Pooled real estate fund PRISA paves the way for pension funds looking for a new way to invest.
U.S. Steel Corp.'s pioneering Harvey Moule, who had put his fund into domestic and international stocks before practically any other corporate fund, also pushed into real estate investments. Beginning in 1957, he did sale-leasebacks to major corporations and invested in timberland.
Another pioneer was General Electric Co., which started investing in real estate around 1960. GE mostly did sale-leasebacks, purchasing office buildings, warehouses and manufacturing facilities and leasing them back to the sellers.
But real estate investment remained relatively rare before 1973. Too often, plan sponsors' investments in real estate involved the pension fund buying corporate property, and the deal benefited the employer as much as, or sometimes more than, the pension fund.
The real estate field presented problems for pension funds, with its wide range of return and risk and differing cash flow characteristics. But efforts were under way to create a real estate market for pension funds.
PRISA'S ORIGINS
Meyer Melnikoff of Prudential began thinking about real estate as an investment for pension funds early in 1967. He began to research real estate as an investment, but found the written record very sparse. By chance he heard about the Pension Fund Property Unit Trust of London, a pooled fund for real estate investment managed for British pension funds.
Drawing on the British experience, Mr. Melnikoff began to structure his pooled real estate fund, to be known as Prudential Property Investment Separate Account, or PRISA. The first task was to make sure it would work under the insurance laws of New Jersey, New York and other states, that it wouldn't run afoul of any Securities and Exchange Commission requirements, and that it would satisfy federal tax laws and IRS regulations.
When it cleared all these hurdles, PRISA was activated on July 31, 1970, receiving its first assets from the retirement plan for Prudential employees. (Unbeknownst to Mr. Melnikoff and his Prudential colleagues, Wachovia Bank and Trust Co. of Winston-Salem, N.C., had established a commingled real estate fund for pension funds in 1968, but except for Wachovia's own pension clients, its existence was virtually unknown.)
Marketing the new separate account proved to be tough. The top investment officer at one of the nation's major pension funds asked Mr. Melnikoff how much leverage PRISA would use. Mr. Melnikoff said PRISA would not create any debt and would limit the leverage to that resulting from buying mortgaged properties. The pension executive replied he would not be interested in PRISA unless it leveraged up 400% to 500%. That kind of leverage was not unusual in real estate investment trusts at that time.
Mr. Melnikoff did not know it, but that leverage in REITs would cause him problems in the reverse way two years later.
No one foresaw what was about to hit the U.S. economy. The country was entering a prolonged recession, while inflation began a dramatic rise. At the same time, interest rates rose and the stock market stumbled. The REITs, which were highly leveraged, were soon in trouble, and many were liquidated with large losses to their investors. Mr. Melnikoff had to spend a great deal of time explaining to pension fund executives why PRISA was not like a REIT, especially the REITs that had failed.
It would take time, but by 1975 PRISA was on its way to being successful, and other insurance companies were rushing to develop and market their own real estate separate accounts. Other real estate management firms would soon emerge. Pension funds had begun pouring their assets into real estate, and the very size of those flows would change the industry.
SEEKING ALTERNATIVES
Post-1974, while pension fund executives were still trying to come to terms with ERISA's implications, they also were trying to adjust to the bear market. Pension executives were looking for alternatives -- investments that would be more stable than stocks and bonds, or at least would not be affected by the same economic forces at the same time.
And because of the advent of PRISA and the missionary work of Mr. Melnikoff and his colleagues, many funds were considering real estate as an alternative.
By July 1974, 34 of the 100 largest corporate plans were investing in real estate, excluding mortgage investing, and other funds were actively seeking to invest in real estate.
The Nevada Public Employees' Retirement System announced it would seek legislative approval to invest part of its $250 million in assets in real estate. Vernon Bennett, executive officer, said trustees hoped to invest 5% to 10% of total assets in real estate.
By July 1974, PRISA had $450 million in assets from 85 clients. But PRISA no longer had the field to itself. At least four major insurance companies and several banks had established real estate separate accounts or commingled funds. Equitable Life Assurance Society of the U.S. took in its first client in August 1973; Metropolitan Life started its account in 1972; New England Mutual Life Insurance Co. also started its account in 1972; and John Hancock Mutual Life had $70 million in its separate account by July 1974.
Among the banks, the first after Wachovia was First National Bank of Chicago, which established Fund F (named because it was the sixth of the bank's commingled trust funds) in 1972.
Fund F truly was started to meet client demand. In 1970, the First National Bank of Chicago bought a real estate consulting firm called Real Estate Research Corp. The firm was bought, not for any specific purpose, but because it was available and the price seemed right. During the next two years, First Chicago noticed RERC was putting a number of the bank's trust clients into real estate. Clearly, pension funds had a demand for real estate investment expertise. By July 1974, Fund F had gained 32 pension and profit-sharing fund clients and had about $65 million invested.
