You can see it in the headlines—pension funds are once again making bets on commercial real estate.

Last May, the California State Teachers’ Retirement System (CalSTRS) paid roughly $800 million for a majority interest in LCOR, an investment, management and development firm whose portfolio includes 7,400 multifamily units, 7.7 million sq. ft. of commercial space and multiple development projects.

In June, the California State Public Employees’ Retirement System (CalPERS) plunked down $100 million for one-third of Bentall Kennedy, a real estate investment advisor with $8.4 billion in U.S. assets under management.

And in December, the Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF) agreed to pay $250 million for a 49 percent equity stake in a high-rise apartment tower at 8 Spruce Street, in downtown Manhattan, and put down another $551 million for a 70 percent stake in MiMA, a luxury mixed-use complex at West 42nd Street.

The same month, the Tennessee Consolidated Retirement System paid $105.75 million for 343 Sansome, a 360,000-sq.-ft. office building in downtown San Francisco.

More recently, TIAA-CREF formed a joint venture with Norges Bank Investment Management to buy approximately $1.2 billion worth of office buildings in New York, Boston and Washington, D.C.

All of these deals have come just a few years after pension funds lowered return expectations for commercial real estate investments and revamped the criteria for qualifying the success of a buy to include measures such as potential liabilities and future cash flows. But with fundamentals improving across property types, institutional investors, like everyone else, want to take advantage of microscopic interest rates when placing their money.

Today, U.S.-based public pension funds have 6.8 percent of their total assets, or an average of $758 million, allocated to commercial real estate, according to London-based research firm Preqin. Private pension funds have 5.2 percent of their assets, or an average of $434 million, tied up in real estate investments. Endowment plans have allocated 6.1 percent of their money, or $143 million, to commercial property.

For all three groups, these allocations are below target goals. Public pension funds aim to have up to 8.1 percent of their total assets allocated to commercial real estate, while private pension funds aim for 6.7 percent and endowments for 9.2 percent, Preqin reports.

“It’s my view that pension funds will continue to increase their commercial real estate allocations, particularly when you have a low interest rate environment and low returns on alternative investments,” says Christopher R. Ludeman, president of capital markets with global real estate services firm CBRE Group Inc. “There will be continued movement to expand their real estate equities. It will become more attractive because the relative yields are going to be higher, at least in the near to intermediate future.”

In addition, pension funds and endowments will likely become more adventurous with their investments as the year progresses, according to both Ludeman and Jeffrey H. Cooper, chairman and executive managing director with real estate services firm Savills. Until now, most pension funds have been focusing on core properties in gateway markets in order to minimize risk. But with fewer of those assets available for acquisition and with hopes for an improving economy in 2013, this year, pension funds may start looking into smaller markets and slightly less pristine assets, according to K. C. Conway, managing director of market analytics with Colliers International.

Money on the table

While pension funds have been conservative with their real estate allocations after getting burned in the real estate crash of the 1990s, they find themselves today in an environment where commercial real estate represents the best risk-adjusted return, according to Conway. Institutional investors may like to play it safe, but current returns on government bonds are so low, they offer too little upside.

Commercial real estate assets, on the other hand, not only offer higher yields but can serve as a hedge against inflation, which could become a serious threat if the Federal Reserve ends its quantitative easing policy, Conway notes. As a result, pension funds’ allocations to commercial real estate continue to grow. In 2011, the pension funds Colliers International works with increased their allocations to the sector by 20 percent to 40 percent compared to the year prior. In 2012, the same funds plan to increase their allocations again by 25 percent to 50 percent, Conway says.

“I was talking to one very large pension manager. They have a large commingled fund focused on real estate, and he indicated their investment target for 2013 had increased almost 40 percent from what it was in 2012,” says Savills’ Cooper. “And that’s the result of a large number of clients trying to get into that fund.”

Ludeman predicts that going forward, pension funds and endowments will be allocating anywhere from 6 percent to 10 percent of their assets to real estate equities. (When debt investments are added in, the numbers will likely be even higher). Over the past seven years, pension funds’ real estate allocations ranged between 5 percent and 7 percent of total assets, according to Suzanne Mulvee, real estate economist with the CoStar Group, a Washington, D.C.–based research firm.

Risk vs. reward

So far in this cycle, pension funds have been sticking with core product. Multifamily assets, which benefited from a busted housing market, have been at the top of their acquisition list. TIAA-CREF and CalSTRS, for example, made the list of top five buyers of apartment properties in 2012 by investment volume, according to Real Capital Analytics (RCA), a New York City–based research firm. TIAA-CREF was also the second most active apartment buyer in the Northeast.

Multifamily was closely followed by class-A office buildings in Central Business Districts (CBDs) and medical office properties, according to Cooper. Due to the multitude of retailers that had closed stores during the recession, pension funds have been less enthusiastic about buying retail centers and have completed virtually no acquisitions in the hotel sector, adds Thomas Beneville, international director with the capital markets group at Jones Lang LaSalle. CalPERS and TIAA-CREF did make the list of the top 15 retail buyers last year, reports RCA.

