FEATURE: Filling the void

Limited partners want to take control. And as LPs start to rebalance their portfolios in the wake of poorly performing real estate assets, many are starting to look to alternative, less traditional, strategies as a way of boosting their investments.

For US state pension funds, that strategy is also including whole loan debt origination.

The collapse of CMBS market and the decision by many lending institutions to either withdraw or significantly scale back their operations has created a void in the credit markets that non-traditional players are keen to explore. As reported by PERE magazine last month, private equity real estate players are among those looking at whole loan debt origination, alongside life insurance companies and regional and local banks.

However, it's not just private equity real estate firms that are taking advantage of the current credit market dislocation – so are US pension funds.

“What is motivating them is that the returns that they're able to achieve with these loans are very close to the target returns they've been trying to achieve for their core equity [and core debt] returns and they can obviously do it in a less risky investment,” says Douglas Hercher, managing director of real estate services firm Cushman & Wakefield.

“So if they can get 7.5 percent to 8.5 percent for a 50 percent to 60 percent loan-to-value senior loan that's a very attractive return given the risk.”

The Teachers Retirement System of the State of Illinois, the California Public Employees' Retirement System and the California State Teachers' Retirement System are among the state pension plans that have done deals on a direct basis, according to Hercher. Others, including the Washington State Investment Board, are looking at deals.

The most notable player in the debt origination space though has to be the New York State Teachers' Retirement System (NYSTRS), which in February provided a $43 million, seven-year fixed rate loan backed by three grocery-anchored retail centres in Virginia and Florida.

The $43 million loan though is just the tip of the iceberg for the New York pension. According to sources at the pension, NYSTRS plans to allocate $1 billion to debt origination in 2009 alone.

NYSTRS' financing capacity is “striking”, adds Hercher, who says that the New York pension fund typically makes loans for a minimum of $50 million, with the ability to lend as much $200 million “fairly comfortably”.

The emergence of US state pensions into the whole loan space are not new. NYSTRS has been making loans since 1979. But until recent market dislocation caused traditional lenders to turn the credit spigot off, pensions were unable to compete on any significant scale. Before the collapse of the CMBS market last summer, the amount of capital provided by pensions in the lending space was little more than a drop in the ocean.

Historically, pensions have been constrained by how slow and deliberate their investment processes are. In a more liquid market, pension funds were simply unable to keep up. However, in today's market, where everyone is acting much more cautiously, pensions have become much more competitive.

Less competition also means that the pensions can be highly selective. Pensions are making only senior loans and are very discriminating about the markets, assets and sponsors they eventually choose. “We've really only seen them doing deals on the very highest quality assets, typically office buildings, and with sponsors they know, generally the strong real estate investment trusts and the strong private institutional investors,” says Hercher.

Although certain large pensions are gaining traction in the changing landscape, the level of lending by pensions will remain limited by the simple fact that few pensions have the scale to start a debt origination platform

Most pensions, such as the Teachers' Retirement System of Texas (TRS), are gaining exposure to debt through investment funds as opposed to direct loans. TRS' debt programme, for example, invests in a fund manager that will be making first mortgage loans, according to managing director of real assets Eric Lang.

“It would be very difficult for a pension fund to make loans directly because you have to have the infrastructure set up for that,” said Lang. “You've got to have the under-closing teams and the staffing. It would be challenging. I don't see how many pension funds would be doing that directly. Maybe there's some that can but we're not set up to do that.”