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Pension funds returning to real estate... but they haven't forgotten the '80s

In the late-'80s and early-'90s pension funds -- like many other investors -- were burned by the "death and destruction" of the real estate downturn, but by the end of the decade, the size of their assets will probably surpass the National Debt, so it's back on the real estate wagon they go...

Pop Quiz: You're a pension plan sponsor whose contributions have gone up more than 12% in the last five years. The stock and bond markets, which have made up a sizeable chunk of your asset allocation in the past, are becoming less attractive investments, but your actuarially required rate of return has not decreased. You have to meet your investment obligations somehow; what do you do? What do you do?

Though many plan sponsors may just feel like they're on a speeding bus, with mad bomber Dennis Hopper poised at the trigger and waiting for an answer, the question is indeed being riddled over by the pension industry today. Of course, this is not a movie -- and you can't shoot the hostage -- so, if you're like thousands of other investment officers under the gun, you'll take a second look at real estate and decide it's worth another try.

The reality of the situation is this: In 1994, pension plan assets totaled more than $2.6 trillion, according to Greenwich, Conn.-based Greenwich Associates. These assets are estimated to hit more than $3.2 trillion by 1997.

Total fund contributions in 1994 were estimated by Greenwich Associates at over $101.8 billion, up from $90.2 billion in 1990. Meanwhile, benefit payments also rose, from $105.6 billion in 1990 to an estimated $125.6 billion in 1994.

Out of all these billions of dollars, 44.8% was invested in common stocks and 27.7% was invested in bonds, but only 3.2% was invested in equity real estate in 1994, down from 4.9% in 1991. (Real estate mortgages didn't even show up in the mix until they weighed in at 1.6% during 1994.)

The good news for real estate is that pension fund advisers say the tide is turning, and they see renewed interest by their clients in real estate as an asset class.

"Beginning with the middle of last year, the level of interest by pension funds relooking at real estate has gone up, and there have been an increase in the number of pension plans who are, in fact, beginning to invest again," says Charles H. Wurtzebach, president and chief operating officer of Heitman/JMB Advisory Corp., Chicago. "It hasn't been an onslaught of capital. It's really been relatively modest compared to the volumes of dollars that were going into real estate in the late-'80s, but it's a definite net increase in both interest and actual dollar flow," Wurtzebach says.

"A lot of them had investment strategies in the '80s and stepped out in the early-'90s," agrees Richard F. Burns, managing director, institutional real estate for Boston Financial, Boston. "They wanted to sit down and evolve a strategy how to re-enter the market."

Of course, this is not pension funds' first foray into real estate. They were among the many investors who shied away from the market during real estate's recent downturn.

"The nature of U.S. pension funds is that, as long-term investors, they are cautious, calm investors and won't rush into anything just for the sake of meeting their allocations," says Paul J. Dolinoy, senior executive vice president of Equitable Real Estate Investment Management, Atlanta. "The interest has always been there," Dolinoy points out. "Since '73, the first time they had a negative experience with real estate to any great extent was '90.

"More recently, with the writedown in real estate values, with their getting their arms around the problems and understanding the methods for improving real estate, there has been a rededication to the asset class," Dolinoy says.

Illustrating this "rededication," Dolinoy says that during the first six months of 1995, Equitable had, on behalf of pension funds, $514 million in 27 separate transactions that were either closed, approved and in the closing process, or under letter of intent. That compares with just under $700 million in transactions Equitable did for pension funds during all of 1994, and Dolinoy says he expects to do "between $750 million and $1 billion of new transactions" this year.

Advisers point out that this renewed interest does not necessarily mean an immediate, gushing fountain of capital for real estate.

"Many pension funds, if you asked what their planned allocation to real estate is, probably would indicate something like 8% to 10%," says James W. O'Keefe, CEO of Aetna Realty Investors, Hartford, Conn., "but what they actually have in place yet probably is something like 3.5% or 4%."

"There's always a lead time. Some people started in it faster than others" agrees Burns. "One large fund has been talking about going back into real estate for a year and a half now, and they're still no farther ahead with their program. But if you called them, they'd tell you, 'Oh yes, we're putting a lot of money back into real estate.'"

To what does real estate owe this rededication of funds?

"I think they've become increasingly comfortable that the market correction that occurred throughout the early-'90s is near its end and that operating fundamentals generally are attractive," says Daniel W. Cummings, managing director of LaSalle Advisors in Chicago. "They see pricing pressures also positive, and they may anticipate an increase in capital in the future."

