Occupancy may be down and sale prices high in many property types, but pension funds have big plans for buying commercial real estate in 2003. The funds have allocated $14 billion to the U.S. real estate equity market this year, according to LaSalle Investment Management. And, in a break with tradition, they are prepared to leverage this year's purchases to the tune of 25% to 50%.

If the pension funds follow through, the $14 billion investment would be a $1 billion increase over actual acquisitions made in 2002, or about an 8% increase, according to William Maher, director of North American investment strategy for Chicago-based LaSalle Investment Management, a pension fund advisor.

Though pension funds collectively had planned to invest $15 billion of equity in U.S. real estate in 2002, they fell short of their goal mainly because other buyers outbid them. “A lot of private money beat them out on deals,” Maher says. Privately held real estate firms and investment companies can afford to pay higher prices for property, given their willingness to borrow and leverage purchases, experts say.

Even though the fundamentals in commercial real estate have eroded over the past year, the sector is still a preferred asset class for institutions. The Dow Jones Industrial Average, for example, fell nearly 17% during 2002, the first time the index has dropped for three years running since the Depression. On the other hand, well-stabilized and well-leased real estate assets that offer returns of 7% to 8% can help portfolios begin to recover from the shellacking they have taken in the stock and bond markets.

“Many of our clients are increasing their real estate allocations,” says Maher. “As long-term investors, they realize that real estate deserves more than the 4% to 5% allocations they have traditionally made.”

Analysts estimate that pension funds that invest in real estate — not all do — typically allocate between 5% and 7% to the category. Today's most aggressive pension funds are moving above the averages. The California Public Employees' Retirement System (CalPERS), for example, raised its real estate allocation to 9% in 2002.

Maher says that about 25% of the firm's three-dozen clients have increased their overall real estate allocations for 2003. The rest have retained their existing allocations. None has reduced its commitment to the property market.

“Emerging Trends in Real Estate,” an annual report prepared by Lend Lease Real Estate Investments and PricewaterhouseCoopers LLP, estimates that as of September 2002 pension funds owned $148.7 billion, or 36.9%, of the $402.8 billion real estate equities market. That figure is up from $144 billion the previous year. Only real estate investment trusts (REITs) can lay claim to a bigger percentage of the total equity pie. As of September 2002, REITs accounted for $171.2 billion, or 42.5% of the U.S. real estate equity market.

Insurance companies, once major institutional buyers of real estate equities, have sold the lion's share of their real estate over the past five years and turned to lending. In 2002, for example, insurance companies sold $7.5 billion of property and reduced their total holdings to $32.4 billion, a level substantially lower than the $47.1 billion of real estate owned by foreign investors (please see chart).

The insurance industry's departure from real estate equities has taken place as top insurers such as Prudential Insurance Co. of America and John Hancock Insurance Co. convert from mutual ownership to public ownership. While fully leased real estate assets generate reliable returns of 8% to 9%, those investments tend not to produce returns that satisfy stockholders demanding high quarterly earnings, except during a severe bear market.

Pension Fund Property Allocations

To account for the fluctuating performance of the various property sectors, pension funds routinely alter their investment targets. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), which tracks pension fund investments, 41.5% of pension fund money currently is invested in the office sector, followed by industrial (19.6%), multifamily (18.5%), retail (17.1%), and hotels (3.4%).

Using the NCREIF numbers as the benchmark, LaSalle Investment Management recommends that clients underweight 2003 office investments by 10% and overweight new industrial and retail investments by 5% each. LaSalle also suggests remaining neutral on existing apartments. Core investors are advised to avoid hotel investments altogether.

Prices Escalate

Pension fund managers are not the only ones beefing up their real estate holdings. Hurt by falling stock prices and low bond yields, myriad investors are scouring the U.S. property markets in search of safe havens and opportunities.

Institutional equity investors, including savings & loans and banks, pension funds and REITs, pumped $30 billion of new funds into real estate in 2002, compared with an overall $6 billion decline the year before, according to Lend Lease. On the debt side, lenders too are fueling increases in real estate prices by increasing the amount of cash available to investors seeking leverage. Total real estate debt rose by $165 billion in 2002 over the year before to a total of $1.8 trillion.

