What is the largest category of real estate in the United States, and also the category that has had almost no pension equity investment? The answer is, single-family housing.
The total value of U.S. real estate is estimated to be $3 trillion, fully 50% of which consists of single-family homes. Yet pension equity investment in homebuilding, with the exception of the much publicized equity commitment of $375 million by the California Public Employees' Retirement System, has been virtually non-existent. Plan sponsors have limited their exposure to low-risk securitized pools of mortgages collateralized by owner-occupied single-family homes.
One reason pension funds have not been equity investors in single-family homes is that the homes ordinarily are owned by their occupants, not third-party investors. The only practical way for an institutional investor to acquire an equity stake in the single-family sector is by investing in homebuilding.
Until recently, however, there has been little impetus for pension investing in homebuilding because banks and thrifts provided all of the capital that was necessary. Since 1989, the world has changed dramatically. Congress, bank regulators and Wall Street have forced traditional sources of financing to cut the capital available for homebuilding by more than $40 billion. As a result, pension funds have begun to consider financing housing production.
One of the largest obstacles in pension investing in homebuilding has been the perception that homebuilding is simply social investing, and is not suitable for bottom-line-oriented investors. This view is surprising in light of the fact that U.S. banks and thrifts, which are not exactly eleemosynary institutions, channeled nearly $150 billion a year into homebuilding in the 1980s. Indeed, the predominant source of funds for the single-family homebuilding industry, which represents approximately 5% of the U.S. economy, always has been profit-seeking private sector investors.
A study my firm prepared sheds some light on the suitability of equity investments in homebuilding. The study, which relies upon audited homebuilding data covering the construction of approximately 350,000 single-family homes (valued at more than $50 billion), shows single-family homebuilding produced substantially stronger performance than all other forms of investment real estate, as measured by the Russell-NCREIF Property Index, produced by Frank Russell Co. and the National Council for Real Estate Investment Fiduciaries.
In addition to offering the highest risk-adjusted rate of return, homebuilding provides broader diversification than other forms of real estate. The same study showed that among real estate categories, returns from homebuilding had the second lowest cross-correlation with other categories, after apartments. Homebuilding returns also show a very low cross-correlation with stocks, bonds and inflation.
The combination of high risk-adjusted rates of return and low cross-correlations with other investments means homebuilding investments can increase a portfolio's return while lowering its overall level of risk. Indeed, according to the study, a plan sponsor whose real estate portfolio duplicated the Russell-NCREIF index could have increased its returns by almost 200 basis points per year from 1980 to 1990 by including homebuilding in its portfolio. At the same time, the addition of homebuilding would have lowered the real estate portfolio's standard deviation (level of risk) by 13% during the same period.
If homebuilding has such appeal when measured by traditional investment yardsticks, why haven't more funds invested in it? Apart form a prejudice among some investors that investing in homebuilding is social investing, the homebuilding industry suffers from an image problem. As far as many institutional investors are concerned, a homebuilder is the fellow who remodeled the investor's kitchen at twice the cost, taking three times as much time as the builder promised.
In actual fact, homebuilding on an institutional scale is a highly sophisticated industry. Its returns are far more predictable and its risks are significantly lower than many believe. A study by the U.S. Office of Thrift Supervision found the average annual loan charge-off rate for single-family construction lending from 1990 to 1992, (the worst period in the thrift industry's history for real estate lending), was less than 65 basis points. During the same period, the charge-off rate for office buildings was five times this level.
The lack of direct pension fund investment in homebuilding is even more surprising in light of homebuilding's acknowledged social benefits. The National Association of Homebuilders estimates that every home constructed creates 1.8 jobs. If this figure is correct, the $375 million California Employees' program, if fully leveraged at about 2 to 1, has the potential to create as many as 15,000 jobs per year.
Because homebuilding is such a specialized industry, pension funds that do invest in this area inevitably will turn to professional investment managers. Some firms are dedicated exclusively to managing institutional investments in single-family homebuilding. Others, including Prudential Realty Advisors, Wells Fargo Bank and Bankers Trust Co., have established groups within their organizations for managing homebuilding investments.
Each of these firms has their own investment style. Some structure their investments with builders as joint ventures or participating loans, while others actually own the homebuilding project and hire the builder to construct the homes for a fee. My firm's portfolio of investments in 23 projects on behalf of the California Employees' fund is generating an average return of more than 35% on a leveraged basis. Other investment managers in the California Employees' program also are reporting strong results.
It is probably only a matter of time before single-family homebuilding becomes commonly accepted by institutional investors. Given homebuilding's superior returns, surprisingly low level of variability and diversification benefits, homebuilding satisfies the most rigorous test of the modern portfolio theorist. The fact that homebuilding also creates jobs, provides shelter for young families and stimulates the economy should not be held against it. Fortunately, there is no iron rule that investors cannot do well for themselves while they are doing good for others.
James Z. Pugash is president, Hearthstone Advisors, San Francisco, Calif.