Another reason for the increased interest in real estate, Wurtzebach says, has to do with pension plans' actuarially determined rates of return that they have to hit to fund their liability. That rate, he says, generally ranges from 9% to 12%. However, when 10-year Treasuries are at the low 6% level, and yields have dropped in general in the bond market, it's very hard for the plan to meet its actuarially required rate of return, he says.

"Your options, in terms of alternative yields, have gone down in the market," Wurtzebach says, "but what you are expected to earn has not. This has resulted in re-looking at a lot of alternative assets and trying to pick up yield while managing risk."

"The level of interest rates started to fall rather dramatically in 1992 and 1994," Wurtzebach notes. "Alternative yields in fixed-income, after the fall in interest rates, were much less attractive to pension plans than what they had been. So, as an alternative investment, yields and total returns on real estate became much more attractive as chief investment officers compared the opportunity to invest in real estate vs. their expectations of what they were going to earn in the bond market or the stock market."

Now that all agree pension funds will be putting more money into real estate in the future, the next question is where that money will go.

The four areas, or "quadrants," available to pension fund investing in real estate today are: private equity, which typically has drawn the lion's share of pension fund investments through commingled funds and separate accounts; public equity, most common as REITs; private debt, in the form of commercial mortgages and whole loans; and public debt, such as commercial mortgagebacked securities. While pension funds have traditionally been more interested in equity investments, most advisers say they are open to investing in each type.

"I do believe there's a place for both equity and debt in everyone's portfolio," says Jack Cohen, president of Cohen Financial Corp., Chicago. "And what happens is, depending on the market, you change your weighted average in equity vs. debt based on what the market is doing."

As far as equity investments go, opinions seem mixed as to what property types and locations are most attractive.

Dolinoy says that, of Equitable's 27 transactions so far this year, 14 were industrial, six were office, two were multifamily, two were hotels and three were retail properties. They were located in Philadelphia, Chicago, Southern California, Atlanta, Dallas, Washington, D.C., and New York.

Multifamily heads some lists

"Apartments essentially led the four major property types," Wurtzebach says, "primarily because the supply was shut off in 1986/87 after the tax reform act changed incentives to build apartments."

The economy and job growth support development and redevelopment of apartments, says Aetna's O'Keefe. "There's a good opportunity to add some supply selectively around the country and some to take control of properties built in the '70s and add value," O'Keefe says. "We don't see oversupply."

However, Marvin Franklin of Aldrich Eastman Waltch sees "tremendous capital demand" for industrial real estate. "The percentage of these pension funds' portfolios that have been historically invested in industrial relative to other property types has been so low that they really want to increase their allocation in industrial."

Retail properties generally receive less enthusiastic reviews.

"There has been a significant amount of construction, not only in the '80s, but in the early-'90s, and it never stopped," notes Franklin. "If you look at sales volumes, they're not exactly going through the roof.

"People are really fairly cautious about retail," Franklin adds. "There's interest in some components of the retail sector, specifically grocery-anchored centers."

Interest in hotels seems to be confined to "a more opportunistic basis," he notes. Indeed, Dolinoy says that the two hotel purchases this year by Equitable were on behalf of its Value Enhancement Fund.

Pension funds are even looking at that most notorious sector of all -- office. In fact, some even say it is the favored property type.

"Top on the list would be office property," says Cummings. "It's generally perceived that category went through the most severe price correction and that operating fundamentals generally are at the bottom or moving in a positive direction, and we foresee capital returning to that market, with some construction in some markets."

Certainly one of the most high-profile examples of pension funds' interest in the office market is Monarch Tower, a new $80 million office building under way in Atlanta's Buckhead area by Equitable -- with New York State Teachers money.

New York State Teachers agreed to finance and own the building that was 54% leased at its June groundbreaking. The 24-story, 575,000 sq. ft. tower, which is slated for delivery in January 1997, will be Equitable Real Estate's new headquarters.

However, this project appears to be the exception rather than the rule.

"Pension funds are longerterm sources of capital, and the issue of buying or investing in real estate relative to replacement costs is a major concern," says Franklin of AEW. "In markets that are still somewhat oversupplied, people would prefer to invest at well-below-replacement cost levels, which would suggest that they would avoid new construction."

Some even say that it is this hesitancy that distinguishes the pension fund investor of the '90s from the pension fund investor of the '80s.

"Most pension funds to date don't see themselves taking significant levels of speculative risk," Franklin says. "Pension funds have alternatives today. Whereas in the '80s there was so much capital in the market, not only were they buyers of existing product, there was aggressive buying of new product."

