Reality check for PREA conference attendees

Harvard professor says lure of emerging markets growth doesn't mean it's easy to invest there

After a long evening of wining and dining, attendees at the Pension Real Estate Association's 22nd Annual Investor Real Estate Conference were brought back to earth by presentations giving a dismal view of the global economy and real estate landscape.

In the opening speech, Carmen Reinhart stabbed a fork in many real estate investors' next great hope for returns. Ms. Reinhart, the Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School, told the crowd that while emerging markets are considered the engine of growth, that doesn't mean investors have an easy time investing in those regions. The conference was held at the Beverly Hilton in Beverly Hills, Calif., Oct. 22-24.

“The common boom-and-bust theme is alive and well in the emerging markets,” Ms. Reinhart noted during her speech. “We are in a situation in which (governments in the emerging countries) don't want too much capital inflow and they have been putting in controls to restrict capital inflows.”

“Emerging markets want to keep capital out. Developed markets want to keep capital in,” Ms. Reinhart said.

Also, financial repression resulting, in part, from increased regulation since the financial crisis will have a negative impact on fixed income, she warned.

Fixed-income assets are getting hit hard by financial repression, which is wreaking havoc on institutional investors' portfolios.

“Governments want to create a captive audience for domestic debt, which are pension funds, insurance companies and domestic banks,” Ms. Reinhart said.

When asked how investors will be able to hit their 7% or 8% assumed rate of return in today's economy, she quipped: ”With a lot of luck.”

“In an era of financial repression, those targets are a tall order,” Ms. Reinhart said.

Investors and consultants who spoke at the conference said they all favor real estate, but gave different reasons for their views.

Stephen Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC in Marina del Rey, Calif., said none of his clients sees real estate the same way. Investors allocate assets to real estate either as a return generator, an inflation hedge or an asset class that hovers between stocks and bonds.

Mr. Nesbitt was a panelist during a session on “Real Estate's Relative Value in an Institutional Portfolio.” The other speakers on the panel were Jon Braeutigam, deputy treasurer and chief investment officer of the Michigan Department of Treasury, Bureau of Investments, and CEO/CIO for the $50 billion State of Michigan Retirement Systems, Lansing; James Walker, managing partner, Fir Tree Partners Inc., New York; and James Williams, vice president and CIO of the $5 billion J. Paul Getty Trust, Los Angeles.

Mr. Braeutigam stressed that the Michigan pension fund is a long-term real estate investor.

Some 10% of the pension funds' total assets are in real estate, said Mr. Braeutigam, who had spent 10 years as administrator of the real estate division before becoming CIO of the Bureau of Investments.

Pension plan officials view real estate as “a diversifier with returns between stocks and bonds, in a perfect world,” Mr. Braeutigam said.

“I don't think inflation is coming around the corner any time soon,” he told the crowd, although there may be modest inflation in four or five years.

Mr. Williams explained the J. Paul Getty Trust has 8% allocated to equity real estate and 5% in mortgages and credit that is sprinkled throughout the trust's portfolio, including in fixed income and hedge funds.

Trust officials have taken “an opportunistic or value-add view” of the real estate credit market, he said. Recently, the trust has made more investments in real estate credit than in equity real estate

“We do not worship at the altar of diversification,” Mr. Williams said.

“Real estate has to compete for dollars” with the other alternative investments, he said. ”We are not just trying to hit a target of 8% or 10%, but we are comparing asset classes and allocating opportunistically to where we can get the best risk-adjusted return.”

At the same time, the trust tries to have enough liquidity to “keep the trustees off the ledge,” he joked.

In general, trust officials try to have enough liquidity to last four years, Mr. Williams said.

Right now, 50% of the fund is relatively liquid, the other half of the fund is invested in alternative investments, he said.

Mr. Nesbitt cautioned that investors are in a risk-on/risk-off world and that real estate is a risk-on asset class. Real estate investment trusts have performed well during the past 20 years, but core real estate funds are “liquidity challenged.”

“I don't see continued core real estate allocations,” Mr. Nesbitt said.

While sovereign wealth funds and big institutions will maintain their allocations to core or stabilized real estate, core allocations overall will go down, Mr. Nesbitt predicted.

Even though opportunity real estate fund returns have been “mediocre at best,” Mr. Nesbitt said investors are looking for debt or opportunistic real estate investment that can demonstrate “value add.”

Mr. Walker interjected that opportunistic real estate is “scalable, complex and often misunderstood.”

Investors today are looking at real estate differently. There's a new interest in residential real estate, which in the past was not considered an investible asset class for institutional investors, Mr. Walker said.

However, Michigan's Mr. Braeutigam said his pension fund sold most of its single-family real estate investments before the financial crisis and wrote down the rest.

“It's difficult to invest in single family on the equity side,” he said.

There's more opportunity on the debt side, Mr. Braeutigam added. The Michigan retirement funds have invested 5% in credit strategies including commercial mortgage-backed securities, residential mortgage-backed securities and mezzanine debt.