Friday Letter At the core of the matter

LPs around the world, including CalSTRS, are eyeing greater core exposure, but how do they balance that against a need for higher returns? 

After suffering write-downs of up to 50 percent on its real estate investments over the past year, it’s understandable that the second largest public pension in the US, the California State Teachers Retirement System, would want to change its risk appetite.

Indeed, the quest to rethink real estate allocations is a global trend and not one restricted to the $132.2 billion CalSTRS. The coming year will undoubtedly involve plenty of policy reviews by institutional investors worldwide, and will be an extremely interesting phenomenon to watch.

However, in setting out its new real estate investment strategy this week, CalSTRS is trying to balance two seemingly conflicting philosophies – to significantly increase its exposure to core assets (which are supposedly less risky investments) at the same time as trying to achieve a higher rate of return from its deals.

Outlining its new 2010-2011 business plan – and due to be voted on today -the California pension has said it wants to increase its allocation to core real estate to 50 percent of overall real estate, with value-added and opportunistic strategies set to account for 20 percent and 30 percent, respectively. CalSTRS has traditionally allocated its real estate investments according to core and tactical strategies, with core accounting for roughly 35 percent of the portfolio, as of the end of September 2009, and tactical (value-added and opportunistic) accounting for around 65 percent.

In terms of returns, CalSTRS is also raising the bar. In future years, the pension wants its $13 billion real estate portfolio to achieve an overall return of 9.25 percent net of fees, with core, value-added and opportunistic investments returning between 7 and 9 percent net, 8 and 12 percent net and in excess of 15 percent net, respectively. Previously, core was expected to return a minimum IRR of 5 percent net of fees, with tactical investments returning a minimum IRR of 9 percent net.

On top of that, CalSTRS also wants to limit the use of leverage according to strategy, with 50 percent, 65 percent and 75 percent LTV caps for core, value-add and opportunistic deals.

The pension investment staff must understands only too well the dilemma they face in asking for safer, core-like investments, while demanding better performance from its capital.

When debating the issue in June, staff members said that with core return expectations of just up to 8 percent “additional investment risk must be taken to achieve the net premium of 125 to 225 basis points [to achieve the overall 9.25 percent benchmark], representing a significant premium over the core market”.

The challenge for CalSTRS, and other investors, is where to take those “additional investment risks”, bearing in mind core real estate in the US has delivered just 5 percent returns over the past decade, according to the ODCE NCREIF Townsend Fund index, an indices that CalSTRS will be benchmarking itself against going forward.

It begs the question therefore that with much of the US real estate equity already chasing high quality, core assets in primary markets, will CalSTRS be putting its money to the highest and best use or will it be paying a premium for lower risk?

It’s a Catch-22 that will truly test many institutional investors in the US and abroad. One issue appears clear though – for now at least, LPs won’t be piling on the risk without extensive due diligence.