This caution is probably a good thing for the real estate market, as well as for the pension fund industry.

"The thing that's keeping this market in check, and keeping the investment process from going crazy, is there's still some discipline on the supply side," notes Burns of Boston Financial. "It's still the Damocles sword that's hanging over this industry right now. As long as that thread holds, we should be alright."

So it seems that, for now, Monarch Tower is a development anomaly, but Dolinoy defends his project. "It just happens that this is one of those markets that has (the right) supply/demand, preleasing and location," he says.

Deciding which other markets look good for acquisitions and construction is not as simple as identifying the dozen or so most healthy cities or submarkets.

Location, location, location?

"In general, pension plans this time around are much more sensitive to the allocation within their portfolio in the various markets," Wurtzebach says, "but it has as much to do with where their existing holdings are as opposed to just picking which they think are good markets. They take both into consideration.

"Some plans, for example, that made investments in particular property types in markets that had been weak, may find that those markets now are recovering," Wurtzebach says. "They don't need to go in and buy more assets in that market, they just need to manage the assets they currently have."

Burns agrees that allocations are more tailored to the needs of the portfolio than to specific location.

"We follow 120 markets for multifamily," Burns says. "We select groups of markets depending on particular strategy, client and investment product. It depends on what we are trying to achieve investment-wise."

Cohen attributes market choices to "cap rate arbitrage."

"If cap rates are going up and prices are going down in California, and, in Chicago, cap rates are going down but prices are going up, they will sell in Chicago, take the profits and invest in California, where they can have higher yields," he says.

Public markets

As far as the public markets go, it appears that pension funds have the will to invest in them, but finding the way may not be quite so easy.

"The attractive characteristics of the public markets -- liquidity and constant market pricing -- continue to be viewed as positive, and so we expect to see continued strong interest in the public markets," Cummings says.

However, the size of the public markets poses problems for interested pension funds.

"The challenge today is that the market is relatively small," Wurtzebach says. "It is difficult because of the lack of depth in the market for pension plans to make a large commitment.

"For many of the smaller plans," Wurtzebach continues, "that may be the most reasonable option to go even now."

The question, according to Burns, is "will there be enough good companies to go public to grow that business, and are the existing companies strong enough to continue to grow?"

Besides, pension funds still need to iron out the kinks in the way they deal with the public markets.

"Some people still feel REITs perform more like small cap stocks than they do like real estate," Burns says. "Others are saying REITs are looking more like real estate in their performance."

Likewise, in the CMBS arena, says Edward G. Smith, senior executive vice president heading Equitable's Mortgage Investors group, "basically it demands an education process for a lot of them. They understand residential mortgage-backed securities, but not necessarily commercial."

Nevertheless, those public markets aren't going away, Smith observes, "but neither will they overtake private. There's a place for all."

"With all the death and destruction that happened in the industry in the early-'90s," Cohen says, "a lot of the pension funds that are coming back are coming back in debt."

"We see an increasing appetite by pension funds for mortgages," notes Smith. "This is not so much because it's an alternative real estate vehicle, but because it's an alternative to corporate bonds and other fixed-income securities the pension funds are used to buying."

However, as with REITs, not all pension funds agree as to whether these mortgages actually count as real estate in their portfolios.

"There's some confusion in some funds whether a mortgage is a real estate asset and should be generated by the real estate side, or a fixed-income asset and belongs on the bond side of the house," Smith says.

Relationship changing

In light of all the recent changes in pension fund investing, it's inevitable that the relationship between pension fund and adviser change, too.

"Advisers are having to work harder at all aspects of the relationship," Franklin says. "As far as reporting goes, there's much more information needed and requested by funds from their advisers."

"The hot button today seems to be research," Cohen says. "If you're not providing them with research, you're sort of passe.

"We're getting more astute questions. We're getting greater scrutiny. We're getting more follow ups being asked, all in the spirit of not only understanding but staying on top of the changes in the industry," Cohen says.

He points out that many pension funds remain cautious because they don't have a high comfort level with real estate.

"There are certain cities that people feel really comfortable in, and others they don't. You get in a groove -- you know who to call and where to go and what restaurants to visit," Cohen says. "That's sort of like what's going on in the pension advisory area because not everyone has figured out who all the players are. Comfort takes time."

"We've seen an increasing amount of questions, services and information that they need to make their decisions," Dolinoy agrees. "It isn't easy. You have to devote more resources to meet that. Yes, pension funds have become more demanding, but we agree, it's their assets in question."

