Putting down stakes

Pension funds and endowments are boosting their allocation to real estate. Are they arriving on site too late?

Pension funds and endowments are boosting their allocation to real estate. Are they arriving on site too late?

By Charles Keenan
December 2002
Institutional Investor Magazine

For 12 years the $800 million Smith College endowment had no money in the real estate market. But in September the fund decided to make a small commitment to the asset class, pledging to invest $8 million over the next three years in a real estate fund managed by Boston-based TA Associates. The move is part of the endowment’s plan to place about 10 percent of its portfolio in inflation-hedging investments. Says Jay Yoder, Smith’s director of investment: “Inflation has the potential to degrade the value of our investment portfolio. In addition, real estate gives us increased diversification and a reduction in volatility.”

In September the $1 billion endowment of the University of North Carolina at Chapel Hill, which started investing in real estate in 1998, increased its allocation target from 7.5 percent of assets to 10 percent; it may go as high as 15 percent next year. “We like the cash flow, and we’ve been steadily increasing our allocation. We’re going to push it as far as we can get it,” says Mark Yusko, CEO of UNC Management Co., the in-house manager of the university’s endowment.

The California Public Employees’ Retirement System in October increased its real estate allocation target to 9 percent from 8 percent. Just two years ago the $136 billion fund, the nation’s largest, upped the target from 6 percent to 8 percent. In May CalPERS approved raising the target for the amount leveraged in its real estate portfolio; the increase, from 34 percent to 40 percent, will potentially boost returns.

Like CalPERS and the college endowments, more and more pension funds, foundations and endowments are increasing their real estate holdings, either through real estate investment trusts or direct property investments. Not surprisingly, they’re drawn to the sector’s explosive returns. For the three years ended September 30, the Morgan Stanley REIT index posted a total return of nearly 47 percent, versus a 31 percent decline in the Standard & Poor’s 500 index. For the 12 months through September 30, REITs notched an 8.6 percent gain. The National Council of Real Estate Investment Fiduciaries property index, a benchmark of directly invested property values, rose 5.6 percent for the year ended September 30. That compares with a 19 percent drop for the S&P 500 during the same period.

But are pension funds arriving on the scene too late? “Institutions often make the mistake of chasing performance,” says David Shulman, a real estate analyst at Lehman Brothers. “In the end, they will get burned.”

Says UNC’s Yusko: “There’s clearly some risk if the very large pension funds decide to increase their allocations significantly. Yet you’ve got pretty good balance for supply and demand. And on a relative basis, it’s a very attractive asset class. There is still plenty of room for real estate to appreciate.”

Among 2,515 domestic pension funds and endowments, allocation to real estate averaged 3 percent of total assets in 2001, up from 2.3 percent in 1999, according to Greenwich Associates. Although data is unavailable for 2002, the firm expects a slight increase over last year.

Investors are searching for a haven from a grim equity market, of course. But most also insist that they are looking for the advantages that come with diversifying into an asset class that tends not to correlate with either stocks or bonds. “There is a much greater appreciation of the diversification that real estate provides than there was two years ago,” says Bruce Eidelson, director of real estate advisory services for Russell Real Estate Advisors, a division of Frank Russell Co. These days, too, REITs and unleveraged direct investment offer yields of between 5 and 10 percent, versus a yield of about 4 percent for ten-year Treasuries.

All real estate sectors don’t move together, however. The office property market, for example, is reeling. Vacancies for offices, representing 40 percent of the NCREIF property index, reached 16.1 percent at the end of the third quarter, up from 8.3 percent two years ago, according to Torto Wheaton Research, a Boston-based consulting firm. Meanwhile, office rents declined 1.2 percent in the third quarter, their seventh consecutive drop.

Commercial property values for the roughly 4,000 income-producing, investment-grade real estate owners declined 2.4 percent, to $124 billion, for the year ended June 30, according to NCREIF.

Still, if funds choose the private market and make a long-term commitment, they can ride out short-term turbulence, says Youguo Liang, head of research at Prudential Real Estate Investors in Parsippany, New Jersey. He recommends commingled funds, which generally hold 100 to 150 properties and tend to be fairly stable. They are relatively liquid because, typically, investors can pull money out on a quarterly basis. REITs, on the other hand, “are subject to the vagaries of public forces,” Liang says.

