Funds look farther afield

Faced with decreasing domestic real estate equity returns, U.S. pension plans are looking overseas and to less traditional areas for their real estate allocations.

Spurred by an expected decline in returns for the next several years, some consultants said pension executives will maintain or trim their allocations to the once-hot asset class. They are also shifting some of their real estate investments to riskier, off-the-beaten-track investments such as infrastructure, student housing, self-storage and air cargo facilities. Investors are also more global in their real estate outlooks.

Projections are, indeed, dismal:

cChicago-based LaSalle Investment Management's 2006-2008 investment outlook puts U.S. equity real estate returns for year-end 2008 at 5% overall and 4% for core investments.

cConsultant Townsend Group, Cleveland, expects U.S. real estate equity to return 9% annualized in the next 12 to 24 months.

By comparison, the NCREIF Property index returned 20.06% for the year ended Dec. 31, and 18.7% for the year ended June 30. Some 60% of the index is invested in core real estate.

U.S. real estate investment trusts are expected to return 6.25% this year, down from 7.5% in 2005, and core private real estate's anticipated return is one percentage point lower, according to the 2006 return forecast by Wilshire Associates Inc., Santa Monica, Calif.

These lower returns mean real estate no longer is expected to outpace asset classes such as U.S. equities; Wilshire projects domestic equity returns this year will be 8.4%.

But real estate investment managers have yet to feel the pinch, because most now offer global and individual country investment funds.

As investor interest in domestic core investments may be waning, many managers have positioned their businesses to capture the global business. What's more, oil-rich investors from the Middle East as well as European investors are increasingly investing in U.S. real estate, said William Maher, director of North American investment strategies for LaSalle.

For example, Grosvenor Investment Management US Inc., the Philadelphia-based subsidiary of Grosvenor, London, has separate real estate investment funds with a variety of global investors, including the $150 million Shmael U.S real estate fund aimed at investing in the U.S. office market for a single Middle Eastern investor. Another subsidiary, Grosvenor Fund Management, London, has A$500 million (US$ 384.1 million) in mandates from the Industry Superannuation Property Trust, a Melbourne, Australia-based firm that invests in real estate for a large number of Australian pension funds. That fund invests in the United Kingdom, Spain, Canada and the U.S., said Jeremy Newsum, group chief executive at Grosvenor in London.

Also, a number of real estate investment firms are either starting or seriously investigating infrastructure businesses. LaSalle is putting together an infrastructure team because infrastructure is expected to produce better cash flow than real estate, Mr. Maher said.

Real estate investing is "a cyclical industry," said Mark Grinis, global real estate partner at consultant Ernst & Young LLC, New York. "Most people don't expect it to be a complete crash, but people are being cautious."

Institutional investors new to equity real estate are more likely to enter the market gradually, with smaller first-time allocations in global, rather than U.S., real estate, said Steven J. Foresti, managing director of Wilshire. Institutional investors already invested in real estate are likely to keep their allocations at their current target weight or rebalance down a bit, he said.

LaSalle executives also expect real estate allocations to be flat in 2006, said Mr. Maher. This is a shift from a year ago, when more investors increased real estate allocations, he said. That shift is also reflected in the number of requests for proposals so far this year — about half the number he saw six months ago. "Institutions are trying to be smarter and make the move before the market makes a big shift," Mr. Maher said.

For many investors, discussions on cutting back are still in the earliest stages, Mr. Maher said. Among those that have cut their exposure is the New Hampshire Retirement System, Concord. On July 11, New Hampshire's board cut the real estate allocation in half as a result of a new asset-liability modeling study, said Kim France, public information officer for the $ 4.3 billion system.

The lower returns also are pushing some investors to shift their current allocations outside the U.S., said Mark Baillie, executive director of Macquarie Bank and head of real estate for Europe and North America, London.

"Last year or so, people started to look more and more offshore as cap rates have contracted in the U.S.," Mr. Baillie said. (The cap rate is the net operating income divided by the value of a property, expressed as a percentage.)

U.S. institutions invested $12.5 billion in foreign real estate in 2005, up from $7 billion the year before, according to a survey of cross-border real estate investments by Jones Lang LaSalle Inc., Chicago The data do not include multifamily residential investments.

Investors are increasingly more comfortable with international real estate as transparency has improved, Mr. Baillie said. Transparency has increased so that investors can go offshore and get enough information to make most investment decisions, he said.

The $36.8 billion ?Illinois Teachers' Retirement System, Springfield, will explore shifting some of its 14% real estate target allocation to international real estate in fiscal 2007. Officials at the $210.7 billion California Public Employees' Retirement System, Sacramento, could shift as much as half of its $15 billion real estate portfolio into international real estate.