In addition, funds are expecting their advisers to have an exit strategy, according to O'Keefe.

"Every time anybody buys an asset, there's much more focus on what you are going to do to dispose of it," he says. "There's much more sell discipline, and we expect to see more trading."

Another demand being made by some pension fund clients is for property management expertise.

"Some pension funds are moving in the direction of wanting their advisers to have direct property management skills or services," says AEW's Franklin. "There's not a mad rush that way, but clearly some funds have been leaning in that direction."

These increased demands have contributed to consolidation in the advisory industry.

Steven Goldmark, senior investment manager -- real estate for IBM Retirement Fund, told the Eastern Chapter of the Real Estate Investment Advisory Council (REIAC) at a recent meeting that he sees ongoing pressure for consolidation in the advisory business.

"People in the middle will constantly feel pressure, and there will be continued pressure on fees," he said.

"There's clear evidence of consolidation of managers to become more full-service," concurs Dolinoy. "There'll always be a role for niche areas. The area of concern might be advisers in between."

Leaning toward defined contributions

A wild card in the whole investment scenario may be the trend by some corporations away from pension fund investing in an attempt to control costs.

"I think we'll see corporations transferring liability from defined benefit plans, which are pension funds, into defined contribution plans like 401(k)s," Goldmark told the REIAC meeting.

Others agree that this is a trend, but they aren't worried. They see the trend as an opportunity to tap into a new market.

"The pool of defined benefit assets is not growing as rapidly as the pool of defined contribution assets," says Aetna's O'Keefe. "Obviously, those defined contribution assets are a key to future funding of all types of assets."

Greenwich Associates reports that the estimated defined benefit net cashflow for 1994 was negative $27.879 billion, while the estimated defined contribution net cashflow for 1994 was (positive) $8.668 billion.

"I don't think the defined benefit market will go away," Dolinoy says, and he talks about developing an investment vehicle to meet the needs of the defined contribution market.

Not only are pension funds thinking about the future, but they're still remembering the mistakes of the past and they're determined not to repeat them.

"Everyone's business instincts seem correct," says Franklin. "However, as more capital flows into the market, and as we see construction start to increase, one ought to be cautious about where cap rates are headed."

Funds and advisers alike do appear to be paying attention to the signs.

"Clients and advisers are more thoughtful than ever about understanding basic investment fundamentals -- both operating market and capital market -- that determine values and risk," says LaSalle's Cummings.

There's a more "healthy" skepticism among pension funds than there was in the past, according to Burns of Boston Financial.

"They're better informed, less-easily sold on things than they were in the '80s," Burns says.

"What's really news on the pension fund front," according to Cohen, "is their attitude has gone from scared to cautious to confident in the last three years; and, therefore, their comfort with risk has gone up.

"They're willing to take a higher position on the risk spectrum," he adds, "and they want to get paid for it."

In an attempt to help remove some of the barriers to pension funds investing in real estate, the National Association of Real Estate Investment Managers (NAREIM), the Pension Real Estate Association (PREA) and the National Council of Real Estate Investment Fiduciaries (NCREIF) have worked together to develop a set of information standards for the industry.

"One of the issues that have been facing pension investment in real estate over the past 25 years has been the fact that the accounting and the performance reporting have not been uniform from investment manager to investment manager," says Charles H. Wurtzebach, president and chief operating officer of Heitman/JMB Advisory Corp., Chicago. "Nor has it been uniform on a basis that makes it easy for a chief investment officer in an investment plan to compare the relative performance of real estate to stocks and bonds, and I believe that, to a great extent, without some uniform standards for accounting it will inhibit the ability of pension plans to get comfortable with investing in real estate," Wurtzebach says.

"We in the industry are trying to make the path smoother," says Jake Young, partner in the Chicago office of Deloitte & Touche Realty Consulting Group. He worked with the industry task force to develop the standards, which are expected to reduce the cost and complexity of information sharing and gathering.

The standards incorporate four categories: investment and asset information, valuation information, performance measurement and the NCREIF-developed market value accounting policies. As the table indicates, many of the standards are based on those already in use by various industry groups.

"Fundamentally, we feel comfortable with the standards," Wurtzebach says. "Part of the challenge is to see how they actually work."

Those interested in the Real Estate Information Standards may write to PREA at 95 Glastonbury Blvd., Glastonbury, Conn., 06033, or call (203) 657-2612 for further information.

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