William J. Maher, director of North American research and strategy for LaSalle Investment Management Inc., Chicago, said half or more of the pension plans he deals with are looking at increasing — or have increased — their leverage.
That's because"they are recognizing the historic low interest rates and are hedging their bet by backing low interest rates," he said.
Bob Fabiszewski, senior vice president and managing director, GMAC Institutional Advisors LLC, Horsham, Pa., said institutional investors "have definitively taken a more strategic and active approach to using leverage in their real estate investment strategies.
"One main reason for this lies in recognizing the clear opportunity presented to enhance returns, given the significant arbitrage presented by historically very low fixed-interest rates."
If you borrow at a lower rate than the total return of the properties, it boosts returns, explained Kenneth P. Riggs Jr., chief executive officer of Real Estate Research Corp., a research and consulting firm.
When pension plans first started using leverage, many only allowed debt to be used on certain parcels. Now, it's part of their overall strategy, Mr. Fabiszewski explained.
For example, at the $3.6 billion San Bernardino County (Calif.) Employees' Retirement Association, the real estate portfolio continues to employ 35% leverage on the portfolio level, but is implicitly increasing that by switching more assets from core to non-core, which uses more leverage, said Don Pierce, investment officer.
"Our real estate consultant opined that 35% (leverage) on real estate is prudent at a portfolio level," Mr. Pierce said. The fund's non-core investments tend to be more highly leveraged than its core investments, "which implicitly increase leverage because we are increasing non-core." About 8% of the fund's assets are in real estate.
But is this the right move at the wrong time? The Wilshire report warned of the additional risk.
"The increase in leverage is one that staff appropriately notes can increase the risk of the portfolio and should be closely reviewed by the investment committee to ensure their understanding of this move," it said. "Though within policy, it does present a risk in the face of rapidly rising interest rates. Wilshire has no view on the probability of that happening, but future declines in interest rates are less likely than future increases."
Should interest rates go up, these plans can stop using leverage, but "the increase in borrowing rates hasn't been enough to change their thinking," Mr. Maher said.
Leverage makes sense as long as it's a conservative amount — 50% or less, said Gary Koster, Americas director real estate funds investment, Ernst & Young LLP, New York. "More than that, a pension fund is getting to a riskier, opportunistic strategy," he said. "If interest rates increase greater than rental rates, then you may see distress."
Anticipating a rate hike, fund officials are trying to lock in fixed rates when using debt, said Scott M. Stuckman, senior managing director of CB Richard Ellis Investors, Los Angeles.
Most plans use 35% leverage on the core real estate portfolio, but will take note of CalPERS increase to 50% portfolio-wide, Mr. Stuckman said. "They are a terrific barometer that others will watch closely."
Many pension funds are adding some leverage, up to 50% from 20% or 30%. They began inching up a year or so after the equity markets began to tumble, Mr. Koster said.
"I think pension plan advisers have been advocating increasing leverage because of how cheap debt is in real-dollar terms, and it gives them greater exposure to real estate without increasing their allocations," said Charles W Tiedemann, partner and chair of the national real estate department at the Washington-based law firm Holland & Knight.
