Despite a dearth of transactions, pension funds are finally in the throes of writing down the value of their commercial real estate assets in the face of a troubled economy and clogged credit markets. While the write-downs by these industry bellwethers will effectively balance their allocations to the sector, the move has sweeping implications for the funds' investment strategies in 2009 and in the years ahead.

Pension fund advisers spent the first two months of 2009 wrapping up their year-end reporting with many advisers using aggressive mark-to market programs, or bringing the value of their real estate assets more in line with actual market pricing. “The plan sponsors are putting a lot of pressure on their advisers to mark to market as much as they can so that they can just move on,” says Greg Vorwaller, president of investment properties with CB Richard Ellis in Chicago.

Recent property pricing levels certainly point to a continued decline. The National Council of Real Estate Investment Fiduciaries (NCREIF) fund index, which measures pricing changes at stabilized commercial real estate properties, dropped 10.92% in the fourth quarter of 2008 compared with the prior quarter. The S&P 500 was off nearly 22% during the same period.

“It's safe to say that real estate values have not been written down yet to reflect current valuations, but that's actively happening,” says Jim Woidat, a principal with researcher Kingsley Associates in San Francisco. The firm recently completed its 13th annual survey of 100 top institutional investors, in partnership with Institutional Real Estate Inc., a publishing and consulting company based in San Ramon, Calif.

“Investors do expect significant write-downs in their property values in 2009,” says Woidat. Survey respondents predicted that their real estate values would drop by an average of 8.3% in 2009. “I think it's going to be a lot more dramatic than that, but the bottom line is that investors are expecting write-downs in their current holdings,” says Woidat. “But it makes another challenge for 2009 in that pension funds certainly aren't very comfortable investing into a property market that may be somewhat of a falling knife.”

The net effect of lower real estate values will be an easing in the “denominator effect.” For the past year, many pension funds have seen the value of their real estate assets push past their allocation targets, measured as a percentage of total assets under management.

But as the value of the funds' other managed assets falls — most notably stocks and bonds — the value of other assets rises, often pushing past preset limits. Stocks and bonds are valued on a daily basis in the public markets, but commercial real estate assets are much less easy to quantify.

A moving target?

Marking to market affirms what nearly every property investor has known for some time — that property values have been falling. But the process has been slow to occur, and for good reason. Valuing any commercial property in a market that is best characterized as stalled presents appraisers with a unique set of challenges.

“The good news is the pension funds want to get mark-to-market done,” says Vorwaller. “The getting-it-done part is a little more problematic because those in the valuation business would suggest that they don't have the comprehensive set of comparable sales or data points they used to have due to the diminishing level of transacting activity last year.”

For now, appraisers are muddling through the situation by comparing deals in similar-sized cities and making the appropriate market adjustments.

One closely watched barometer is likely to be a new survey conducted by the Massachusetts Institute of Technology's Center for Real Estate. According to the survey, prices for properties sold from the NCREIF database dropped by 10.6% in the fourth quarter of 2008 compared with the previous quarter. Stated another way, prices have dropped 21.9% since their peak in the second quarter of 2007.

The general lack of credit in the financial markets also has taken its toll. “Until you can really get your arms around debt, it's hard to know the value of the assets because that is such a huge component in determining pricing,” says Steve Pumper, executive managing director with Transwestern in Dallas. “We are deleveraging an industry, and as a result that in and of itself immediately has a negative impact on pricing, coupled with the illiquid markets at this point in time.”

Due to the moving targets that make accurate valuations “squishy” at best, many pension fund advisers have the discretion to independently adjust property valuations based on their own internalmetrics. “Some of the advisers are taking that tack,” notes Vorwaller.

For their part, many pension funds are making it easier on themselves simply by increasing their target investment allocations. Both the California State Teachers' Retirement System (CalSTRS) and the California Public Employees' Retirement System (CalPERS) have raised their real estate asset allocation targets to compensate for the severe drop in the value of stocks and bonds. “This gives them a little more latitude to manage within a target allocation, so they are not forced to meet an artificially temporary threshold and be forced to liquidate,” says Vorwaller.