In the Southeast, Wachovia found itself in a battle with North Carolina National Bank and Citizens & Southern National Bank in Atlanta. Wachovia had a head start, and by 1974 had $12 million in its commingled real estate fund.
DIRECT INVESTING
Pension funds clearly preferred the commingled or pooled approach, where they owned parts, along with other pension funds, of a number of properties and therefore had more diversification. Still, some pension funds chose to have separate real estate accounts, through which they would purchase 100% of a property themselves.
Southern Bell Telephone Co.'s $550 million pension fund, for example, hired Wachovia as a separate account manager. By mid-1975 this account had assets of $30 million in 10 properties, including a $7.5 million, 500,000-square-foot, 51-store shopping mall in Atlanta, and a $12 million, 26-acre industrial and office park, also in Atlanta.
The FMC Corp. pension fund, then with $300 million in assets, was among the first to invest directly in real estate when it bought a 2,800-acre ranch in Texas. FMC's intent was to hold the land for future development, and in the meantime, lease it for cattle grazing to pay the taxes.
TIGHT MARKET
By mid-1975, however, PRISA was turning down some accounts because it could not find sufficient good properties. Mr. Melnikoff blamed a decline in short-term interest rates, which, he said, encouraged people to hold buildings they otherwise would have had to put on the market.
First Chicago's Fund F also was having difficulty finding quality properties. It had grown to $80 million by midyear and begun to slow the rate at which it accepted new clients.
At that time, most of the 100 largest corporate pension funds had either made initial commitments to real estate or were studying the asset class. But it was to be tough going for the next several years because there was relatively little nonresidential construction in the mid-'70s due to inflation and economic uncertainty. At the same time, pension funds were trying to pour significant amounts into the asset class, and as a result, yields on the investments were declining.
Nevertheless, economic conditions, particularly high inflation, turned pension fund executives' attention even more toward real estate.
The Standard Oil of California pension fund, for example, boosted its real estate commitment to 4% from 1% of its $800 million in assets during 1979, and then raised the target to 10% by early in the '80s. R.L. Norman, manager of financial analysis for the fund, said officials were seeking real returns between 1% and 5% from their real estate holdings.
Such was the rush into real estate that the assets of PRISA jumped $500 million between the end of 1979 and June 30, 1980.
CLOSED-END OPTION
Pension executives were beginning to look beyond the open-end funds such as PRISA and were willing to tie their assets up for eight to 10 years in closed-end funds.
The Rosenberg Real Estate Equity Funds were the largest of the closed-end funds, with assets of $600 million in five funds by June 30, 1980.
However, late in '81 there was a hint of trouble on the horizon. Prudential announced in August that it would take in $1 billion in new commitments for its PRISA I and PRISA II accounts by the end of the quarter. However, it fell more than $200 million short of its ambitious target. And in October, the real estate consulting and management company of Julian Studley & Co. warned the office market boom had peaked. Another omen? Meyer Melnikoff, the father of PRISA and pension fund real estate investing, retired from Prudential.
Real estate investing developed indigestion in 1982. While some funds, particularly AT&T and a number of public employee pension funds, continued to commit money to real estate, other corporate funds were pulling back, particularly to open-end funds such as PRISA.
Some wanted out of PRISA so they could invest directly. A few wanted to step back and see which way real estate investing was likely to move.
In addition, new real estate investment organizations were starting and they all had marketers out in the field offering something supposedly better than PRISA.
As a result, PRISA, which by this time had $4.2 billion in assets, suffered a surge of withdrawal requests in the first quarter of 1982. Contractually, PRISA was not obligated to honor withdrawal requests until the quarter after the request was made. Previously, so much money had been flowing into PRISA that it had been able to honor the infrequent withdrawal requests almost immediately from cash flow. Now, however, the withdrawal requests exceeded cash flow, and PRISA had to ask funds to wait for their money.
WITHDRAWAL HEADACHE
A Prudential executive at the time noted PRISA had about 60 competitors, and the competition had slowed the flow of funds into the account. In addition, many funds had reached their target level for commitment to real estate and were not making additional commitments to PRISA. The Prudential executive said a number of requests were from funds where the appreciation in the value of PRISA shares had pushed the funds beyond their real estate targets. At the end of March, the withdrawal requests totaled $150 million from 19 clients. By the end of June that amount had risen to $259 million from 26 clients.
The publicity about PRISA's withdrawal problems caused a slowdown in real estate commitments until mid-1983, when the pace of activity picked up again.
By 1984, defined benefit funds once again were pouring money into real estate investments. The Florida State Board of Administration hired five managers to invest $265 million through open-end funds. In midyear, 15 institutions, including at least five major pension funds, committed $150 million to Corporate Property Investors, a private REIT more than half owned by institutions.
