Tax-exempt real estate assets of the 50 largest managers grew modestly in the year ended June 30, inching up 6.8%, vs. a hefty 21% gain in the previous year, according to Pensions & Investments' annual survey.
Managers that did experience growth got it mainly from real estate investment trusts, mezzanine debt, core and value-added strategies. In real estate equity, income-generating properties were favored, and will continue to be in the year ahead, according to several managers.
While overall growth among the top 50 real estate managers was unimpressive, there was a huge increase in mezzanine debt, which surged 83.9%, according to the survey. Hybrid debt, meanwhile, plunged 62.1%, and real estate equity inched up a mere 1.2%. The commercial mortgage-backed securities market, which also has been in favor, gained 10%. For the first time, P&I analyzed assets in REITs and real estate operating companies separately. In previous years, REOCs were included under the REIT category. Had they been combined again this year, they would have posted a 37.5% gain from last year.
Reflecting the increase in managers' foreign investment, P&I ranked managers by total worldwide real estate assets under management. Firms profiled, however, still reflect the top 50 managers within the U.S. institutional tax-exempt market, and all comparisons in this story are based on U.S. institutional tax-exempt assets. The 2001 survey ranks 102 managers, 15 more than the previous year. Despite the additional firms, overall growth was moderate, up 10.8%, vs. 19.8% the previous year. But total worldwide assets grew considerably, up 18.7% - including Deutsche Realty, which did not report the previous year - vs. 9.7% for 2000. (Excluding Deutsche, assets were still up 12.5%.)
The leading firms
The top three managers - TIAA-CREF, New York; J.P. Morgan Fleming Asset Management, New York; and Lend Lease Real Estate Investments, Inc., Atlanta - maintained last year's rankings, while RREEF, Chicago, and Principal Capital Real Estate Investors, Des Moines, flipped positions to rank fourth and fifth, respectively.
Several managers interviewed said that between the economic downturn and the World Trade Center disaster, transaction activity in recent months had practically halted. At the same time, the spread between what sellers asked and buyers offered has widened considerably.
"We're looking at the prospect of activity over the next 60 to 90 days being totally dead," said Jerry Barag, chief investment officer at Lend Lease. "Real estate is performing well, but investors aren't paying much attention. They're more concerned about their domestic stock portfolios and are thinking about that. At the same time, the real estate market is unsettled. People are waiting for a direction before trading. We think a direction will emerge in the next 60 days."
Overall tax-exempt assets at Lend Lease were down around $900 million in the 12 months ended June 30 because of some old closed-end funds were liquidated, and a fair amount of selling to take advantage of a strong market, Mr. Barag explained. He saw more activity in multifamily housing, which became the investment of choice compared with recent years, when office buildings had been the favored sector. At the same time, the firm did see an increase in its core separate account business, and the $2.8 billion Contra Costa County Employees Retirement Association, Concord, Calif. hired it for a $140 million REIT mandate, its first.
At top-ranking TIAA-CREF, the growth in tax-exempt assets came mainly in mortgages, which climbed to $22 billion from $20.9 billion a year ago, and CMBS, which grew to $7.7 billion from $5.9 billion. Joe Luik, senior managing director for the TIAA mortgage and real estate division, said he was cautiously optimistic about the future, and he believes both debt and equity real estate products will provide plenty of opportunities for returns that will be superior to other alternative investments. "Presently, I see prudence on the part of lenders on the debt side, which would forestall any dramatic overbuilding in the market," he said. "The equity side, however, is extremely competitive for quality products as pension funds increase their allocations to the real estate sector. And with interest rates being at historic lows, moderately leveraged properties should produce superior returns."