The upshot is a steep rise in real estate prices, that industry observers expect to continue this year. “The continued reliance on real estate by all investors is an overwhelming trend,” says Douglas Poutasse, chief of investment strategies with AEW Capital Management, a Boston-based pension fund advisor. “Over the past 18 months this has caused, and is continuing to cause, a fundamental re-pricing of real estate.”

Some properties are experiencing price increases even as income streams decline, says Poutasse. He cites the multifamily property index compiled by NCREIF as proof. The index tracks apartment real estate totaling approximately $20 billion. Net operating income across the index fell 10% between the third quarter of 2001 and the third quarter of 2002. At the same time, the cap rates based on trailing income fell from 8% to 7%, indicating a rise in sale prices.

The institutions seem unfazed by the price hikes. “There is a run to quality,” says Thomas Lydon, president and CEO of SSR Realty Advisors of Morristown, N.J., which manages a $5.5 billion portfolio for 100 institutional clients. “Pension funds want to be conservative and invest in stabilized, core properties with 7% to 8% returns,” he says.

A Tale of Two Markets

On the other hand, higher prices make acceptable core real estate returns difficult to find these days. Indeed, some of today's price tags are stunning. In September of last year, Boston Properties, a REIT that has assets in Boston, New York, San Francisco and Washington, D.C., purchased 399 Park Ave. in Manhattan from Citibank N.A. The $1.06 billion purchase of the 1.7 million sq. ft. building translated into a whopping $627 per sq. ft.

The transaction illustrates one side of what investors describe as a bifurcated office market (please see “Rational Exuberance” on page 10). With the national office vacancy at 17.5%, according to Grubb & Ellis, many investors, including advisory firms, won't consider an average building with considerable vacancy or the prospect of expiring leases. “You are willing to pay a good price if the property has credit tenants and lease terms extending a minimum of five years,” Lydon says.

In January, for example, SSR Realty purchased two 72,000 sq. ft. office buildings in a suburban Seattle corporate park for $26.1 million, or $180 per sq. ft., on behalf of a public pension fund client. Completed in 2000, the buildings are 100% occupied by healthy Weyerhaeuser, a $14.5 billion company, under a long-term lease. Lydon pegs the cap rate on the acquisition at 8.5% and anticipates that the internal rate of return, or expected annual yield, will be 9.5% to 10%.

But such attractive investment opportunities are limited. SSR Realty generally buys eight to 10 office buildings a year, according to Lydon, but the Weyerhaeuser property was the firm's first office acquisition in 15 months.

In the retail property category, Lydon estimates that price tags for grocery-anchored shopping centers have risen by at least 10% in the last 24 months. Worse, the universe of acceptable centers has declined as the category has come under attack from alternative grocery retailers such as Wal-Mart and Target. “As investors, we will only pay those higher prices in areas that are infill and fully developed, where a Wal-Mart Supercenter cannot come into the trading area,” Lydon says. “We'll buy grocery-anchored centers in fully developed cities on the East and West coasts, but not in fast-growing markets like Dallas and Atlanta.”

What about industrial? While LaSalle recommends that investors overweight their holdings in industrial properties, Lydon isn't so sure. “Industrial has done well over the last five years, but vacancy rates are now edging above 10% and credit defaults are occurring,” he notes. “We think this category will have a lot more risk over the next three years.”

Seeking Value

Core investments in the office sector account for about one-half of SSR Realty's portfolio. The firm invests the other half of its capital in multifamily properties. The goal is to achieve returns between 8% and 12%.

SSR Realty is buying apartments, albeit in lower quantities than in the past. “We normally buy $500 million to $750 million in apartments per year,” he says. “This year, we are only going to buy $300 to $400 million.”

The reason, once again, is competition from other buyers. In the multifamily sector, private buyers using leverage are willing to pay more for apartments than pension funds. Leveraged private buyers are exerting upward pressure on prices in all real estate categories.

