The US pensions landscape has changed but many are still investing in housing - and structured finance for that matter - to exploit market dislocation. Jon Peterson reports

The changes in the debt market have led many pension funds to consider new investment opportunities, sit on the sidelines until pricing issues are resolved and be selective on new purchases.

California Public Employees Retirement System (CalPERS) has had a very active single-family investment programme since 1992. The pension fund is now taking a hard look at the housing segment within its real estate portfolio. There has been no definite decision made about the future of the single-family programme.

There has been some talk in the pension fund real estate community about the current financial situation of the CalPERS single-family assets. It is suggested that, if the assets were marked to market, the pension fund would be incurring losses in the range of $3bn to $4bn (€2-2.7bn). This would eliminate all the profits that the pension fund has generated in single-family investments over the past 16 years. CalPERS has had Hearthstone as its major real estate manager for single-family. Both refused to comment on this situation.

There are some pension funds that look at the current state of affairs in the housing industry as an investment opportunity. One major investment consultant - the Townsend Group - takes precisely this view. Rob Kochis, a principal at the company, works with some of the major pension funds around the United States. One that has invested in the single-family arena is Teacher Retirement System of Texas.

Kochis says: "We are very aware of what is going on with the housing industry. It's our thinking that to invest in this situation is now a contrarian play. The supply/demand characteristics are not there right now but we do believe that the market will come back in the future. There are some good investment opportunities available with land or finished lots that many builders would like to get rid of now."

The degree of the housing slump in the US is clear. Residential construction dropped nearly 40% in 2007, while permits for new buildings fell by 34% last year. Nationally, sales of single-family homes have dropped by 50% from a peak in mid-year 2005 according to the US Bureau of the Census and the National Association of Home Builders.

There will also be a decline in the percentage of the population that can afford to own a house. The projection is that this will fall by 1.5% to 2% in 2008. Kochis says: "These figures aren't pretty but long-term we still believe in investing in housing."

Last year, Texas Teachers did become the lead investor in a new single-family commingled fund. It made a $125m commitment to the Tricon IX, L.P. This allocation was put to work as a springboard that allowed Tricon Capital Group to go out around the country and try to attract additional investors.

Kochis says: "We still believe in the strategy that Tricon has. This is to fill in the equity cap that some builders are having with their projects. Some of our other clients are looking at this commingled fund as a possible investment. One of these is Ohio PERS."

David Berman is president and chief executive officer of Tricon. He feels there has been a big change in investor sentiment. He says: "At the middle part of last year, there were not a lot of investors interested in our fund. I have noticed a big change in the last few months. There are many investors now willing to listen to our story and starting to believe that there is a strong long-term investment play to what we are trying to accomplish. We truly believe that we will be able to reach our goal of raising $600m of equity capital for the fund."

California State Teachers Retirement System (CalSTRS) is another pension fund that has invested some of its capital in single-family. In the summer of 2007, the pension fund created the BrookCal joint venture. This was a $400m venture with Brookfield Homes for land acquisition and development.

The pension fund has only invested $30m of the capital for the venture so far. This has been placed in the Inland Empire region of Southern California. CalSTRS is proceeding very cautiously in placing capital in the housing sector on a very prudent basis.

CalSTRS in July 2006 made a $300m commitment to Hearthstone Housing Partners III. The other $300m commitment for the commingled fund came from CalPERS. Hearthstone is looking for deals for this commingled fund on a very limited basis. Both of these investments fell within the CalSTRS Residential Land Programme. This covers both the acquisition and development of land.

Going forward, CalSTRS will not be very active in investing additional capital in single-family. The pension fund does not have a set allocation for the property type but it would consider making investments on an opportunistic basis.

Los Angeles County Employees Retirement Association has had one of the largest separate account programmes for single-family investing for the past 12 years. It has always tried to have $300m of capital involved in the programme. The manager it works with on the account is TriPacific Capital Advisors.