Until now, pension funds have also displayed a strong preference for 24-hour cities on the East and West Coasts—New York, Boston, San Francisco—notes Ludeman. They may have been willing to venture into secondary markets for multifamily acquisitions, reassured by the strong fundamentals in the multifamily sector, but office buildings and malls had to be located in areas with the best fundamentals.

Endowments have been more willing to put their money into value-add and opportunistic transactions. For example, in late 2011, Texas Permanent School Fund approved a $50 million commitment to Oaktree Real Estate Opportunities Fund V, which targets distressed properties. And last June, the University of Michigan endowment made a $100 million contribution to Canyon Capital Realty Advisors’ Discretionary Mortgage Investment Account IV, geared toward bridge and mezzanine loans and real estate-backed collateralized securities. These are the types of vehicles pension funds would typically stay away from, but endowments can accept greater risks because they don’t have to pay out pensions to retirees, notes Cooper.

The issue with pension funds’ risk averse-strategy is that returns on the safest real estate investments have been declining and there are fewer and fewer of them available for sale, which is why many in the industry expect that pension managers’ appetite for risk will gradually increase.

The National Council of Real Estate Investment Fiduciaries’ (NCREIF) Property Index, which measures a total rate of return for properties acquired on behalf of tax-exempt institutional investors (mostly pension funds), fell to 2.5 percent in the fourth quarter of 2012, down from 3.0 percent in the fourth quarter of 2011 and 4.6 percent in the fourth quarter of 2010. The rate of return was slightly above the 10-year average of 2.1 percent. The index encompasses 7,270 properties with a total market value of approximately $320 billion.

Where the yields are

On average, pension funds try to achieve cash-on-cash returns of 8 percent to 9 percent on their investments, notes Cooper. On a leveraged basis, that works out to returns in the 11 percent to 15 percent range, according to William T. Barry, senior vice president for commercial mortgage production with Draper & Kramer, a Chicago-based property and financial services firm.

In this environment, paying a premium for a class-A office building in Manhattan, which most people would consider a safe asset, would appear more attractive than putting money into government bonds and earning a return of less than 2 percent, Cooper says. But a 5 percent yield on a New York office tower would still be below target.

Meanwhile, cash-on-cash returns on value-added acquisitions currently range between 12 percent and 15 percent, Cooper notes. With opportunistic investments, the returns can rise up to 20 percent.

Pension funds aren’t likely to make drastic changes to their allocations in order to achieve those yields, but they may be willing to get more comfortable with acquisitions in secondary cities, according to Mulvee. That would mean more deals in markets that are benefiting from growth in the technology and energy sectors, like Denver, Houston, Dallas, San Diego, Portland, Ore., and Pittsburgh.

According to NCREIF’s Property Index, the South was the best performing region in the U.S. in the fourth quarter of 2012, delivering total returns of 3.0 percent, while the West delivered the best returns for the year, at 12.0 percent. Properties in the East delivered the lowest returns, at 2.2 percent for the fourth quarter and 9.0 percent for the year.

“We are starting to see a shift—we are not seeing the same price appreciation in core markets that we have been seeing [in the past few years], so the supposition is that the money is starting to get pushed to riskier assets and next tier markets,” Mulvee says.

For instance, pension funds’ interest in multifamily assets may cool and become more focused on office buildings, large industrial portfolios near port cities and grocery-anchored shopping centers. Already in the fourth quarter of 2012, TIAA-CREF paid $390 million for Valencia Town Center, an 865,000-sq.-ft. retail center in Valencia, Calif., while CalPERS, in a joint venture with Miller Capital Advisory, put down more than $1 billion for the 2.2-million-sq.-ft. Woodfield Shopping Center in Schaumburg, Ill., according to RCA data.

NCREIF reports that retail proved the best performing real estate sector for tax-exempt institutional investors in 2012, delivering a return of 11.6 percent followed by multifamily, at 11.2 percent, and industrial properties, at 10.7 percent. Hotels were the worst performing asset class last year, with total returns of 8.2 percent.

In addition, the industry may see more institutional money going toward funds that target opportunistic investments, as long as those funds are managed by asset managers with a long track record in delivering promised returns, says Cooper. In August, the Illinois Teachers Retirement System agreed to place $100 million in Walton Street Capital’s seventh real estate fund, aimed at opportunistic investments. And in October, the Oklahoma Police Pension & Retirement System committed $20 million to TA Associates Realty X, a value-added opportunistic real estate fund.

October was also the month when the Blackstone Group closed its $13.3 billion real estate opportunity fund, its largest opportunistic real estate fund ever, with equity commitments from 250 investors. Some of those investors included Virginia Retirement System, New Mexico Public Employees Retirement Association and Hawaii Employees’ Retirement System. In fact, public pension plans contributed the most money to the fund of any investor group, according to a Blackstone press release.