BOISE, Idaho - Preferring to take a big hit on its real estate portfolio to the smaller writedowns that have persisted since 1990 like a dripping faucet, the $2.8 billion Public Employee Retirement System of Idaho took the unprecedented step of hiring an independent fiduciary to value its commingled fund investments.
The preliminary finding is that the system's 11 funds are, on average, overvalued by 16%, or a total of $28 million, according to the minutes of a meeting in May when the report was presented to the board of trustees.
The conclusions will be used by the retirement system's investment staff and its real estate managers as a starting point to determine what the system believes to be the true value of its real estate investments.
Though introduced at a public meeting of the board of trustees, the report - prepared by Atlanta-based Saylor Property Capital and the Liquidity Fund, Emeryville, Calif. - will not be released to the public.
Pensions & Investments has learned that the funds evaluated are: Cabot Partners' CP Institutional Partners Inc.; The O'Connor Group's Community Center Fund III L.P. and Retail Property Trust; Equitable Real Estate Investment Management's Prime Property Fund; Prentiss Property Realty Advisors' Prentiss Property Acquisition Partners L.P.; LaSalle Partners' LaSalle Street Fund; and Prudential Real Estate Investors' Prudential Property Investment Separate Account (PRISA), PRISA II, Prudential Property Account I, PRACE II and Strategic Performance Fund I.
The range of the preliminary overvaluations is unknown, as are the values ascribed to each fund.
But Robert Maynard, Idaho's chief investment officer, told trustees "the most severe overvaluations ... occur on those large giant funds, such as LaSalle, O'Connor RPT, Equitable Prime Property (and) PRISA."
"The reason we did this," said Jody Olson, an Idaho trustee who initiated the exercise, "is to evaluate if writedowns are appropriate or not. We wanted the writedowns to be at the discretion of the trustees, not the managers," she said.
"When you have writedowns year after year, you start to wonder, and then when the taking of a writedown inhibits (a manager's) marketing, you wonder again what their interest is. We could no longer rely on the managers."
"We are not necessarily saying there is a sinister conspiracy on the part of the managers to consistently inflate values," Mr. Maynard told the trustees at the May 24 meeting. "I think it's more a situation (in which) the managers found themselves on a rocky playing field," he said.
"It's the playing field itself that we have problems with, not necessarily the motivations or the professionalism of the managers."
Pension fund real estate managers have relied on appraisal methodologies to value their client's real estate. These valuations have been found to be inaccurate, and in periods of falling real estate prices, contentious.
In its evaluation of the commingled funds, Saylor/Liquidity Fund applied a methodology that analyzed the commingled funds as if they were real estate investment trusts. It took a top-down analysis, rather than looking bottom-up, at each property in the portfolio.
"Basically, this was a valuation of the units, and not the assets," said Paul Saylor, president of Saylor Property Capital. The analysis was subjective and varied from fund to fund because of their different structures, he said.
"Over the next three to five years, the valuation of private real estate will be increasingly influenced by the approaches being used in the public markets," Mr. Maynard told Pensions & Investments.
Not surprisingly, Idaho's managers - when they were not criticizing the Saylor/Liquidity Fund methodology because it relied on information from annual reports with no additional input from the managers on the specific assets in the fund - said it was inappropriate to apply public REIT methodology to valuing private real estate.
"The public market has emphasized short-term cash flow and hasn't valued the total potential return from an investment," said J. Marshall Peck, managing director with LaSalle Partners, Chicago.
"Our investors look at real estate and not current return. In some instances they are looking at overall return," he said. "A valuation that emphasizes just current income is inconsistent with a total long-term return."
Bruce Macleod, president of New York-based O'Connor's RPT, a private REIT composed of shopping centers, said the public pricing methodology does not assign a value to unoccupied space, as would an appraisal-based methodology using a discount cash flow analysis.
"Unoccupied space has value ... because in the future it will produce income," Mr. Macleod said.
To arrive at a value, the Saylor/Liquidity Fund methodology placed a priority on distributable cash, which Mr. Saylor notes is distinct from - and less than - the income component of return reported by the managers. Thus, the exercise, according to Mr. Saylor, is to determine an appropriate price for commingled fund units that have low distributable cash.
"A lot of funds may have income performance of 8% and distributable cash of 4%," said Mr. Saylor. "The dividend paid in the public market is based on cash distributed. If there is no potential for liquidity, we don't think there is value near where the managers are stating," he said. "Liquidity is important in the private markets. If you can't be liquid, we question if you should be in the private market."
Idaho's commingled funds are illiquid, but it is not a problem for the retirement system if the funds are fairly valued, according to Mr. Maynard.
"What we are looking for and what this evaluation is looking for is free cash flow," said Mr. Maynard. "Whether or not it (cash) comes back as a distribution or is invested in new leasable space or to buy out another investor's interest, we are relatively indifferent.
"If we (were to) conclude that a fund is significantly overvalued, I would want to see cash in hand, rather than see it go to (fund) withdrawals or going to renovations that don't increase net leasable space," said Mr. Maynard. "Cash in hand is better than uncertain cash in the future."
PRISA and PRISA II did not make cash distributions to investors, other than to meet withdrawal requests. Prudential's closed-end funds PRACE I and II and SPF I also did not make cash distributions.
Rick Matthews, a spokesman for Prudential Real Estate Investors, Newark, N.J., said the Prudential funds are not designed to throw off cash. "Any cash would be reinvested in new acquisitions or capital expenditures," said Mr. Matthews.
Atlanta-based Equitable's Prime Property Fund made cash distributions, but only if an investor requested it, according to David Bradford, senior vice president-portfolio management.
"Money is automatically reinvested in the fund." said Mr. Bradford. "An investor that wants to get paid money equal to income can have it done, but it's considered a withdrawal."
For the year, Prime Property Fund generated an income return of 7.7%. Appreciation was negative; the fund depreciated 5.6%, which means an investor that requested income would have its position in Prime Property diminished by the amount of the depreciation.
O'Connor's RPT and its Community Center Fund III, a partnership of four investors, both made cash distributions, according to Mr. Macleod. The dividend yield, which Mr. Macleod claims is the equivalent of distributable cash, was about 5.5% for RPT and 7.5% for CCF.
Robert Angland, president of Boston-based Cabot Partners, declined to disclose CP Institutional Partners Inc.'s cash distribution. But he agreed emphatically with a methodology that places the emphasis on cash flow and distributable cash.
"Is it right?" asked Mr. Angland. "You bet. That's what you invest for. Intrinsic value is no longer a factor," he said.
The LaSalle Street Fund, a private REIT composed primarily of office buildings, had an income component of return of 9.2% (appreciation was -9.9%), a cash yield of 5% and a dividend yield of 2%, according to Mr. Peck.
The dividend yield, however, is not an appropriate measure of performance because it is determined by tax laws that govern REIT distributions, said Mr. Peck. By law, a REIT must distribute 95% of its income.
The cash yield and the income component of return are the more relevant measures of value, he said.
The difference between income and the cash yield was retained for portfolio needs, which Mr. Peck described as money to re-lease space and to "keep the properties current."
Telephone calls to Dallas-based Prentiss Properties were not returned.