REIT performance this year has been mixed. As of early November big gainers included retail REITs (up 18 percent), health care REITs (up 16 percent) and industrial REITs (up 14 percent), according to the National Association of Real Estate Investment Trusts. Meanwhile, office REITs are down 8 percent, and apartment REITs are down 9 percent.

“There is an unusually wide bifurcation in valuation these days,” says Robert Steers, chairman of Cohen & Steers Capital Management, a New Yorkbased investor in REITs. “Some property types are overvalued, and some are at record low valuations.”

Steers, who oversees $7.2 billion of assets, thinks many commercial property REITs offer good value. His largest position: Vornado Realty Trust (Institutional Investor, March 2002), which represents 6 percent of Cohen & Steers’ holdings. Early in October the New Yorkbased REIT was trading at a 19 percent discount to its estimated net asset value, versus 9 percent for REITs on average. Steers thinks Vornado stock is a good buy; he predicts a long-term growth rate of funds from operations of 10 percent for 2002, 2003 and 2004.

Similarly, Steers holds a 2 percent position in Kilroy Realty Corp., a Los Angelesbased office REIT active in the Southern California marketplace. Kilroy looked like a bargain in early October, with a discount to asset value of 28 percent and a projected annual growth rate of 8.5 percent for the next three years. Its multiple-to-growth ratio (the ratio of its stock price to funds from operations, divided by the growth rate) was 0.92. “Anything close to one is cheap,” says Steers. “Anything below one is ridiculously cheap.”

Many analysts believe that retail REITs, up 11 percent this year, still have room to gain. Michael Mueller, a REIT analyst at CIBC World Markets Corp., likes Regency Centers Corp., a Jacksonville, Florida, operator of neighborhood shopping centers that has generated a capitalization rate of 10.5 percent developing its own pipeline of properties. That rate is about 150 basis points greater than what Regency would get by purchasing already developed properties for its portfolio, estimates Mueller. He also predicts that GE Capital Real Estate, which owns 59 percent of Regency Centers, will either buy the REIT outright or sell its stake within a year. Either way, he figures it’s a plus for shareholders. A GE purchase would mean a premium, he says, while a sale would make the stock considerably more liquid.

Although Shulman is more bearish on the overall business than most of his Wall Street counterparts, he nonetheless likes Chicago-based General Growth Properties, an owner of more than 50 regional shopping centers nationwide. In the second quarter, General Growth spent $475 million to acquire six malls, four of which will be joint ventures. The joint venture strategy allows General Growth to spread itself over more locations and to collect more management fees in the process. It can also use its greater reach as leverage with retailers.

Of course, retail REITs are vulnerable to a dropoff in consumer spending. Low interest rates have recently fueled spending and allowed homeowners to refinance or take out equity lines of credit. A rise in rates or a drop in home values could quickly dampen their enthusiasm.

David Lee, portfolio manager of T. Rowe Price Associates’ Real Estat Fund, invests in out-of-favor sectors and then waits until the market comes around. Recently, he’s bought apartment REITs, which have been trounced by investors (Institutional Investor, November 2002). The fund’s largest holding as of September 30: Chicago-based Equity Residential, the nation’s biggest apartment REIT, down 16 percent this year as of early November. Lee thinks the sector has hit bottom. “We’re making a contrarian bet that perhaps home buying can’t get any better,” he says.

Newcomers to any part of the REIT market need to bear in mind one potential pitfall, CIBC’s Mueller notes. “The biggest risk is not that real estate funds will collapse or that new supply will come on. The biggest risk is capital rotation out of the group.”

For the moment, though, real estate looks more appealing than most of the alternatives. “People have come back to basics -- fairly stable investments that are fairly easy to value and offer a good yield,” says Craig Leupold, an analyst at Green Street Advisors in Newport Beach, California. “It’s a lot easier to put a valuation on an office building than it is to put a valuation on some new technology that may or may not ever make it to market.”