Two decades on, Stan Hamilton and Robert Heinkel, both from the University of British Columbia, are working on a revised edition of what can be considered to have been a game changing book about pension fund management.Every pension fund should have an allocation to real estate. This is arguably the best asset class in terms of risk-adjusted returns over the last 20 years.
In 1993, the two finance professors and trustees of the faculty pension fund, penned a 165-page book, The Role of Real Estate in a Pension Portfolio. One of the key conclusions: “Having considered the liquidity and management issues relating to real estate, we conclude that real estate should compose between 5% and 15% of the pension portfolio.”
The two – Heinkel is still at it while Hamilton has retired – argued real estate ”is the only asset class that reacts significantly and positively to expected inflation changes.”
Reached Tuesday, the day after a column about the Canadian arm of LaSalle Investment management launching its fourth institutional real estate fund since 2003, Hamilton, said in the early 1990s it wasn’t that common for pension funds to give an allocation to real estate.
By his estimates, about 4% of the industry’s $250-billion in assets was in real estate — or about $10-billion in total.
“In the main it was really insignificant. The vehicles were not always as convenient as they might be,” said Hamilton. By 2011, according to Canada’s Pension Landscape Report, pension funds had doubled their allocation to real estate to 8.9% — or almost $100-billion.
Consulting firm API Asset Performance Inc. said its clients average an overall weight of 5.4% for real estate but it rises to 11.6% when only those with a dedicated real estate portfolio are considered.
Hamilton, as with Heinkel, is too modest to take credit.
“Maybe we were lucky with our timing,” said Hamilton, noting the growth of REITs, the rise of institutional pools of capital dedicated to real estate, the expansion of new ways to invest, and the further development of specialist real estate managers, has meant “the share of pension funds that has gone into real estate has changed quite significantly.
“It has changed dramatically,” said Hamilton, noting that some of the larger pension funds have more than 10% of their assets invested in real estate. A short while after the book, the UBC Pension Plan gave a major allocation to real estate.
The two made the argument for real estate largely on the grounds of portfolio diversification. “It was a great diversifier and fits into a portfolio. We never tried to sell it on rates of return because we thought that was a fool’s game, said Hamilton. “We said ‘if you approach it properly and not going for the hype on rates of return, it is a valuable tool.’ That message resonated,” said Hamilton, now chair of the B.C. Arts Council.
But real estate is different: it has to be considered as a long term investment. While owing REITs wasn’t similar to owning real estate directly, Hamilton said “we saw reasons to go up to 15% in real estate, but because of liquidity we recommended that mid-and large sized pension funds consider going to 10%.”
And 10% is an allocation that Hamilton feels is suitable today. “That story rings true [but] if you have any liquidity concerns, going much above 10% is probably uncomfortable.”
Along the way real estate has enjoyed a change in status: once considered an alternative asset, “it is now more like a mainstream investment,” said Hamilton.
But professor Hamilton is right, pension plans with liquidity concerns have to gauge their liquidity risk and adjust their weightings accordingly. The same can be said of private equity and infrastructure, two other popular illiquid asset classes.
There is a debate going on right now on illiquidity premiums. Some very sharp pension fund managers feel that pensions are taking on too much illiquidity risk and market valuations do not compensate them for taking on this risk. Many pensions learned the hard way all about liquidity risk during the 2008 financial crisis. When they needed liquidity the most, it wasn't there, forcing them to sell public market assets at distressed prices.
Still, pension funds remain undeterred. They're picking up their real estate activity and even taking on more opportunistic risk. Craig Karmin of the Wall Street Journal recently reported, Funds See Opportunity in Real Estate:
A glitzy Manhattan real-estate crowd gathered in March to join Barry Sternlicht, chief executive of Starwood Capital Group, at a party celebrating the launch of condo sales at the Baccarat Hotel & Residences, a new development across from the Museum of Modern Art.I recently covered why the Caisse is betting on multi-family real estate. The Caisse's real estate division, Ivanhoé Cambridge, is one the best institutional real estate investors in the world, which is why it's well worth tracking their activity. They the internal expertise to go direct, co-invest with top funds as well as do deals with other large pension and sovereign wealth funds throughout the world.
The 50-story glass tower, expected to open in 2014 and feature a five-star hotel and Baccarat chandeliers in each condo, is the sort of development rarely seen in the years after the financial crisis. But riskier projects are starting to move forward again, thanks in part to a resurgence of so-called opportunity real-estate funds.
These private-equity funds invest in riskier real estate, such as half-empty office buildings, distressed properties weighed down with debt, or pricey new construction that must find well-heeled buyers to profit. The Baccarat, which is being developed by Starwood and Tribeca Associates for $400 million, is counting on selling condos for as much as $60 million each.