While demanding quality, pension funds and their advisors historically have purchased real estate with cash and avoided leverage or debt. Private buyers usually leverage real estate with 70% to 75% of debt, which can boost returns or make possible the payment of higher prices.

The intense competition in the property markets today has led pension funds to consider leverage as a means of enhancing returns or meeting competitive bids. “With interest rates at historic lows, one of the trends in pension fund investing today is the use of more debt,” Lydon says. “After buying a property for cash, we might leverage it for 10% to 20%.”

LaSalle's Maher agrees that pension funds are willing to take on more debt today. The California Public Employees Retirement System (CalPERS) and the Massachusetts Pension Reserves Investment Management Board (Mass PRIM) have both increased their allowable debt levels, and some funds have decided to allow leverage as high as 50% on core investments, according to Maher.

While leverage can help pension funds match aggressive offers from competing bidders, Maher believes the main reason for using debt today is historically low interest rates. The 10-year Treasury yield continues to hover around 4%. “We calculate that if you use 50% debt today, your leveraged returns will be just as high, if not higher, than leveraged returns achieved two or three years ago,” he explains.

This calculation holds true even with low cap rates, Maher emphasizes. “If you can match good, solid real estate with good credit tenants, low-cost debt makes a lot of sense. I also think that pension funds will be smart about this and not overdo it,” he adds. “Then if interest rates go up, they will still be there with all cash, when other investors drop out.”

The bottom line is that private buyers that grew accustomed to outbidding pension funds last year may find 2003 to be a different story.

Trolling for Opportunities

When the real estate market softens, investment firms form private equity real estate funds to seek out acquisition opportunities. These funds purchase underperforming and even distressed real estate to reposition the properties. Successful acquisitions produce annual returns in the 8% to 12% range or higher.

The Praedium Group, based in New York, specializes in private equity real estate funds for institutional investors, including pension funds. Last year, Praedium announced the formation of a new fund and sought $400 million in subscriptions. Within several months, the fund had attracted $465 million from institutions. “We had to turn people away,” says Russ Appel, the firm's president.

Over the next three years, the fund will use leverage to purchase and reposition $1.5 billion in domestic properties. It will target several product types, including office buildings, shopping centers, apartments and industrial properties.

Among the fund's first acquisitions was 800 Wilshire Boulevard, a 215,000 sq. ft. Class-A office building in Los Angeles. “A large tenant had vacated the property, and the owners didn't want to take the risk of releasing,” Appel says. “We paid $22 million, about $102 per sq. ft., an attractive price.” Industry observers say that asking prices for Class-A office properties in Los Angeles range from $140 per sq. ft. to $190 per sq. ft.

The fund also bought seven high-rise multifamily complexes with a total of 994 units in the Bronx for $42 million, about $42,000 per unit. Analysts estimate that the prices for apartment high-rises in comparable areas of New York City range between $100,000 and $150,000 per unit. “These properties were part of a large bankruptcy,” Appel says. “We feel we can stabilize the assets and enhance their performance.”

Mike Fickes is a Baltimore-based writer.

TOP 10 PENSION FUND REAL ESTATE INVESTORS*

Total Pension Funds Real Estate Assets Total Assets % of Assets
1. California Public Employees' Retirement System $11.7 billion $129 billion 9%
2. California State Teachers' Retirement System $5.1 billion $88 billion 6%
3. General Motors Corp. $4.8 billion $74 billion 6.5%
4. State Teachers Retirement System of Ohio $4.6 billion $42 billion 11%
5. New York State Teachers' Retirement System $4.0 billion $66 billion 6%
6. State of Michigan Retirement Board $3.9 billion $42 billion 9%
7. Washington State Investment Board $3.5 billion $38 billion 9%
8. New York State Common Retirement Fund $3.4 billion $96 billion 3.5%
9. Florida State Board of Administration $3.3 billion $79 billion 4%
10. Public Employees Retirement System of Ohio $3.1 billion $45 billion 7%
*(Total assets are Defined Benefit assets in real estate equity)
Source: Pensions & Investments magazine 2002 rankings, compiled as of Sept. 30, 2002