BEVERLY HILLS, Calif. - Real estate managers were hoping that general consultants at a panel on asset allocation at the Pension Real Estate Association's 12th annual Plan Sponsor Real Estate Conference earlier this month would make the case for raising real estate allocations. Instead, they learned that pension funds have used other techniques to diversify: increasing exposure to hedge funds; cutting back international equity allocations; and making only slight shifts in their real estate portfolios.
Terry A. Dennison, principal with William M. Mercer Investment Consulting Inc., Chicago, said the biggest change he has seen has been a reduction in international equity allocations, because of the convergence of domestic and international equity returns. "It (international equity) used to be 20% of assets, and it's been slipping back to 15% of assets," he said. As for real estate allocations, Mr. Dennison explained many sponsors believe they are spending 80% to 90% of their time on only 10% of their assets. "The allocation (to real estate) isn't higher because equities have produced the greatest value. If it (the real estate allocation) goes higher, people are not comfortable. They don't seem to want to up it."
Matthew Lincoln, consultant at Cambridge Associates Inc., Boston, said his firm has been recommending increased diversification through hedge funds, especially in arbitrage event-driven strategies, but he believes there could be problems with such strategies going forward. Cambridge also has pushed for more investments in real estate investment trusts, because they have been trading at a 20% discount, which has offered an unusual buying opportunity. Some clients did rebalance into REITs, cutting back on stocks, he said. He expects real estate allocations at endowments and foundations to climb modestly higher over the next 10 years.
Recommended by Russell
Robert Blackwell, director of client services at Russell Investment Group, Tacoma, Wash., noted, "People have a tendency to overinvest in stocks during a strong market." He added Russell has been recommending real estate as a diversifier, and clients' appetite for both real estate and private equity has grown.
Frank Blaschka, principal with The Townsend Group, Cleveland, who moderated the panel, asked the panelists what the real estate industry can do to make clients more comfortable about raising their allocations.
Mr. Dennison responded that buying real estate means buying specific properties, which by its nature is inefficient. "The business doesn't offer convenience of pricing. It's an inefficient class, and quite different than owning stocks or bonds. In contrast, private equity has been getting a strong play." That asset class is easier to invest in, according to Mr. Dennison, because it involves ownership of the equity of a company, where the governance and ownership structure are quite different (than that of real estate). "You don't own the physical object, which is subject to problems. In private equity, the manager is seen as having more control, and an investment doesn't require as much interaction as real estate does," he said.
Cambridge's Mr. Lincoln added that private equity offers investors greater profitability than real estate, which is so capital-intensive. "If a fund has only a certain amount to put into illiquid instruments, there is going to be a greater upside from private equity than from real estate."
Mr. Blackwell advised real estate managers they could raise more institutional money by targeting midsized funds with no allocation to real estate, rather than trying to coax larger pension funds to increase existing allocations.
He added that even though real estate investments can offer investors high income, there are liquidity issues, which makes equities a better choice.
"The trend in real estate allocations is down because many pension funds have a `something else' category, where real estate shares shelf space with other asset classes, and real estate has been losing out to the others," summed up Mr. Dennison.
"But the real 900-pound gorilla is the growth of defined contribution plans at the state level; these are creating competition for defined benefit plans. It will be very difficult for real estate managers to get themselves included in the options lineup since the burden is on the sponsor to be sure his selections are appropriate, and there is no reason to add exotic options."
Alternatives future bright
He predicted defined benefit plans will continue, but that they will shrink; alternatives, meanwhile, will broaden, allowing sponsors to consider a variety of investments including spinoffs, venture capital and real estate. He expects the overall allocation to alternatives will range from 5% to 10% of assets.
In another panel, relating to the mood after the Sept. 11 terrorist attacks, the consensus was that investors are in a "wait-and-see mode." Allison Thrush, director of investor relations with Fortress Investment Group, New York, said: "They're not shifting out or moving in, but are processing the downturn, to see how it will affect them."
"They're also waiting for the bid-ask spread to narrow, but some did sell, because they couldn't wait any longer," added Tim Hoepper, managing director of real estate at the $4 billion MacArthur Foundation, Chicago.
But the economic downturn also means opportunities. Steve Draper, investment officer-real estate at the $48 billion Washington State Investment Board, Olympia, predicted the next gutsy play could be hotels, a sector that has fallen out of favor in the past year.
Mr. Hoepper also thought hotels could be a good buy, adding he also might look at the retail and senior housing sectors.