THE P&I 1,000: Real estate growth hints at riddle

Assets invested in equity real estate by defined benefit plans in Pensions & Investments' top 200 rose 4.7%, to $106.9 billion, in the 12 months ended Sept. 30.

When adjusted for the 11.6% gain recorded by the NCREIF Property Index during the period, however, the assets invested dropped 6%. The drop reflects pension fund executives' conundrum during the year. On one hand, pension executives were selling their real estate, to take advantage of high prices and book the profits of their investments. At the same time, however, they were trying to reinvest some of that money, and the rest of their uninvested allocations, into the asset class.

Investments among the top 200 plan sponsors in real estate investment trusts saw a much larger percentage gain — 29.5%, to $19.3 billion — reflecting market appreciation and a growing use of REITs as part of institutional investors' real estate allocations, analysts said. On a market-adjusted basis, the assets in REITs increased 3.2%.

Mortgage portfolios of the defined benefit plans in the top 200 grew 20.8% to $40 billion.

The California Public Employees' Retirement System, Sacramento, continued to hold the most equity real estate, with $11.9 billion as of Sept. 30 compared with $10.4 billion a year earlier. The California State Teachers' Retirement System, also in Sacramento, retained second place in the rankings, with $5.4 billion, compared with $4.7 billion a year earlier.

General Motors Corp., Detroit, was third overall and tops among corporate pension plans with $4.9 billion, up from $4.5 billion in 2003.

Top REIT holders are General Motors, with a bit more than $2 billion and the Florida State Board of Administration, Tallahassee, with close to $1.8 billion. In 2003, Florida was first with $1.4 billion and GM was second with $1.3 billion.

Pension funds and other institutional investors with existing real estate allocations found 2004 to be both a good time to sell real estate investments and to invest further in the asset class, said Jeanne Myerson, president and chief executive officer of The Swig Co., a San Francisco investment management firm.

"Pension funds are trying to take in their profits and also invest their allocations," Ms. Myerson said. "It's harder and harder to buy off market."

Most sellers prefer to get the highest price they can by selling their property in an auction rather than in a private arrangement or "off market," Ms. Myerson said.

Some real estate money managers are paying "amazing prices" on behalf of pension funds. "We're seeing that a lot," Ms. Myerson said. For example, in order to match the price a manager had bid on behalf of a pension fund for property in suburban Washington last summer, The Swig Co., which uses moderate leverage, would have had negative cash-on-cash returns for a couple of years, she said.

She said she expects the first half of 2005 to be "torrid" in terms of the pace and pricing of deals.

Micolyn Yalonis, principal at Townsend Group, a San Francisco real estate consulting firm, said while many pension funds added to their real estate allocations, there have been a number of institutional investors that were new to the asset class — and for smaller pension plans, REITs are an easy way to get started. "The challenge has been putting capital to work, particularly in core," Ms. Yalonis said. "Some pension funds accept REITs as a substitute."

Among Townsend's client base, a number of pension plans with new programs focused on non-core real estate because of the large amount of capital that was focusing on core investments in 2004, she said.

Market appreciation, which was up around 25% during the time period, was only part of the reason behind the growing use of REITs in institutional portfolios, said Jack McAllister, vice president for institutional affairs at National Association of Real Estate Investment Trusts, Washington. "It's typically used as part of a core allocation and we're continuing to see pension plans add or increase their allocations to REITs as well as an increasing number of real estate consultants begin to recommend investing in REITs," Mr. McAllister said. "What this represents is further evidence that institutional investors are accepting REITs as a viable alternative to achieving their real estate allocations in their portfolios."

Even so, pension plans still have five times as much equity real estate than real estate securities, he said.

"While 25% gain is a significant advance in the use of REITs, keep in mind it is from a lower base," Mr. McAllister said.

For example, CalPERS only had about $751 million in REITs as of June 30, the most current number available, according to Brad Pacheco, spokesman for the California fund.

Part of the attraction to REITs is the liquidity of securities as well as five years of stellar returns, Mr. McAllister said. In the 12-month period ended Sept. 30, the NAREIT composite index returned 25.6%.

For the nine months ended Sept. 30, the return was 14.2%. For the five years, the return was a compound-annualized 22.5%.

However, REITs are not a substitute for investment in direct real estate, said Amos J. Rogers, managing director of State Street Global Advisors, Boston, which manages $3.2 billion in REITs and equity real estate, through the Tuckerman Group.

"I don't think investors are making (REIT) allocations in lieu of allocations to direct real estate," said Mr. Rogers. "They are including REITs in their overall allocation."

Investing in REITs is also a somewhat easier way to invest in real estate.

There have been nine- to 12-month queues to invest in open-end real estate funds, said Bill Krauch, managing director of ING Clarion, a New York-based real estate money manager.

"There's a lot of capital flowing into the asset class. … With REITs, you can make investments immediately; private real estate is very different," Mr. Krauch said.

Pension funds are still very interested in core real estate, in part, because many are reallocating a portion of their fixed income portfolio into real estate, he said.

"They are selling fixed income because they think real estate has more upside potential due to appreciation, and if interest rates go up they won't see as much volatility. That's the bet they are taking," Mr. Krauch said.