The pension fund is going to be a supporter of the programme, even in these difficult economic times. John McClelland, principal investment officer for real estate for LACERA, likes the long-term benefits of investing in single-family. He says: "We do not try to be market timers in any of the real estate investments that we make. It's our opinion that, on a long-term basis, the demand for housing is very good. At the same time, we are aware of the current market situation and we will monitor it very closely."

The existing single-family programme LACERA currently has amounts to 53 investments with a total value of $175m. TriPacific is still out in the market looking for deals. The areas it is looking at are places where there isn't a tremendous over-supply of product. These will include the Pacific Northwest and the Texas markets of Dallas/Fort Worth and San Antonio. The pension fund is now looking at less new investment origination and more opportunistic land acquisitions.

The changes in the debt markets that occurred over the second half of 2007 made a lot of pension funds in the United States rethink their real estate strategies. A new investment opportunity to come out of this was pension funds putting more capital into structured debt through mezzanine and commercial mortgage-backed security (CMBS) investments.

One example of this has been with the activity investing in this area by San Bernardino County Employees Retirement Association. Over the past several months it has committed $150m of capital to four managers for structured finance.

Don Pierce is the investment officer for the pension fund. He says: "We felt that there were several sources of capital that were taken out of structured finance by the changes in the debt market. By investing in these commingled funds, we could achieve solid risk adjusted returns. This is something we will continue to look at in the future."
Pension funds in some cases are in no hurry to place more capital into real estate. The changes in the debt markets have taken out the highly leveraged buyers as being a big factor in the marketplace. These were investors that bought properties using 80-90% financing. This has made pension funds think about how active they want to be in the buying and selling of real estate. The end result is a lot less activity by pension funds in real estate.

The attitude of Sacramento County Employees Retirement System is a good illustration of this situation. The pension fund has earmarked $75m for an investment into value-added commingled funds.

Jeff States, chief investment officer for Sacramento, says: "We have decided to do this because our previous $75m that we invested in value-added commingled funds has not been fully invested. The managers of this capital are having some difficulty placing the capital that we committed to them in the summer of 2006. Until this gets invested, we will not be committing the additional capital."

Sacramento County is also now looking at having fewer of its separate account assets on the market for sale. The pension fund in previous years has been an active seller of its properties through Cornerstone Real Estate Advisors and BlackRock Realty. It now has only one property up for sale with BlackRock Realty and none for Cornerstone. States says: "Pricing issues had made it difficult to be an active seller now."

There are some pension funds in the US that think some new distressed investment opportunities are going to be created as a result of the changes in the debt markets. The core property types were not the target of investments by highly leveraged buyers.

Most of these investors went after value-added or opportunistic plays. This has created some new investment opportunities in the market over the next 12 months.

One pension fund that believes this is Oregon Public Employees Retirement Fund. At its board meeting at the end of January, it made $700m-worth of commitments into commingled funds that have a value-added or opportunistic strategy.

The most significant of these was a $100m investment to Lone Star Real Estate Fund I. This is the first time that Lone Star has had a real estate-only commingled fund targeting opportunistic real estate investments in the US. All of its other opportunity funds have had a global investment strategy.

Brad Child is the senior investment officer for real estate for Oregon PERF. He says: "We do think that there is going to be some good investment plays in the opportunity sector with the changes that have occurred over the past six months."

Another significant trend to come out of the changes in the debt market has been that cash will be king of the marketplace. Pension funds could be a leading force of capital going forward. This is mainly because many pension funds do not have a great deal of leverage on their portfolios.

LACERA is a good example of this. The pension fund has a $4.1bn equity real estate portfolio. It has a loan-to-value ratio of 12%. This means that the performance of many pension fund portfolios will not be severely affected by the change in the debt markets. LACERA will be selective on the real estate investments it makes in the US.

McClelland said, "We are going to be picky on the amount of real estate we will invest in in this country. In some cases it will be investing in specialty property types through commingled funds. In others it will be core and value-added acquisitions through our separate account managers."