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CalSTRS considers a ‘risk-on’ approach to real estate

Consultant RCLCO told the $280bn pension it should consider increasing leverage, value-add strategies and construction in anticipation of a market reset.

This relatively new office building is located in West Sacramento near the Sacramento River.

The California State Teachers’ Retirement System is looking at a “risk-on” approach to real estate investment in the months ahead.

During the $280 billion pension’s March board meeting, consultants from RCLCO discussed plans to potentially increase leverage, focus on value-add strategies and take on more construction risk, all in anticipation of a real estate market reset.

“Investors recognize that we are likely at the beginning of a new cycle and there may be more time in which to take on value-creation activities and construction,” Taylor Mammen, chief executive of RCLCO, said during the webcast meeting.

Mammen added that the CalSTRS staff has sought innovative ways to use leverage to enhance value this past year, resulting in a “modest” increase in portfolio-wide debt for the first time in nearly a decade. “That’s a move we support, but it does increase, potentially, the volatility of returns over time as well, if and as asset values change,” he said. “We think everything is being done very prudently, but it’s something for the board to understand.”

RCLCO’s latest semi-annual report as of Q3 2020, which was submitted to the pension plan on February 8, does not disclose the current loan-to-value rate for CalSTRS’ real estate portfolio, but it notes that it is within the limits set by the pension’s investment policy, which caps LTV rates at 40 percent for its stabilized core holdings and 65 percent for its value-add investments.

Presently, the pension’s core portfolio, which makes up about 63 percent of its $36 billion allocation to the asset class, has a collective interest rate of 3 percent on its debt, most of which is on a fixed rate. Mammen said adding new debt now while rates are low could be advantageous in the long run. Overall, he said, CalSTRS’ portfolio is well positioned for both rising interest rates and inflation.

“Our view is there is likely to be limited inflation long-term, but if there is inflation, it typically benefits real estate, particularly real estate that is able to renew leases fairly quickly, such as multifamily. And CalSTRS has a large share of its assets in multifamily, so it benefits from that from an income standpoint. It also likely makes the debt that CalSTRS is securing today potentially more valuable.”

Drawing the line at retail

Gayle Miller, a delegate on the CalSTRS board, asked if investing in distressed retail assets would factor into a ‘risk-on’ approach. RCLCO managing director Ben Maslan said his firm is tracking repositioning strategies to be used on struggling retail assets across the US, but said the sector is not yet primed for investment.

“To invest in distressed in the retail sector is a little like catching a falling knife; no one knows exactly what it’s going to do or where it’s going to land,” Maslan said. “There aren’t those bottom-feeding opportunities in the retail sector yet. That may materialize over the long term but to invest in retail you really have to wait until prices bottom or approach the residual land value of the properties, giving no value to the improved portions of the properties.”

CalSTRS considered RCLCO’s recommendations in a closed session during its board meeting. However, no board actions have yet been taken.

At 12.7 percent of the total CalSTRS fund, the pension’s real estate allocation is short of its 14 percent target, according to RCLCO’s report. Since the first quarter of 2020, its real estate holdings have grown by $2.3 billion, a 6.9 percent bump. And while the pension has prioritized direct control of assets over fund commitments, those investments have fallen from 78 percent of its allocation to 70 percent during that time period.