Outlook 2005: Real estate

Real estate is expected to remain an attractive asset class for institutional investors in 2005, but it will not be for the timid.

Insiders say investors will need to be nimble and focus on risk management.

"In commercial real estate the market is clearly at a point of maturity and most institutions have mature real estate portfolios," said Ken Riggs, chief executive officer and managing principal of Real Estate Research Corp., Chicago.

This maturity means that institutional investors will need to optimize the value that they have in their portfolios because there will continue to be an abundance of capital chasing fewer opportunities, Mr. Riggs said.

"Last year we spoke about the importance of patience and creativity to deal with the capital out there," said Jacques Gordon, global strategist for LaSalle Investment Management, Chicago. "In 2005 we are adding ‘nimble,' knowing in advance what your strategy is so when the right deal comes along you can move quickly."

None of the experts interviewed see a reduction in the massive amount of capital flowing into real estate, but they said if institutional investors want to garner the best returns, they are going to have to take on more risk in general.

Some institutional investors are already starting to make changes. In December, the $182.3 billion California Public Employees' Retirement System, Sacramento, decreased its allocation to real estate to 8% from 9%. Fund officials are selling their core real estate holdings, and changing their strategy to focus more on value-added and opportunistic investments, said Brad Pacheco, spokesman for CalPERS.

"We are selling some assets because the staff sees good opportunities right now to take some profits off the table," Mr. Pacheco said.

Half of the $59 billion Oakland-based University of California system's approximately $2.2 billion real estate program is being devoted to a core philosophy, said Trey Davis, spokesman.

The other half is a combination of strategies: 25% going to enhanced real estate by way of closed-end funds; 15% in a high-return strategy also through closed-end funds; and 10% in real estate investment trusts.

Institutional investors need to expand their definition of real estate beyond the four standard "food groups": apartments, warehouses, shopping centers and office buildings, LaSalle's Mr. Gordon said.

"The pressure on the real estate staff from the chief investment officer is to increase the allocation of real estate, and the push back from the real estate staff is that pricing is at record highs and they're not sure this is a good time to do that," Mr. Gordon said. "With the tried and true selling at record low yields, institutions have to look outside the four food groups to things like parking garages, hotels and medical office buildings."

Rising interest rates are also expected to cause institutional investors to re-examine their real estate allocations, said Maury R. Tognarelli, president and chief executive officer of Heitman LLC, Chicago, "Will they continue to keep their money in real estate in the percentage they have it or will the broader markets produce results that cause them to adjust those allocations?"

Mr. Tognarelli believes more pension funds will include leverage, and others will go international. "They're diversifying outside of core with more leverage, more leasing risk, putting more in development or going into these property types in other countries," Mr. Tognarelli said.

Overall navigating the U.S. commercial real estate market in 2005 will be tricky, Mr. Riggs said. "I look at the financial and geopolitical environment and I see it as more uncertain (than) I've seen it in a generation," he said, mentioning high oil prices and interest rates edging upward.

Certain property types that were out of favor in 2004, like hotels, will become hot while last year's top performer, retail, will lose its luster, Mr. Riggs said.

"Hotels have been priced down. There's not a big piece in institutional investment portfolios, but they are looking as they are beginning to recover with the job growth and the economy moving along," Mr. Riggs said.

Retail markets, on the other hand "will be faced with more challenges than in the last three to five years."

Consumers will have less money to spend because rising interest rates will stop the housing refinancing boom that had given them cash to spend, he said.

The changing economy and interest rate increases also will be a positive for the apartment market because people who will no longer be able to buy houses will have to rent, Mr. Riggs said.

Pension funds, endowments and foundations also are starting to get serious about investing outside the United States, Mr. Gordon said.

They realize the United States is fully priced but markets like Mexico and Asia are not. "It's one way to deal with massive capital flows to real estate."

However, investors around the world are wondering if real estate is becoming a riskier asset class because of the amount of money seeking to invest in it, Mr. Tognarelli said.

"I met with investors and property owners in Tokyo and they asked, ‘Is real estate getting too much capital? Is it overheated and will there be a corrective action?'" Mr. Tognarelli said.

"It applied to all property types in all the regions of the world." However, compared to other asset classes, real estate is a good bet, he said.

"Do I think there will be a pullback of pricing if interest rates go up? Sure, some will pull back, but nothing so dramatic that would cause repricing of the asset class," Mr. Tognarelli said.