For most of the downturn, these real-estate funds struggled to raise money because their main source, big pension funds, were risk-averse and still licking their wounds from when these bets went wrong. The California Public Employees' Retirement System, the largest U.S. public fund with $263 billion, lost nearly half the value of its real-estate portfolio between July 2008 and June 2009—more than $10 billion.
But these days, many pension funds are reconsidering—or trying for the first time—riskier real estate in an effort to boost returns at a time of low interest rates. These funds project up annual returns as much as 20%.
A pension fund has to "take more risk to get double-digit returns," says Bob Jacksha, chief investment officer of the New Mexico Educational Retirement Board. His $10 billion fund recently committed $50 million to Crow Holdings, which manages opportunity funds.
Pension funds also have been emboldened by the steady rise of commercial-property values since 2009 and a winnowing of some of the worst-performing funds. The economy shows signs of stabilizing after a rough period, and borrowing for real estate is cheap with rates so low.
"Many prices have fallen quite a bit, so there's now a lot of opportunity," says Edward Schwartz, a principal at real-estate consultant ORG Portfolio Management. But some pension funds, he adds, "also have short memories."
In recent months, a public-employees fund in Texas, Kentucky's main public fund and an Oklahoma City police fund all have made commitments to opportunity funds.
Such funds raised about $25 billion in 2012, nearly double the amount in 2009, according to research firm Preqin. Nearly half of pension funds and other large investors allocating to real estate expect to make commitments to opportunity funds in the next 12 months, Preqin said.
Private-equity giants KKR & Co. and TPG Capital also are in the early stages of raising their first real-estate funds, which will focus on riskier investments, say people familiar with the matter. Starwood last month closed a $4.2 billion fund, well ahead of its initial $2 billion to $3 billion target, say people familiar with the fund. Brookfield Asset Management has raised about $2.8 billion for an opportunity fund that is targeting $3.5 billion.
During the downturn, many pension funds largely spurned risk and focused their real-estate investments on the safest, well-leased properties in the healthiest markets. But now they are straining to make these strategies work as high demand for these properties drives up prices.
Calpers acknowledged last month that the shift it started in 2011 from risk and toward more-stable property investments is proving tougher than it expected. It is becoming "hard for Calpers managers to make [real-estate] investments in which they can reasonably expect to generate returns in excess of" liabilities, the pension's real-estate consultant wrote the Calpers board.
While some opportunity funds aim for gold with new projects, others try to profit by turning around troubled buildings. Blackstone Group, which recently raised a record $13.3 billion opportunity fund, last month bought London's Adelphi Building for about £265 million ($412 million). That is a 19% discount from what the building fetched in 2007, but with a tenant occupying half the building departing, Blackstone will have to find a replacement.
Pension-fund investors embracing opportunity funds say they know it isn't a risk-free bet.
"The biggest risk, of course, is the downturn in the economy," says Steven Snyder, chief investment officer for the Oklahoma City Police Pension & Retirement System, who made two recent commitments to opportunity funds. "That could be a negative for our investment."
Mr. Schwartz of ORG says he has put clients such as the Texas Municipal Retirement System and state funds in Maine, Indiana and Kentucky in opportunity funds in part because these funds responded to investor complaints that went beyond poor performance.
I've also covered the pickup in real estate distressed debt investing, part of the reason behind the return of private equity giants. Why are some of the best funds ramping up their activity in this sector? It's obvious they see tremendous opportunities and are actively looking to capitalize on distressed properties, work them to sell them at much higher multiples.
CPPIB has been very active in real estate deals, partnering up with GE Capital Real Estate (GECRE) to invest in central Tokyo office properties, betting on a bottom in that market. CPPIB also formed a new 50%/50% joint venture with Hammerson to acquire a 33.3% stake in Bullring Shopping Centre for £307 million from the Future Fund.
But bfinance notes the renewed interest in commercial real estate is raising some concerns too. In particular, experts warn of yield compression as the flood of money into some areas, whether geographic (London, Paris, Frankfurt) or strategy specific (core, inflation-linked long lease), is creating far greater risk on capital invested down the line than investors may realize in their quest for short term cash yield.
Finally, while real estate is a stable asset class, Canadian pension funds are increasing their direct investments in infrastructure, an asset class with a much longer investment horizon than real estate and private equity. This is all part of asset-liability matching, finding assets with long durations which can deliver the targeted actuarial rate of return.
PSP Investments recently bet big on airports in a deal that was attractively priced and will likely pay off nicely for their members as the global recovery takes hold. It also owns timberland stakes throughout the world, including New Zealand, where they own properties with Harvard Management Company and the New Zealand Superannuation Fund.
Below, Walker & Dunlop CEO Will Walker discusses commercial real estate on Bloomberg Television's "Market Makers." And Chaim Katzman, chairman of Gazit-Globe Ltd., talks about their success formula in commercial real-estate market. Lastly, Thomas Shapiro, president and chief investment officer of GTIS Partners, talks about the outlook for investment in the Brazilian and U.S. real estate markets.