Pension funds have been following a clear path of increasing allocations to real estate over the past several years. Despite signs of a maturing market cycle, it appears that most institutions are likely to maintain that same course in 2017.
In past down cycles, institutions have become a bit skittish about real estate and pulled back on allocations. This time, there has been a bigger move towards real estate, says Greg MacKinnon, director of research with Pension Real Estate Association (PREA).
MacKinnon credits the higher allocations to real estate as a broader secular trend driven by two notable factors. First, real estate has become a more mainstream alternative asset class and is now a fairly standard component of institutional investment portfolios. Second, it has proved to be a good diversification play and has performed well in delivering good risk-adjusted returns, says MacKinnon. According to London-based research firm Preqin, U.S. pension funds allocations have been climbing incrementally higher over the past several years—rising from an average of 6.0 percent of assets under management to its current level of 7.3 percent. Global pension funds have an even bigger appetite for real estate with current allocations at 8.8 percent, which is an increase of 160 basis points since 2011.
Other industry data puts pension fund allocations at an even higher level. At the end of 2015, average pension fund allocations were at 9.4 percent, according to PREA’s annual Investment Intentions Survey that was released in January. Although the majority of investors surveyed said they were below target, they also said they expected those target allocations to increase over the next two years—for 2016 and 2017.
Yields remain attractive
Pension funds remain firmly committed to real estate strategies despite signs that commercial real estate is moving into a later stage of the cycle and investors are lowering return expectations. Specifically, the PREA third quarter forecast shows that respondents expect total returns on commercial real estate to decline from 8.3 percent in 2016 to 6.8 percent in 2017 and 5.7 percent in 2018. Yet that decline in sentiment is not deterring pension funds from putting more capital into the sector.
“Many institutional investors are continuing to struggle to achieve their return objectives in today’s low-yield environment and appear to be moving more toward private investments, of which commercial real estate is a significant allocation,” says Jay Butterfield, managing director, fund operations, at American Realty Advisors. In addition, many plans have been chronically underweighted in the asset class and only now, due to moderating returns in public securities, are plans approaching their overall invested targets, he adds.
Pension fund capital directed at real estate is already at record levels. Even for those who haven’t raised allocations as a percentage of assets under management, the dollar amounts have increased along with growth in total investment portfolios. Some of that additional inflow of capital is also due to a number of sovereign wealth entities that are fairly new entrants to real estate investment. “In those cases, they are ramping up their programs and increasing their targets,” says MacKinnon.
Capital follows flight-to-quality
The increased capital flows from pension funds are helping to keep pressure on property values and pricing. Of late, there has been increasing interest in value-add properties due in large part to stiff competition for core assets and a search for higher yields. Real estate investors looking for a hedge against rising interest rates want properties that can take advantage of the improving economy. Value-add properties have room to create rent growth and appreciation, whereas assets with long-term leases in place tend to be more bond-like, says MacKinnon.
But, broadly speaking, core is still the dominant strategy for many institutional portfolios. And core and core-plus investors are gravitating to those markets and asset classes that are most likely to provide stable cash flow.
“Investors are recognizing that liquidity and cash flow are king and opportunities for short-term upside potential in narrower markets, with less institutional presence, tend to dry up just at the wrong time,” says Butterfield.
Plus, pension funds are still wary of taking on too much risk.
“In many instances we are seeing a flight-to-quality and a move toward class-A major market urban assets, with credit tenancy and sold leasing in place,” Butterfield adds. The rush into secondary cities and class-B properties as a means to achieve higher yields appears to be abating and risk choices are being considered more carefully as the market moves into the more mature part of the cycle, he adds.