Pension funds love real estate. (Cover Report: Commercial).

With an estimated $200 billion of pension fund investment already in commercial U.S. real estate, some funds are planning to bump up annual allocations for real estate by another 2 percent or more, pension officials say.

THERE HASN'T BEEN A BETTER TIME FOR PENSION FUNDS TO INVEST IN REAL

* "We believe that real estate allocations definitely should be moved up to at least 5 percent to 10 percent of the total fund, in order to keep pace with the potentially high returns from this portion of the benchmark," Kaiser wrote for an industry publication--nearly five years ago.

Nothing has changed, essentially, in the interval. As BBK's third-quarter 2001 newsletter noted: "In times of uncertainty, many investors tend to prefer hard assets [like real estate and gold]. With bonds yielding under percent and stocks having a price-to-earnings ratio of over 20 times for an earnings yield of less than 5 percent, we believe real estate remains an attractive investment alternative."

* It makes sense, if for no other reason than real estate returns are a solid 7 percent to 7.5 percent cash-yield vehicle, Youguo Laing, managing director, research at Prudential Insurance Real Estate Investors, Parsippany, New Jersey, told Mortgage Banking in April.

"We're hearing that quite a few large pension funds have increased their allocation for real estate by 2 or 3 percent--but that's anecdotal, not statistical, evidence," Laing says.

More pensioners, more earnings

Apart from the satisfaction of achieving decent returns on brick-and-mortar-type investments, public and private pension funds will need higher yields to pay ballooning benefits to a rapidly expanding retirement population--including a huge wave of baby boomers--that will retire over the next 10 years, Laing explains. Pension funds have been pumping up their investment earnings by rebalancing their accounts to squeeze more yield out of investments to be able to honor those looming financial obligations.

Timing is becoming critical. John McMahan, executive director of the nonprofit Center for Real Estate Enterprise Management (Centerprise), San Francisco, says pension funds are "starting to move into a cash-outflow position, in which liabilities exceed incoming contributions. Public plans' retirement ages are often 55 or 62, so they are experiencing cash outflow earlier than the corporations."

Much of the higher yield is coming from public- and private-sector pension fund investment in U.S. real estate, worth an estimated (as of mid-April) $200 billion, according to Jack Nowakowski, director of research, Pension Real Estate Association (PREA), Hartford, Connecticut. With as many as 30,000 pension plans in the United States, it is impossible to precisely measure the swing in allocations for real estate, Nowakowski says. Historically it is about 7 percent, but it can be as low as 2 percent, zero for the smaller plans and, in some cases, as high as 9 percent or 10 percent.

What allocations for real estate are planned by pension-fund superstar Teachers Insurance and Annuity Association--College Retirement Equities Fund (TIAACREF), New York?

Richard Coppola, managing director, West Coast region, TIAA-CREF's mortgage and real estate division, which manages a $27 billion international portfolio (out of $280 billion in total assets under management), told Mortgage Banking in an interview last December, "We expect to continue investing $6 billion to $7 billion a year in conventional and securitized commercial mortgages and property acquisitions. We also expect to purchase about $800 million a year in new commercial real estate.

"Our focus has always been on the longer side of investments, typically seven- and 10-year loans, and buying real estate to hold, which makes us a bit different," Coppola said.

The division's loans for real estate financing range up to $100 million, generally with a co-lender for loans of more than $100 million. Most mortgage loans are intermediate-term, fixed-rate amortizing loans, usually for 10-year terms. Loan proposals less than $25 million are generally arranged through local mortgage correspondents.

Coppola didn't foresee much of a change in TIAACREF's basic strategy on real estate investment, although he said its interest in hotels isn't quite as clear.

Pension funds have generally become comfortable with direct investment in domestic properties, typically through separate accounts or commingled funds. Real estate opportunity funds, created in the early 1990s, are another avenue for pension funds to add a higher return (and risk) component to their real estate portfolio, Ted Bigman, managing director, Global Real Estate Securities, Morgan Stanley Investment Management, New York, noted in an article he wrote in the Winter 2002 issue of Pension Real Estate Association's PREA Quarterly magazine entitled, "Investing in International Listed Property Companies."

Real estate will trump equities

As for the foreseeable future, Marc Louarguand, managing director, investment research and public market investments, Cornerstone Real Estate Advisers, Hartford, Connecticut, predicts: "Real estate will have among the highest expected returns over the balance of the decade. Stock market returns are not expected to be high over the next few years, probably in single digits."

Louarguand agrees that while higher allocations for real estate are logical, they aren't always obvious when those higher allocations are being made. Two years ago those investments, for example, were often blended into a private-equity category, Louarguand says, so that "many of those dollars were shifted toward venture capital, LBOs [leveraged buyouts] and M&A [merger and acquisition] funds." A slowdown in those sectors and lagging venture capital fund performance have diverted even more investment into real estate.

