Asset owners take a break from virus-ravaged market

Real estate consultants and some investors are considering pressing pause on certain investments as the COVID-19 health-care crisis and recession batter the asset class.

One Los Angeles-based pension fund has paused some real estate investments in part due to concerns around the valuation of properties. On June 23, the Los Angeles City Employees' Retirement System's board adopted a fiscal year 2021 real estate plan. Recommended by its consultant, Townsend Group, the plan said that whenever possible the $18 billion pension fund should halt new commitments to open- and closed-end funds with pre-specified portfolios as well as pause in funding recent open-end investment commitments because these assets' carrying value may not reflect current, lower market values.

LACERS has a 7% target allocation to real estate and $777 million invested in that asset class.

The pandemic has already rocked the real estate industry. Open-end fund redemption queues are elevated at roughly $14.4 billion, doubled since Dec. 31, the Townsend report to LACERS said.

"Open-end fund managers are suspending or limiting redemptions to preserve cash and to protect assets of the funds," the report noted.

Early estimates from Townsend executives' discussions with real estate managers are that high-quality, core assets could drop by 10% in the second quarter alone, said Felix Fels, San Francisco-based vice president of Townsend Group, at the investment committee meeting.Among real estate sectors, retail and hotel property values could get hit the hardest, Mr. Fels said.

Townsend executives also said real estate open-end funds also may be forced to sell assets at a loss if too many fund investors seek to redeem their partnership interests.

What's more, it is unknown how closed-end funds and separate account managers will adjust valuations as of March 31, with larger write-downs expected in the second and third quarters, Mr. Fels said at the meeting.

It's hard to know where the values lie because there have been a limited number of transactions since the rise of the COVID-19 crisis and the ensuing recession, Mr. Fels said.

Institutional investors are universally wary of funds raised and real estate investments made before the pandemic due to the potential changes in valuations, said Taylor Mammen, Los Angeles-based senior managing director at real estate consulting firm RCLCO Real Estate Advisors.

A commingled fund in the process of being raised that had already invested 20% or 30% of its capital six months before the pandemic and ensuing stay-at-home policies and business shutdowns "would have been perfect," Mr. Mammen said. "Now it's a liability because the properties were acquired at valuations that will no longer be relevant."

And it's possible that some of the funds that were being raised pre-COVID-19 may not reach a final close, he said.

In the beginning of 2020, there were 918 real estate funds in the market targeting a total of $281 billion, according to London-based alternative investment research firm Preqin. Altogether, real estate funds held an aggregate of $319 billion in dry powder as of Dec. 31, Preqin data shows.

Commingled funds for real estate do not work in a setting when it will take longer to create value, unlike direct investments in properties or separately managed accounts, he said

In closed-end funds, it may take more time for assets and the market to recover enough for properties to be sold at a profit during a fund's lifespan, he said.

So far this year, investors have committed a total of $58.9 billion to 119 real estate funds, compared to $92 billion in 194 funds in the first half of 2019, Preqin data shows.

Open-end funds promise liquidity but can't provide liquidity in downturns when investors want it, except for the limited number of specialized, property type-specific open-end funds, Mr. Mammen said.

"The reason it is very difficult to get out right now is that there are lots of questions regarding valuations," he said.

RCLCO clients typically invest in separately managed accounts or joint ventures due to the lack of liquidity, control and high expense of commingled funds, he said. However, separate account managers, especially those with existing properties acquired in late 2019 and early 2020, are having the same challenges, Mr. Mammen said.

Investors are more interested in separate accounts that are blind pools and not accounts with pre-existing assets that could have been purchased when prices were at their peak, he said.

Investors in real estate separate accounts have the ability to pause investments but so far, few institutional investors have done so because there have been so few transactions, he said.

"But the LPs are absolutely talking to GPs about their concerns," Mr. Mammen said.

A few clients are discussing a change of investment guidelines with their separate account managers that would allow the accounts to invest in other strategies such as debt or loan-to-own programs.

"In those cases we want to make sure those are viable strategies, will materialize and the manager has the expertise," he said.

Pensions & Investments' searches and hires database reveals that investors this year have committed a total of $10.1 billion to 105 real estate strategies through June 10, compared with $17.6 billion to 151 investments in the first half of 2019. Meanwhile, investors terminated $2.5 billion worth of real estate investments in 2020 through June 10, compared with more than $2.2 billion in terminations in all of 2019, P&I's database shows.

Meanwhile, the Los Angeles County Employees Retirement Association is waiting to complete a real estate portfolio restructuring due to the COVID-19 crisis, a presentation to the real asset committee on June 10 shows.

"Given there is much uncertainty on how people interact with physical space (due to COVID-19) and we are currently overweight real estate, we have time in order to thoughtfully come back to the board with recommendations regarding the investment strategy," said Jonathan Grabel, CIO of the Pasadena, Calif.-based $56.9 billion pension fund, in an interview.

LACERA is reconsidering its heavy use of separately managed accounts, which has produced a concentrated portfolio that has underperformed, Mr. Grabel said at the real asset committee meeting. Some 82% of the $5 billion real estate portfolio is in separate accounts. LACERA began investing in separate accounts to gain more control over their portfolio. Instead, many of LACERA's separate accounts are designed so that most of the control over the assets, such as buy-sell decisions, have been delegated to the managers, he said. In LACERA's separate account program in real estate, the pension fund owns nearly 100% of about 125 properties, as opposed to partial ownership of many more properties in a commingled fund, for example.

"The concentrated nature of this program could result in a lumpy return profile. In other words, we have single-asset risk," Mr. Grabel said.

Over the one, five and 10 years ended Dec. 31, LACERA's real estate portfolio underperformed the NFI-ODCE benchmark and its peers, he said.

Mr. Grabel suggested LACERA's board consider a mix of separate accounts, commingled funds and hybrid structures such as club deals with like-minded investors. What's more, LACERA officials need to be more active in portfolio design, he said.

Jeff Giller, San Francisco-based partner and head of global real estate at manager and consultant StepStone Group LP, said that investor behavior in the current crisis so far differs from the global financial crisis in 2008.

In the last downturn, nobody was prepared for it and investors faced big liquidity constraints, he said.

"Fast forward 10 years, LPs, at least the larger institutional investors, had reserves, are well-capitalized and anxious to commit capital to the environment ahead of us," he said. "During the prior cycle, liquidity just froze up."

"Our pipeline of investments in funds have not slowed down at all," because most clients are sticking to long-term investment plans, he said, although some clients may pivot to sectors expected to do well in a recession such as distressed funds.

Last cycle, investors "got hammered in the peak, didn't invest in the trough," he said. Then their real estate portfolio underperformed target returns, Mr. Giller said.