The uncertainty in public and private markets has left many U.S. pension fund administrators uneasy, at best, and has left managers searching for investments that can match long-term liabilities and fight inflation. Since the 2008–’09 financial crisis, pension portfolio administrators increasingly have been allocating back into those same markets but have also made inroads into areas that seemingly provide more stability.
Real estate, especially commercial property, although also having had its share of ups and downs, has provided some measure of calm to institutional investors. For example the California Public Employees’ Retirement System (CalPERS), which, with $285.2 billion in assets under management as of February 28, is the largest public pension plan in the U.S., invests about $25 billion into real estate. The New York State and Local Retirement System, the third-largest pension fund in the U.S., as of March 31 has 6.9 percent of its $176.2 billion in audited net assets directly invested in real estate.
According to the latest edition of real estate valuation and consulting firm Real Estate Research Corp.’s Real Estate Report — Valuation: Now and Then, released June 2, whereas commercial real estate lost value during the recent downturn, values have recovered about 25 percent from their nadir during the financial crisis. “According to our analysis,” writes Ken Riggs, CEO and president of RERC in Des Moines, Iowa, “we expect that within another year, commercial real estate values will have recovered just above 30 percent from the bottom, although it will still be below the high-water mark.”
Breaking that out further, Riggs told Institutional Investor that from a broad market perspective, this level of recovery is slow and measured. But broken down, he adds that “the coastal markets have recovered almost all of what they gave up during the credit crisis, and that most product types in those markets are getting close to a recovery point before the credit crisis.”
Others agree. Allison Yager, global business and investment leader for the Real Estate Boutique unit at human resources consulting firm Mercer in Atlanta, says that shortly after the financial crisis, she saw investors quickly move back to the asset class across several major global markets, including Australia, Canada, Japan and the U.S.
“While we are positive, we also don’t think we are going to see a 400- to 500-basis-point appreciation on core assets,” says Yager. “We don’t believe the type of appreciation we’ve seen on core assets over the last couple of years is sustainable. The growth in core assets will be driven by income growth.”
The RERC report further states that institutional investors feel there is too much capital facing too few deals. Compared with the previous quarter, investors increased their rating, on a scale of 1 to 10, for the availability of capital to 8.2 from 7.6 last year, while they lowered their rating for the discipline of capital, or underwriting criteria, to 6.2 in the first quarter of 2014. According to institutional investors surveyed in the report, high-rated sectors for commercial real estate include the warehouse sector, rated 7.5, and the hotel and apartment segments, which were at 7.1 and 6.8, respectively. The central business district and suburban office sector rose to 6.5 and 6.7, respectively.
David Glickman, a managing director with consulting firm Pension Consulting Alliance in Carmel, California, adds to this point by noting how the historically large number of investors pursuing a limited number of offerings will create divergent price models for the same properties. As a result, he says, some pension funds might get priced out of the market.
“There are offshore investors from the Middle East, Europe and Asia who are now competing for the same large, attractive deals for which they historically did not compete,” he explains. “You have more people in the room with checkbooks. And what happens when there are more people and no additional supply of assets? The prices go up.”
“Ultimately, as net assets from other larger parts of a pension fund’s portfolio increase, the fund looks to rebalance its holdings in sectors such as real estate to keep pace with the asset allocation model ranges,” adds Glickman. “A pension fund might be hard-pressed to find property assets that are priced well enough to ensure a proper return.” One final point, he stresses, about pricing and the lack of supply, is that “while interest rates remain low, some private investors are also able to bid up prices knowing they can leverage a majority of the asset’s price at a low cost.”
But, notes Yager, low interest rates could encourage developers to build more and potentially oversupply the market. “We think some increase in interest rates is a good thing for the industry — it slows down developers whose only goal is to build new buildings.”
Still, Riggs says, despite more capital chasing deals, real estate is “a hard asset and the underwriting criteria for what we are looking at today are much different from what they were before the credit crisis.” Riggs points out that despite real estate’s status as an alternative investment, much of the return comes from income. According to the RERC report, commercial real estate has provided 75 percent of its return from income.
Glickman says that many retirement systems are seeking out so-called core, or finished and leased, properties. Historically, these have provided a net return of 7 to 9 percent, “the components of which are probably 5 to 6 percent income over time and 2 to 3 percent appreciation,” he says. “These levels of return are not easily achieved when the ten-year Treasury is priced to yield at 2.5 percent or more.”
Overall, notes Riggs, because of the higher levels of capital chasing deals, there is a concern that things are getting too competitive and that institutional investors will need to become more aggressive on the underlying criteria they use to understand what rents will be, what expenses will be and where capital expenditures will go. “The fundamentals should get better,” he adds. “There is pent-up demand to a certain degree in all of these sectors. Businesses have been thrifty about taking on space and making capital expenditures.”
The RERC report says that given the demand in some areas of the U.S., commercial real estate remains reasonably priced and valuations are rational. The most recent five-year National Council of Real Estate Investment Fiduciaries annual compounded rates of return have been around 7 to 8 percent, which were also reasonable. Looking at next year, RERC expects total returns to be slightly higher.
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