"Over the past 10 years, these allocations have been running at about percent," Louarguand says, "and now lots of plans are trying to push that allocation to 7 [percent] to 10 percent."

Just as pension funds diversify their various asset classes as a matter of course, large plan sponsors with large real estate allocations typically invest in both hard assets and real estate investment trusts (REITs), Louarguand says.

"For small plans [that] want a little bit of real estate, very often REITs are the only choice because they can't create big separate accounts or make direct investments," Louarguand explains. REITs are very tax-efficient vehicles, he adds, and he expects pension funds to invest more in REITs this year. (Yields on REITs have risen more than 50 percent from March 2000 to April 2002, according to the Morgan Stanley REIT index. During the same period, Standard & Poor's 500 stock index was down about 20 percent.)

What types of real estate are favored by pension funds? Louarguand ranks multifamily residential as No. 1, because apartments are proving to be the most recession-proof investment, then industrial/warehouse, retail and office, in that order.

Life insurance company chief investment officers like multifamily for similar reasons, but are not as ready as pension funds to go up against the aggressively competitive financing power of Fannie Mae and Freddie Mac for those properties.

Centerprise's McMahan comments, "In the current interest rate environment, Fannie Mae and Freddie Mac projects are very cost-competitive, but the market is so big and pension funds so attracted to multifamily that equity investors such as pension funds and REITs haven't backed off. There has never been such a demand for apartments since the Second World War."

Safety in diversity

Pension funds are also, of course, invested in stocks and bonds. Have the Enron Corporation and Kmart bankruptcies, among other stock market casualties, created less diverse investment options that could damage pension funds' investment capability? "The common equity exposure of most major pension plans is so diversified," Louarguand replies, "that the downturn in the stock market won't have a meaningful effect on a major plan sponsor's ability to meet its obligations to pensioners."

Particularly not since real estate has been performing so well, before and after Sept. 11, says Stanley Ross, chairman, USC Lusk Center for Real Estate, University of Southern California, Los Angeles. "The supply side has come down, demand is up, rents are stable, vacancies low, cash flow is equivalent to some bond yields or better and there is consistent value," Ross notes.

Ross acknowledges that the national office vacancy rate is in the 15 percent territory and especially severe in San Francisco and Seattle, for example, but he is confident that won't discourage investment because "pension funds will pick markets with lower vacancies, where little supply is coming on, and will take advantage of opportunity-buying."

When asked for his take on rising allocations in real estate after an International Council of Shopping Centers (ICSC) business forum in Toronto in mid-April, John Parsons, managing director, MacGregor Associates, Chicago, said, "Pension fund trustees are asking for more conservative, safer investments with cash flow and income, as opposed to high-growth but problematic technology stock portfolios and private-equity portfolios which have declined in value and performed poorly." MacGregor Associates specializes in institutional real estate strategies and real estate capital markets.

"There has been a renaissance of real estate and a general inclination to invest more in that sector, possibly a 7 [percent] to 9 percent allocation," says Parsons.

CMBS are hot

Commercial mortgage-backed securities (CMBS) are becoming very popular and highly sought-after by fixed-income managers. What's hot about them? "They are viewed as a conservative vehicle because of pension funds' diversification and because volatility of the corporate credit market is encouraging investors to revisit CMBS. Investors took a pass on it before, but they're looking at it more seriously now," Parsons says. (The Commercial Mortgage Alert, a subsidiary of Standard & Poor's, New York, traced annual CMBS issuances from $14 billion in 1992 to $60.9 billion in 2000 and a record $96.9 billion last year.)

Prudential's Laing says most pension funds invest in the CMBS market through fixed-income departments, and regard investment-grade CMBS as a fixed-income investment. It is difficult to track how much individual pension funds may have invested in CMBS, but some of the record CMBS origination last year had to come from pension funds, Laing says.

What about commercial mortgages? Laing says, "Most larger pension funds have a strong interest in mortgages, which can be considered fixed-income or real estate. Figures don't exist, but someone is buying those mortgages, pension funds included."

Parsons speaks of "a tremendous demand for high-quality mortgages and private-equity real estate in the United States," instead of interest in "growth-oriented investment concepts that didn't materialize and failed to generate portfolio growth investors expected, like technology."

Mortgage lending up by 8 percent

Pension funds and REITs, the other main equity player in commercial real estate investment, no longer have to be concerned about competing with life insurance companies, which have slowly abandoned equity real estate over the past decade, says Jonathan D. Miller, principal of corporate communications with Lend Lease Real Estate Investments Inc., New York.

"Life companies are concentrating on originating commercial mortgages and buying CMBS. Pension funds aren't big mortgage investors, but are big equity investors," says Miller.

In January, the American Council of Life Insurers (ACLI), Washington, D.C., representing more than 400 member companies, noted in a press release that its members expect to increase mortgage lending this year by about 8 percent, according to a survey of 23 active-member commercial mortgage lenders, accounting for about 70 percent of total industry mortgage lending.