A number of large pension funds also invested in timberland through pooled vehicles offered by Travelers Insurance, John Hancock, the First National Bank of Atlanta and Wagner Southern Forest Investments. But timberland would remain very much a minor investment vehicle for pension funds, as would agricultural land.
PRISA was still experiencing high withdrawals, as some pension executives moved to direct investing from pooled investing. Nevertheless, Prudential Insurance remained the largest manager of pension investments in real estate, and at the end of 1985 pension funds had more than $30 billion invested in real estate.
DARK TIMES
But the outlook darkened in 1986. Late in 1985, commingled fund returns fell, and quality properties also became scarce as interest rates fell.
Some sponsors of open-end funds closed them and sold off some of their properties. Goldman, Sachs & Co. announced it would close its fund, send $100 million in contributions back to the clients and concentrate only on megadeals for separate accounts. Bank of America also announced it was closing its $80 million open-end fund and would sell off the properties, as did Crocker Real Estate Investment Group.
Other open-end funds continued to suffer from withdrawals as a result of terminations, the down market in real estate and a shift to closed-end funds and direct investing. While other funds were cutting back on real estate, the newly spun off regional Bell operating companies were bucking the trend. Between mid-1984 and mid-'86, they hired a total of 23 real estate managers to control their own destinies in real estate investing. At the same time, they were preparing to withdraw from the Telephone Real Estate Equity Trust, the $4 billion private REIT established by AT&T before the Bell system breakup.
The real estate returns for the 1980s were about equal to the returns on bonds. While the Shearson Lehman bond index returned 11.27% for the 10 years ended June 30, 1989, the median open-end real estate fund returned 11.8% before fees, and the median closed-end fund returned 11.6%. For the last five years of the decade, the results were even worse: Annual real estate returns were only 8.7%, compared with 13.2% for bonds and 20.3% for stocks.
This was not what real estate managers had promised pension funds. They had promised equity-like returns with lower risk. Many pension funds were disappointed.
However, as the decade ended, the situation seemed to be improving. For example, PRISA's assets were rising in value after four years of decline because of increased new client contributions, reduced client withdrawals and better investment returns.
Houston's property market, one of the nation's weakest in the mid-'80s because of overbuilding during the oil boom, appeared to be rebounding, and office vacancies around the nation had begun to drop. In addition, commitments to real estate jumped 20% in 1989, taking total real estate investments to $113 billion, making pension funds major owners of office buildings, shopping centers and industrial properties.
FALSE HOPE
But the light at the end of the tunnel proved illusory, in large part because of the savings and loan crisis, which dumped hundreds of billions of dollars in real estate on the market at distressed prices.
S&Ls had been major sources of financing for developers in the 1980s, and while they were now out of the market, the Resolution Trust Corp. was trying to market many of the buildings they financed at a time when office supply equaled 20 years of demand in many markets and 100 years of demand in some.
In addition, the bankruptcy of Federated Department Stores Inc. suddenly threw into question the value of shopping malls pension funds owned through pooled funds.
Looking at the S&L situation, the office supply vacancy figures, the probable drop in mall values as overextended retailers went bankrupt, along with the economic outlook, many pension funds decided to cut their real estate commitments.
Withdrawals hit one of the oldest of the real estate open end funds, First Wachovia's. Early in 1990 the fund's clients filed to withdraw 37% of its $385 million in assets. Travelers Insurance Co. decided to liquidate its Separate Account R, sparking threats of lawsuits over how the assets would be allocated among the participant funds. First Chicago's Fund F also was sued by pension funds seeking return of their assets.
By midyear, the rush to exit real estate pooled funds was on in earnest as pension funds filed to pull $1.9 billion from open-end funds.
This forced some funds to sell properties to meet the redemptions, further weakening the real estate market. While some of the withdrawn money was earmarked for direct investing, it would not flow rapidly back into real estate as the investors looked for bargains.
The situation worsened when Canada's Reichmann brothers, owners of real estate developer Olympia & York, had to sell some of their U.S. holdings as a weak U.K. property market threatened their huge Canary Wharf development in London.
The difficulties continued into 1991, presenting a problem for The RREEF Funds, some of which were maturing. The principals of the firm, and many of the pension fund clients, did not want to sell the $175 million in property held by the three maturing funds in the middle of a weak market. But some other clients wanted to get their money out of the funds and reallocate it elsewhere. The debate over how the sale could be avoided continued for some time.
Meanwhile, pension funds again cut their allocations to real estate, and the $22 billion IBM pension fund froze its allocation at 10% of assets. IBM officials said even if the allocation dropped below 10% because of the growth of the fund, or a decline in property values, they would not buy more.
