Public pensions are rushing into real estate the way they rushed into tech in the late 1990s. Maybe it's a good time to get out.
When the tech boom went bust A few years ago, New Jersey's public pension fund was among the hardest hit in the country, suffering a loss in its tech-laden portfolio of nearly one-third of its value, or $30 billion. Now the State Investment Council has another great idea: In January it decided to jump into--this can't be a surprise--real estate.
Plenty of other public pension officials have decided to make the same play. After getting out of real estate altogether in the late 1990s, the Teacher Retirement System of Texas has decided to invest up to $2.7 billion, or 3% of its $90 billion in assets. For the first time the Arizona and New York City funds are buying up property.
All told, the top 50 public funds increased their commitments to real estate last year by $9.8 billion, equal to 11% of their property holdings, according to the newsletter Real Estate Alert. Now they have set a target of loading another $34 billion into land and buildings as quickly as is practical, representing a 37% hike to $128 billion, or 7.2% of their assets.
The rush of public money into real estate has many signs of the rearview-mirror investing that cost New Jersey so dearly during the tech bust. As with homes, commercial real estate has been on a tear for several years. The S&P Index of real estate investment trusts returned 17% a year over the past three years, versus 6% for both the S&P 500 and corporate bonds. The run-up has pushed down the yield on commercial property (rent minus expenses) to 7.9%. That's the lowest it's been since at least 1989, according to Real Estate Research Corp.
"We're drowning in liquidity," says Dale Anne Reiss, who heads Ernst & Young's real estate practice. "Banks are lending aggressively, and every flavor of institution thinks real estate is the best alternative out there. Some of us remember an equal degree of enthusiasm in the late 1980s just before the market collapsed."
Public pension managers may feel particular pressure to follow the trend because of actuarial expectations that they will wring 8% or so in returns out of their assets each year. Money managers are going to be hard pressed to deliver such results from their stocks and bonds.
"High [property] prices are clearly an issue," says Timothy Barrett, executive director of the San Bernardino County Employees' Retirement Board, which has 8% of its $4.6 billion in real estate. "But real estate is still attractive from the point of view of our 8% hurdle and the outlook for bonds to earn maybe 4%."
To get that 8% using property, investors aren't just buying shares of publicly listed REITs or owning easy things like leased office buildings. They are taking chances.
Alaska's state pension, for instance, has invested $500 million in five "high risk" real estate funds to try to meet its target, concedes investment officer Michael Oliver. He expects these investments to earn 15% to 17% annually, after fees.
The California State Teachers' Retirement System is trying to increase its real estate holdings from 4.6% to 6% of its portfolio. That has forced it to look to more exotic fare than in the past, including a joint venture that invests in medical offices and student housing. "Real estate is a tough market these day," says Michael DiRé, director of real estate at CalSTRS. "There are a lot of players out there using a lot of leverage."
Another popular ploy: "opportunity" funds. Many are financed with 65% or more debt and invest in properties in unusual places or in need of improvements. For their trouble, opportunity funds charge hedge-fund-like fees of 1.5% or so of committed capital plus a 20% cut of profits.
They may not be worth the cost. Recent data indicate the median opportunity fund opened between 1996 and 1999 will have net returns of about half its promised 20%, according to Nori Gerardo Lietz, a cofounder of the Pension Consulting Alliance. Investors would have done better on a risk-adjusted basis putting money into "core" properties, she adds.
Another hazard for public funds: A conflict of interest among some of the consultants whom they pay for advice on where to invest. Russell Real Estate Advisors tells pension funds where to invest while simultaneously running its own real estate funds and managing an $800 million property portfolio. One large fund says it stopped working with Russell earlier this year after the firm repeatedly pushed for lucrative money management assignments, which would have created a conflict with its existing role as a supposedly objective adviser. Russell says it "may make a consulting client aware of other Russell products and services, but it always remains the client's decision whether to retain these services."
Public pension funds might do well to follow the lead of California's pension fund Calpers, the nation's largest public fund and often in the investing vanguard. As less savvy funds rush in, Calpers has lately sold about $7 billion in expensive real estate and taken profits.
"We think the timing is right" to sell, says Brad W. Pacheco, a Calpers spokesman. "We have a property on the block right now and plan to continue selling."
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