Real estate allocations that were shifted by pension funds last year grew without new investment as equity allocations fell because of the sagging stock market, noted Joe Azelby, managing director at J.P. Morgan Fleming. "It's called the denominator effect," he said. And some of the pension funds that were overallocated to real estate took some redemptions, which contributed to the firm's overall flat performance, he said. Yet, at the same time, many pension funds revisited the asset class and invested in REITs, core, mezzanine and CMBS strategies. In core products, the focus was on the residential sector, he said. The firm took in $100 million in new separate account money overall, and it expects that to grow to $300 million in the next year. But some clients that recently hired Morgan have deferred funding those programs until next year, mainly because of the softening economy and the World Trade Center disaster. Like Lend Lease's Mr. Barag, Mr. Azelby also noted that the widening spread between buyers' and sellers' prices has led to a slowdown. But he predicted that transactions will start taking place again before the end of the year.
Bucking the trend
RREEF bucked the trend toward flatness, however, and took in $2.7 billion in new tax-exempt money. Stephen Steppe, principal in charge of client relations, said around $1.5 billion came from separate account clients, including the $45 billion pension fund of Lucent Technologies, Murray Hill, N.J; the $34 billion pension fund of AT&T Corp, Basking Ridge, N.J.; the $5.9 billion pension fund of Textron, Inc., Providence, R.I; the $30.6 billion Los Angeles County Employees Retirement Association, Pasadena, Calif.; the $155 billion California Public Employees' Retirement System, Sacramento; and the $13.6 billion San Francisco City & County Employees' Retirement System. Another $500 million went into its publicly traded REIT strategies, which received allocations from such clients as the $32 billion Public Employees' Retirement Association of Colorado, Denver; the $63 billion pension fund of SBC Communications, Inc., San Antonio; and the AT&T pension fund.
The firm in the last year has focused on low-risk, core strategies that use little leverage, mainly in the industrial and apartment sectors. Mr. Steppe expects that trend to continue, noting that "This is the time to be very defensive, because you're managing for cash flow."
At Principal Capital, U.S. institutional tax-exempt assets fell by $1.1 billion during the survey period. Frank Schmitz, director of institutional marketing, noted that the company needed to reduce its balance sheet to conform with requirements as it prepares to go public in the next month. "We sold $1.2 billion in real estate assets for one client, but other clients have been adding assets," Mr. Schmitz said. The firm added $200 million last year and also won a couple of mandates that haven't been funded yet. Clients have been interested primarily in the firm's value-added and core strategies. In addition, it has received commitments for its new high yielding debt mandates and increased assets in its open-end core fund. Currently Principal is marketing a new fund focused on industrial and multifamily markets.
At Heitman LLC, Chicago, much of the activity in the past few years has been selling off commingled funds that were started in the 1980s, said Mary Ludgin, president and chief executive officer. "We sold $6 billion worth of property in the last five years and are nearly done," she said.
While the firm's overall tax-exempt assets slid by $140 million year over year, due to the selling volume, the firm took in $1 billion in new money, with about 55% from separate accounts and 45% from joint ventures in which Heitman clients teamed up with a REIT or private REOC. The firm's publicly traded REIT business also grew to $639 million from $596 million. The firm focused on apartments, community retail centers and industrial and suburban offices, making new investments on behalf of such clients as the $32 billion Colorado Public Employees Retirement Association, Denver; the $111 billion California State Teachers' Retirement System, Sacramento; the $115 billion New York State Common Retirement Fund, Albany; and the $30 billion Pennsylvania State Employees' Retirement System, Harrisburg.
Ms. Ludgin said some of the firm's clients have been actively seeking investment opportunities in the aftermath of the World Trade Center attack. "We believe it makes sense. While returns will be down in the near term, with lower rents and higher vacancies, we expect the market will bounce back."
Tom Dobrowski, managing director real estate and alternative investments at General Motors Asset Management, New York, also believes the Sept. 11 disaster could result in good buying opportunities. "I don't think the CBD (central business district) sector will go away, despite the disaster. It still has certain attractions. But some companies are more likely to spread out, which could result in more growth in more suburban markets."
Nevertheless, most managers expect the softening in real estate that started before Sept. 11 to increase, particularly in the office market - except for New York and Washington, where demand is likely to be higher.