CalPERS portfolio bucks a trend and returns 40.8%

SACRAMENTO, Calif. — A cutting-edge strategy of selling core properties and making riskier investments paid off for CalPERS, with a 40.8% real estate return for the year ended June 30.

The return, net of fees, was a record for the $193.3 billion California Public Employees' Retirement System, surpassing the previous year's portfolio return of 13%.

The $9.6 billion portfolio, which returned a gross 51.4% for the year, had a core unleveraged return of 38.4%, more than 20 percentage points over the 18% return of the NCREIF Property index, which is also unleveraged.

Including 41.7% leverage, the core return was 46.4% after fees, according to a staff memo to the board.

Core investments account for $5.3 billion of the total real estate portfolio and non-core, $4.3 billion.

Much of the return came from selling slightly more than $6 billion in core assets and a greater emphasis on opportunity and international strategies.

"The sales of core are significantly driving the performance," said Brad Pacheco, CalPERS spokesman.

Among the transactions was the $1.4 billion sale in June of CalEast Industrial Investors LLC to RREEF America II Fund. CalEast, which owned a portfolio of industrial properties, was a joint venture between CalPERS and LaSalle Investment Management, Chicago.

Also in June, First Washington Realty Inc., Bethesda, Md., and CalPERS sold a portfolio of 101 neighborhood shopping centers for $2.7 billion to a joint venture between Regency Centers and Macquarie Countrywide Trust of Australia.

CalPERS also began placing more emphasis on international and opportunistic real estate strategies. Currently, 66.6% of its real estate commitments are in non-core strategies. For the year ended June 30 — CalPERS' fiscal year — the system invested $3.11 billion in 25 opportunistic and international non-core funds, and staff is considering investing in 11 more, according to the staff memo to the CalPERS board.

The non-core portfolio returned 30.5% after fees.

If approved by the board this week, CalPERS will continue its non-core emphasis. For the fiscal year ended June 2006, the staff will seek attractive opportunities that include buying non-core real estate portfolios and/or operating companies and investing in global real estate investment trusts through third-party managers.

CalPERS staff expects returns of 15% to 20% from its $378.2 million international real estate portfolio and its $565.7 million real estate opportunity fund portfolio. CalPERS has a long way to go before hitting its allocation targets of $2.23 billion for international real estate and $1.86 billion allocation for real estate opportunity funds.

The high return of the overall real estate portfolio was achieved despite a downward trend in real estate returns, according to a staff report. Returns in most areas dropped by roughly three percentage points, to between 6% and 7.5% for core properties using up to 25% leverage, from 9.5% to 11% four years ago. Opportunistic fund returns dropped to 15% from 18% over the same time period, the report noted.

Other institutional investors earned sizable returns on their real estate portfolios, but none approached the CalPERS numbers. The $5.7 billion real estate portfolio of the California State Teachers' Retirement System, Sacramento, earned 35.1% gross and 30.4% net of fees for the same one-year period, said Sherry Reser, spokeswoman for the $133 billion system. CalSTRS' return was the result of the sale of several large properties and high lease income, she said.

The $4.7 billion real estate portfolio of the $59 billion State Teachers Retirement System of Ohio, Columbus, returned 21% for the same period. During the Ohio system's fiscal year ended June 30, officials sold real estate assets for rebalancing and to take advantage of the high prices, according to its 2005-'06 annual investment review. System officials were more selective with their purchases, because of projected lower returns for new purchases.

David W. Ziegler, partner in the real estate group of Ernst & Young LLC, New York, said institutional investors have been selling off direct investments, which are primarily core properties in separate accounts, and investing in commingled funds. Investors are broadening the risk spectrum of their real estate investments because they have been increasing their allocations to the asset class, giving them more money to invest.

"From what I see, investors are clearly looking to invest in non-core, but not to the exclusion of core," Mr. Ziegler said.

While the strategy of selling off core assets might be successful, investors who are moving into non-core might be losing sight of the reason they began investing in real estate in the first place — the income stream, Mr. Ziegler noted.

"As investors move out on the risk spectrum, are they achieving that objective?" he asked. He added that non-core investments are less steady and less predictable.