of 55” in California, Colorado, Arizona and Washington.

Maury Tognarelli, president and CEO of Heitman LLC, which has $12 billion in assets under management for mostly institutional clients, says his firm has been targeting more specialty properties over the past year, such as student housing, medical office, self-storage and some parking facilities, which are all subsets of traditional property types. “Those specific specialty properties offer you the best risk-adjusted return,” Tognarelli says.

When pursuing specialty properties, Heitman chooses a joint venture structure with expert operators in the sector. In a deal completed last July, Heitman paid $114 million for an 80% stake in a portfolio of self-storage properties owned by Storage USA. The 21 properties, totaling 13,600 units, were 82% leased at the time. Heitman is betting on a rebound in the self-storage market and expects the properties to eventually generate returns in the 14% to 16% range.

Heading into uncharted waters

Institutions are also eyeing property types that they never dreamed of before. Just as institutions shied away from manufactured housing for the longest time (since it carried the “trailer park” stigma) before eventually betting heavily on that sector, investors are now also putting money into another non-traditional asset type: middle-income urban housing.

Institutions with money already invested in the four major sectors of office, retail, industrial and mainstream housing, are seeing opportunity in this sector, which offers yields in the range of “high teens” (roughly 17% to 19%), says Keith Rosenthal, president of Phoenix Realty Group. The New York City-based firm's “smart-growth equity funds” finance moderate-income and urban infill housing in Southern California.

“Institutions see us as a yield enhancer to their portfolios,” according to Rosenthal. Building in inner cities is nothing new, and neither is aggregating portfolios of properties, he says. But seeing this sector as an “institutional investment” is new, he adds.

Phoenix Realty Group, which claims its $100-million Genesis Workforce Housing Fund is the nation's first institutional source of capital to focus exclusively on workforce housing, provides equity capital to create for-sale and moderate income rental housing in the greater Los Angeles area. A separate $60-million smart growth fund in San Diego is under way.

Allocation adjustment

The influx of institutional money into real estate is not expected to slow down anytime soon, since new pension funds continue to enter the marketplace. On one side of the institutional landscape are the small- to medium-sized state and city pension funds, which have recently been entering the market. On the other side are the so-called “megafunds” such as CalPERS, which have been longtime players. And both sides continue to pour dollars into real estate, experts say.

“Across the board, most investors are desiring to raise their allocations to real estate. At the same time, they understand that the asset class is in strong demand,” says Tom Garbutt, managing director of TIAA-CREF's real estate group, which owns $14 billion of real estate. Garbutt says the real estate allocation in TIAA-CREF's general account has remained steady at 4% to 5% over the past few years.

Large pension funds generally have real estate allocations in the 5% to 8% range. In recent years, smaller pension funds have been aiming for that range as well. Smaller funds just getting into real estate investing typically invest in commingled funds, says Frank E. Schmitz, managing director at Principal Real Estate Investors. His Des Moines firm manages about $25 billion in assets, mostly for pension funds.

Along with direct investments in real estate, commingled funds — which pool together institutional dollars to buy properties — are the most popular methods for pension funds to invest in real estate, according to research from the Pension Real Estate Association. REIT securities also comprise a sizeable piece of institutions' real estate holdings.

Latecomer joins party

One of the newest institutional players to the commercial real estate investment arena is New York City Retirement, which is investing money for the pension benefits of the city's firefighters, teachers, police and other city employees. Up until 2003, the city's pension funds chose not to pour any capital into real estate. But after paying a consultant to examine its allocation strategy, the city decided in late 2003 to add real estate as an asset class — with a 5% target allocation.

So far, $805 million has been committed to real estate, with a target of $3 billion to $4 billion over the next several years, says Deborah Gallegos, chief investment officer for New York City Retirement. The biggest investment to date was $450 million into City Investment Fund LP, run by Tom Lydon, which invests solely in New York City commercial properties.

In the summer of 2004, the New York City fund also invested $75 million in Blackstone Group's fourth opportunistic real estate fund. The Blackstone fund focuses on value-added real estate investing, taking advantage of office repositionings, corporate divestitures and undervalued retail.

Risk-taker's challenge

Value-added opportunities, which enable investors to achieve higher yields by either repositioning or renovating properties, remain a major focus of many pension funds. But finding those deals is getting more difficult given the high pricing in the market, says Garbutt, managing director of TIAA-CREF's real estate group. “Some funds are looking to go out further on the risk spectrum to go after yields, but it appears to us that those opportunities are less than they used to be,” he says.

TIAA-CREF continues to invest mostly in stabilized properties, but as much as 15% of its accounts may include value-added investments, he says. An example of such an investment came last year when a partnership between TIAA-CREF and Equity Office Properties acquired Colorado Center, a 1.1 million sq. ft. Class-A office complex in Santa Monica, Calif. The property was 82% occupied at the time of sale. The property is currently over 98% leased, exceeding original lease-up expectations, TIAA-CREF says.

A view into the future

According to a recent Deloitte & Touche report entitled “Real Estate Industry Breaking Out — 2004,” real estate allocations by institutions are likely to increase from the current level of approximately 5% to between 10% and 15% over the next several years. But to make a meaningful impact on institutions' retirement plan income, higher-yield investments will need to play a substantial role in funds' investment strategies going forward, the report concludes.

Institutions will also likely turn to other higher-yield real estate investments such as mezzanine loans. “We got a lot of blank looks from institutional investors back in 1997 when we started pitching these mezzanine products,” says John Klopp, CEO of Capital Trust, a major mezzanine lender. Capital Trust offers several funds that allow third-party investors, including institutions, to co-invest with Capital Trust and Citigroup Alternative Investments in mezzanine loans and other high-yield commercial real estate assets.

Institutions are also looking for investment opportunities overseas, particularly throughout Europe and Asia. Wherever investments go, industry watchers expect institutions to remain aggressive players.

Nicholas Yulico is an Oakland, Calif.-based writer.