After some bad experiences during the crisis, pension funds in the US are playing it safe, writes Michael Lester

Real estate officers at pension funds tend to move slowly. Such is the nature of the beast. Their transactions are always complex and often cumbersome. It takes more time and more calculations to sell a portfolio or even a single building than it takes to sell stock in a company that leases that building. And so, although real estate markets and the economy in general are improving day by day, pension funds still seek safety and security. As Mike Kirby, founder of Green Street Advisors, says: “They’re cautious now, because they just got hit over the head.”

During the first seven years of this century, pension funds explored new, value-added territories. These were years of exceptional growth, and most pension funds reduced their core holdings and chased yield. The big pension funds aggressively led the way, but soon most funds were adopting similarly riskier strategies.

In 2008, the global financial crisis turned the pension world upside-down. Concentrating once again on low-risk assets was an understandable “psychological response” says William Hughes, global head of real estate research and strategy for UBS Realty Investors.

Hughes, who hates to use the word ‘core’ because he feels it is a term that is not sufficiently defined, says: “It was also a reasonable response. The low-risk sector is low-yielding, but that’s appropriate given the current economic outlook. We’re pretty conservative in the pension world.”

According to Kirby: “At the peak, pension funds supplied the capital for some of the most profoundly stupid real estate deals imaginable”.

He adds: “They gave money to advisers to go buy parcels of dirt that are now trading at five cents on the dollar. Pension funds, as a whole, are bad at timing cycles. They tend to become much more accepting of risk five years into an up-cycle.

“Like a lot of other investors, they red-line anything risky after the damage has been done – and that’s probably the time when you should buy the distressed stuff. While some pension funds avoid this trap, most of them are the opposite of opportunistic investors.”

But Hughes disagrees. “When there’s a shock to the system, as there was in 2007, the public market will rapidly address that shock through price. But the private markets will address it through liquidity.

“What we saw was an evaporation of transactions. Those in the public market like to think of themselves as early movers. I don’t know if they’re early; I think of them as fast movers.”
Kirby, whose advisory firm focuses on the public markets, suggests that many pension funds can suffer from a herd mentality. “Everybody gets the timing wrong, that’s human nature. But I think that pension funds are worse than most when it comes to backing up the truck at the right time.”

Publicly-traded real estate investment trusts (REITs) are Kirby’s area of expertise. He sees a major difference in investment style between REITs and public funds. When the market was at its peak, he says, REITs were big sellers, primarily through privatisation, and thus
among the smart players. Once the economy bottomed, REITs were “the first ones going back into the water,” engaged in all kinds of real estate deals.

“On an opportunistic investment spectrum of intestinal fortitude and financial wherewithal, REITs have been at one end while pension funds that focused solely on private-market investments were at the other,” says Kirby. Of course, pension funds that own REIT stock have been able to participate in REITs’ success.

Of course, Kirby agrees that there is a wide range of investment strategies among the pension funds.

“There is no single unifying style,” says Jacques Gordon, who leads the global team for research and strategy at LaSalle Investment Management. But style is often dependent on size. There are 10 to 20 large state plans with dedicated real estate staff. They have the experience and capability to discern development, international and opportunistic risks.

“They are comparable to an APG, PGGM or any of the successful UK pension plans like Hermes or the Wellcome Trust,” says Gordon. “These larger plans are comfortable with underwriting risk. They move away from core when it makes sense to do so.”

Gordon would also lump some large municipal plans (like Los Angeles County) and a handful of Canadian plans into that smart-and-savvy box. “The Canadians are investing internationally, including managed portfolios in the US,” he says.

In a totally different box are the small state and county plans that have no history in real estate investing, no expertise and no staff. Many of these small funds have absolutely no real estate allocations.

One thing that US pension plans do have in common is ethical issues and disclosure, which are very important to them. Gordon points out that US funds usually maintain strict discipline “on process, reporting, transparency, conflict-of-interest issues and disclosures.”
Especially when their shareholders are civil servants such as teachers, firemen and policemen, the public pension funds need to keep their ethical standards high and their transactions transparent.

The return of risk appetite?
Since the end of 2012 funds have slowly but surely been willing to take on more risk. “The desire to stick to core and very safe investing is still the dominant one,” says Gordon, “but an appetite for development, for leasing risk and for secondary markets is starting to appear.”

What are these secondary markets? “Many pension funds tend to get into places that are easy to get into,” says Kirby. “They’ll avoid New York, Los Angeles and San Francisco, because cap rates are already down to 4% there.”

Gordon says: “We’re not looking at very many large portfolio deals. We build our clients’ portfolios one property at a time, generally looking for core-plus returns. We’re certainly moving beyond cities like New York, and we’re getting comfortable in some secondary markets like Austin, Texas.”

Hughes says: “Even though the apartment market has been hot, it still has life left in it; we’ll probably see growth there for the next five years. The most interesting sector is retail.
We’re operating at a higher consumption level over the last year than in the fourth quarter of 2007, which was the previous peak. We’ve recovered from the 11% fall and we’re at a new peak for retail sales every quarter.”

The nation’s biggest pension plan is the $255bn (€195bn) California Public Employee Retirement System (CalPERS). The fund has $22bn invested in real estate. It leads the industry in investments and, often, in strategy. In 2011, CalPERS initiated a five to seven-year plan to lower its real estate investment risk. The fund is moving as much as 75% of its investments back to core assets.  

As of 30 September 2012 (the last reporting quarter), 42% of CalPERS’ real estate portfolio was invested in core, 12% in value-added and 46% in opportunistic (see box). As with most real estate deals, this return to lower-risk investments takes time because real estate is illiquid.

Europe remains off most radar screens. Following the global financial crisis, US pension funds refocused on domestic investments. Investing in Europe requires a solid understanding of different cultures, tax structures and currency valuations, all involving additional risk.

Initially, there was some interest in Europe. The motivation, according to Hughes, was:
“Things are distressed over there, so I can pick up things more cheaply.” He adds: “But if you’re active in the European market, you realise that it’s still pretty competitive and not an easy game. At the moment, it’s more window shopping. There are a few buyers, but there hasn’t been a big wave yet.”

CalPERS spokesman Joe DeAnda puts it bluntly. “At present, CalPERS’ focus is in the domestic space.”

Perhaps the investment style of US pension funds is related to their history in the country. European pension funds have a few hundred years of experience ahead of their US counterparts. Real estate officers are paid noticeably less in the US compared to those in Europe. US real estate teams are often significantly smaller. They often are hampered by political decisions made by their boards of directors, and so they move differently.

“Pension fund managers outside the US – generally throughout Europe and particularly in the Netherlands – have more training and more marketability,” says Kirby. “In Europe the attitude is, ‘Let’s pay whatever it takes to do the job well’.”

Different perspective
According to Hughes, UK real estate investors tend to think “more like us here in the US, but continental European investors look at real estate differently. They view real estate as a long-term structural asset, and not as something that you buy and sell at any given time. In Europe, it’s not what you can sell it for today, but what it is worth in the long term. They almost have regulated values. It’s a different perspective.”

Given this history and these constraints and uncertainties, says Hughes, “institutional investors in the US tend to wait and see what the result is rather than jump on information and try to anticipate results.”

Kirby says, half-mockingly: “The pension fund community is always slow to change. They will increase their risk-taking appetite as time goes on... and, by the time the next peak occurs, promptly forget the lessons they learned during the downturn.”