Friday Letter A tale of two pensions

Over the course of the past week, the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS) reported their investment returns for the fiscal year that ended on June 30.

While overall results at the two largest pension plans in the US were equally subpar and fell short of their benchmarks, real estate was the best performer for the two institutions, both of which have put an emphasis on core, income-producing properties.

That, however, is where the similarity ends.

CalSTRS’ real estate return stood at 9.2 percent for the fiscal year, underperforming its benchmark – the NCREIF Property Index – by 4.2 percent. The pension plan’s fiscal year 2011-2012 performance was considerably weaker than its results for the 2010-2011 fiscal year, when it posted a 17.5 percent return for real estate.

CalPERS, meanwhile, had a strong showing in real estate during the fiscal year, with investments in income-generating properties helping to deliver a gain of 15.9 percent and outperform its benchmark by more than 3 percent. That represents an improvement upon the pension plan’s 10.2 percent gain for real estate for fiscal year 2010-2011 and a substantial turnaround from its 37.1 percent loss for fiscal year 2009-2010.

One can be forgiven for thinking that real estate returns at the two pension giants should be closer to each other, particular given how vocal each has been about shifting their portfolios toward core, income-producing properties in an effort to strengthen returns. However, despite having similar investment strategies over the past year, CalSTRS’ real estate return declined from the previous year while that of CalPERS continued to improve. So why the disparity in fortunes?

On the surface, there are a few notable differences between the two real estate portfolios. For example, CalSTRS’ real estate portfolio currently is split evenly between core properties and opportunistic and value-add investments, while CalPERS’ portfolio is 70 percent core, with plans to grow that to 75 percent over the long term. That puts CalPERS further along the path to its ultimate goal than CalSTRS.

Furthermore, CalPERS expects to put out more capital than it receives back this year, while CalSTRS is in the reverse position. Indeed, CalSTRS is looking to decrease its overall real estate allocation over the long term from 14.5 percent currently to 12 percent through the sale of existing holdings, likely from the value-added and opportunistic components of its portfolio. CalPERS, meanwhile, still has capacity under its allocation target to add more income-producing properties.

Ultimately, however, the difference may come down to such subjective issues as valuation and timing.

On the valuation front, CalPERS is known to have written down its real estate holdings pretty substantially in the wake of the global financial crisis, hence the portfolio’s abysmal return in fiscal year 2009-2010. As the overall market recovered, however, those assets provided a pop as their values also recovered. CalSTRS, meanwhile, is believed to have not been as aggressive in its write-downs, shielding the pension from a big hit but providing less upside as the market recovered.

With regard to timing, CalPERS moved into core assets pretty quickly after the global financial crisis, which allowed it to buy quality assets cheaper with less competition and more upside potential. CalSTRS arrived on the scene a bit later as competition increased and cap rates compressed, allowing for less upside. Its acquisition of LCOR is a passive acknowledgement of that froth, as well as the fact that pensions will need to think outside the box if they want to generate steady, solid returns in the core space.

A general consensus among the vast majority of US investors these days is to weight real estate portfolios more heavily towards core in order to focus on stable long-term cash flow. But, as the different fortunes of California’s biggest pension plans show, there are factors to consider when doing so.