MANAGERS CUT BACK
The declining interest in real estate affected the management professionals. Prudential Insurance, the largest manager of real estate investments for pension funds, with about $5 billion in assets, laid off 10% of its 1,100-person real estate staff. Soon afterward, Equitable Life Assurance, the second largest manager with $3.7 billion in assets, laid off 90 real estate employees.
When the real estate investment returns were in for 1991, they were horrendous. The median fund had a return of -8.6%. The previous low median total return was 2.2% in 1990. The value of the assets in the JMB Institutional Realty Corp. Fund IV dropped 25.2% in 1991 alone. Income of 4.6% helped bring the total return to -20.6%. The LaSalle Street Fund of LaSalle Advisors Ltd. lost 18.25% of its property value, but income of 5.86% improved total return to a loss of 12.39%.
The terrible results were the result of writing down the values of buildings in the funds. In some cases, the buildings were written off. GE Investments, the investment arm for General Electric Co.'s pension fund, placed two buildings in which it had the majority equity interest into bankruptcy when the values fell below the mortgage. And because of the declines in the market values of the assets they managed, realty money managers reported the total real estate equity assets they managed for pension funds declined to $94.9 billion in 1992 from $101 billion a year before.
But some pension executives were beginning to wonder if it was not time to buy. At the end of 1992, the Virginia Retirement System committed $420 million to real estate investing, on top of the $700 million it already had invested in property. However, the move was early as companies began massive efforts to reduce their employee headcounts, bringing about huge layoffs and greatly cutting the need for office and industrial space.
Some pension funds began to recognize their real estate losses. In mid-1993, the $16 billion Washington State Investment Board wrote down a $450 million real estate portfolio to $250 million. The Washington Board and the $24 billion Ohio State Teachers' Retirement System sued The New England Mutual Life Insurance Co. and its real estate subsidiary, Copley Real Estate Advisors Inc., over investments Copley made for them.
Late in the year PRISA, the grandfather of all open-end real estate funds, received a black eye when Mark Jorgensen, the $2.3 billion fund's portfolio manager, charged that appraisals of its properties had been inflated. Mr. Jorgensen had apparently been demoted and reassigned after expressing his unhappiness with the appraisals to his superior, and filed suit to regain his former position.
GROWING OPTIMISM
There was one bright spot in the real estate investment picture -- timberland. Although still a minor asset class, some pension funds found it attractive. As John Carroll, then president at GTE Investment Management Co., noted, even when the value of the property did not change, the trees on the property still grew at least 4% a year, faster in some parts of the country.
Hancock Timber Resources Group reported in September 1993 that it had $2 billion of pension and other tax-exempt assets invested in timberland, up from $1.3 billion the year before. Much of that gain was the result of appreciation in the value of the property because of a rise in timber prices. Hancock announced nine new clients for the fund a month later, including the Michigan Municipal Employees' Retirement System, the Hoechst Celanese Corp. pension fund and the Colorado Fire & Police Pension Association.
By mid-1994, pension funds once again appeared to be increasing their commitments to real estate, driven by disappointing returns in the stock market and a growing feeling that the real estate market had bottomed. Real estate managers reported their assets under management in June 1994 were 2.8% greater than a year earlier, adjusted for 4% investment returns. The nation's pension funds by then had about $120.4 billion invested in real estate. The improved outlook continued into 1995 and by the end of June, the value of real estate managed for pension funds had climbed to $136.8 billion.
Nevertheless, the tougher property market was still having an impact on real estate management firms. From 1990 to 1994, the number of real estate investment management firms fell to 73 from 130. Among those to disappear was JMB Realty Corp., one of the pioneers of the closed-end approach to real estate investing for pension funds, which was acquired by Heitman Financial Corp.
The consolidation continued into the mid-'90s, as firms such as Copley Real Estate Advisors and AEW Capital Management merged, and Lend Lease Corp. acquired Equitable Real Estate Investment Management.
NEW APPROACH
While pension funds continued to move their assets into real estate during the next three years, many changed their approach. Some spurned the open- and closed-end commingled real estate funds in favor of direct investing with one or two other pension funds, or they went to the opposite extreme and invested through real estate investment trusts, which are, in effect, open-end real estate mutual funds. The pension funds hoped the public nature of REITs would give them almost the liquidity of common stocks with returns better than those of fixed-income investments.
Not every fund liked real estate's prospects. Digital Equipment Corp. executives announced late in 1995 they would gradually sell all of the pension fund's real estate investments because they believed stocks and bonds would outperform property over the long run. Connecticut Trust Funds started exiting real estate investing in mid-1996, and Shell Oil Co. sold its $100 million in commingled real estate investments. But still, by mid-'97, total pension fund commitments reached $145 billion.