The survey responses indicated the increase could hit a record $29 billion this year, compared with an increase of about $27 billion last year. (Total life insurers' holdings in commercial mortgage loans will likely amount to $230 billion at year-end, compared with an estimated $216 billion in 2001, reports ACLI. If those holdings in commercial mortgages have gone up by year-end, it will be for the sixth consecutive year.)

Gerry Crute, AGLI's associate director, investment research, reported in an interview that in 1997 the industry's total investment in commercial mortgages was about $187.9 billion, up 10.2 percent over the previous year. By 2000 that investment was $212 billion, an increase of 10.3 percent over the previous year, and by mid-April this year it was already at a record level of about $230.5 billion--of which $212.5 billion was commercial, $13.2 billion was in farm loans and another $5.3 billion in residential, Grute says.

"The [life insurance] industry's investment philosophy, generally, is focused on safety, liquidity, flexibility and the long term," Crute says, which is why real estate mortgages as an asset class are favored, apart from the fact that they outperformed stocks and bonds over the past year and a half.

Pension fund managers can take great comfort from that stellar level of performance, along with a growing population that depends on pensions to live securely in retirement. The real estate industry can also expect some practical benefits. As Devin Murphy, a New York- based Morgan Stanley & Co. Inc. investment banker, noted in the firm's weekly review dated April 19, 2002, the pension funds are "beginning to leverage their real estate investments, which could funnel billions of dollars of capital into the real estate sector."

RELATED ARTICLE: Pension Funds Flush

Pension funds head the list of eight sources of available capital for real estate investment, according to Emerging Trends in Real Estate 2002, released by Lend Lease Real Estate Investments Inc. and PricewaterhouseCoopers LLP, both based in New York.

The report stated that as of Sept. 15, 2001, pension funds accounted for $144 billion in equity and $37.6 billion in debt out of the $4.6 trillion invested in commercial U.S. real estate.

An estimated 5.8 percent increase in real estate investment was forecast for all of 2001 (the report was released in October), and an estimated 6.3 percent increase for this year.

When asked if the forecast for 2001 proved on-target, Jonathan D. Miller, principal of corporate communications for Lend Lease, told Mortgage Banking in April that it had. Moreover, he said, there is no reason so far to question the estimate for this year will be anything but accurate.

Capital sources off the sidelines

The Lend Lease/PricewaterhouseCoopers report noted that pension real estate portfolio allocations "shot up past targets in 2001 as Wall Street's bear market savaged plan sponsor stock holdings." But that was last September. Whether real estate as an investment adds value to diversified portfolios will become more clear in 2002, the report concluded.

By mid-April 2002, when Mortgage Banking interviewed John McMahan, executive director of the Center for Real Estate Enterprise Management (Centerprise), San Francisco, a nonprofit clearinghouse of ideas for the real estate industry, real estate's investment luster had not dimmed. "It's better to have a higher percentage of a portfolio in something that's throwing off cash than in a stock market with dividends of I percent," he says. "It's not rocket science to turn to assets with relative stability and a cash return of 60 [percent] to 75 percent."

Pension funds and real estate investment trusts (REITs) dominate the real estate industry in the United States, McMahan says, and because the funds own much of the REITs, they are directly or indirectly in control.

(Likewise in Canada: The four largest pension funds, Caisse de Depot et Placement du Quebec, Montreal; and Toronto-based Ontario Teachers' Pension Plan Board; Ontario Municipal Employees Retirement System; and Riocan Real Estate Investment Trust, own most of the shopping centers across the country. With the exception of Brookfield Properties Corporation, Toronto and New York, pension funds own all the former publicly traded major real estate developers. TrizecHahn Corporation, also based in Toronto and New York, turned itself into a REIT in May.)

Rolling the Investment

"Without taking some investment risk, pension funds would not receive returns sufficient to generate the assets required to pay promised benefits which, in turn, would necessitate much higher contribution levels from sponsors or members to meet the pension obligations," Ratings-Direct, a Web-based credit ratings and research subsidiary of Standard & Poor's, New York, noted on its Web site in February.

"In the last decade, public pension funds accelerated the shift in asset allocation toward equity investments at the expense of fixed income. The domestic equity allocation, under 40 percent at the beginning of the 1990s, was approaching 50 percent by the end of the decade."

For all of the pension funds' enthusiasm about real estate as an asset class, there are caveats and reservations in very high places. Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), New York, one of the top pension funds in the United States, for example (total assets of $270 billion as of Feb. 28, 2002), reports this on its Web site background material: "Real estate is subject to risks not associated with many other investments, including liquidity risk, appraisal risk, environmental risk and casualty-loss risk,

"Moreover, the account is a variable annuity. Past performance doesn't guarantee comparable returns in the future, and no one can guarantee that historical trends and relationships between real estate and other investment markets will continue. Both your returns and the value of your invested principal will vary throughout your participation."

Albert Warson is a Toronto-based writer specilizing in real estate-related subjects.