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Why midsize investors are ramping up in direct real estate

The Arizona State Retirement System's $450m joint venture with Tricon shows direct investment structures appeal to more than the top US pensions.

A master planned community in Scottsdale, Arizona.

Large public pensions are not the only US investors pursuing more direct real estate investments. Some smaller institutions are looking to enhance returns by committing capital to non-fund structures.

One such institution is the Arizona State Retirement System, a $40 billion pension that committed $400 million last week to a joint venture with Tricon Capital Group to develop for-rent single family homes.

RCLCO, the real estate consultant for ASRS, said separate accounts and direct investments in operating companies will be the focus of the Phoenix-based public employees’ pension’s new real estate implementation plan, presented during a meeting on June 17, which calls for the firm to grow its target real estate allocation to 20 percent by 2027.

In 2011, the pension had a 5 percent allocation to real estate, totaling $1.4 billion, of which just $9 million went to direct investments. Since then, real estate has made up a larger portion of its portfolio almost every year. At the end of the 2018 fiscal year, its real estate holdings stood at $4.9 billion, 12.4 percent of the total fund, with separate accounts and operating companies accounting for more than 61 percent of the allocation.

ASRS began focusing on direct investment eight years ago, a pension spokesman told PERE, and has committed $10 billion to the strategy throughout its private market portfolio. These structures now make up two-thirds of the overall program. Unlike other investors that have moved in this direction, ASRS has not added more staff to support the strategy.

ASRS plans to continue growing its real estate allocation through non-fund investments because of their track record of producing outsize returns. Over five years, its separate accounts have produced an internal rate of return of 12.4 percent and its operating company investments have returned 15.7 percent, according to meeting documents. Commingled funds, meanwhile, have delivered an IRR of 10.6 percent. Overall, the pension has beaten its benchmark by almost 2 percent during that time.

The joint venture with Tricon will focus on the development of master planned communities of ‘build-to-rent’ houses throughout the southern US. The Toronto-based manager has committed $50 million to the partnership and will use one of its subsidiaries, Johnson Companies, to execute the strategy.

Tricon chief executive Gary Berman lauded the alliance for bringing “increased scale and operational synergies,” to his firm’s housing platform. ASRS could not be reached for comment.

Working together

For investors with deep pools of capital, joint ventures, separately managed accounts and club deals allow them to write large checks, limit fee-based expenses and align their interests with those of their managers. These include Canadian investors such as the Ontario Teachers’ Pension Plan, Caisse de dépôt et placement du Québec and the Canadian Pension Plan Investment Board, all of which have pursued joint ventures and separately managed accounts for years. More recently, similar-sized US pensions such as the California Public Employees’ Retirement System, the California State Teachers’ Retirement System and the Teachers’ Retirement System of Texas have followed suit.

Mid-level pensions are gravitating toward non-fund structures for the same reasons. In May, the South Carolina Retirement System, a $32 billion fund, earmarked $500 million for a private debt joint venture with Barings BDC that includes a mandate for real estate lending. When SCRS announced the joint venture, Steve Marino, the pension’s managing director, cited “strong risk-adjusted returns” and a “heightened focus on superior investor alignment” as key expectations for the $550 million partnership.

A higher allocation to direct investments does not always result in better performance, however. The Alaska Permanent Fund has allocated roughly $4 billion to real estate and 98 percent of that is in separate accounts and direct acquisitions, according to a report by Callan for the $65 billion sovereign wealth fund’s annual meeting this week.

The portfolio has lagged its benchmark, the NCREIF Property Index, by 2 percent over the past three- and five-year periods and more than 8 percent year-to-date. The fund credits the shortfall to an overweight to retail, an underweight to multifamily and investments in Europe. Also, at 6.5 percent of the total portfolio, the fund’s real estate holdings are below its 11 percent allocation target.

Other investors remain unconvinced that direct strategies are the way to go. Last year the Los Angeles Fire and Police Pension commissioned a study on establishing an in-house, direct investment platform. When the results came back in January of this year, it was clear the $23 billion pension was not well suited for the strategy.

LAFPP runs a separate accounts program that accounts for nearly $500 million and it had hoped to build upon that program to achieve greater cost savings. But the pension’s consultant, the Townsend Group, found it lacked the manpower to execute a more direct strategy.

As Ray Ciranna, the fund’s general manager told PERE at the time: “We’re a pretty good size fund, but a lot of the folks that really have dabbled in more direct investment are considerably larger than us.”