If any doubts still linger about a rebound in the real estate market, look no further than the last few fiscal-year returns of the largest US pension plan as evidence. For fiscal year 2008-2009, the California Public Employees’ Retirement System (CalPERS) was hit with the most severe single-year decline in total market value in its history, falling 23 percent from $237.1 billion to $180.9 billion. Of all the asset classes comprising its portfolio, real estate experienced the sharpest decline, plummeting 35.8 percent.
The following fiscal year, real estate saw an even steeper drop of 37.1 percent – the only asset class yielding a negative return for CalPERS, which saw an overall 11.4 percent return during the period. Moreover, the real estate loss represented 1.3 percent of the pension system’s total market value at the time.
Fast forward to today, however, and CalPERS’ most recent fiscal-year results show a strong comeback for real estate. In preliminary estimates for fiscal year 2012, which ended 30 June, real estate was the top performer for the $233 billion pension system, yielding a return of 15.9 percent and beating its benchmark by 3 percent. CalPERS’ 1 percent return for the overall portfolio, despite market volatility, “was helped by improved performance of real estate investments,” which include those in income-generating properties in office, industrial and retail, the pension system noted in its earnings announcement.
CalPERS, however, isn’t alone in counting real estate as one of the best performers in its investment portfolio. Other public pension plans, such as the California State Teachers’ Retirement System (CalSTRS), Florida State Board of Administration (SBA) and Washington State Investment Board, also saw real estate bring in the highest returns among the asset classes in their investment portfolios.
Return driver
“We’ve seen very strong performance over the past two fiscal years, and that really has to do with the buoyancy in the core real estate markets,” says Dan Krivinskas, director of real estate consulting at RV Kuhns & Associates. “We had a very sharp correction in 2008 and 2009 – down more than 40 percent from peak to trough – and now we’ve seen a bounce back up.”
Strong capital appreciation from the market bottom has driven core returns over the past few years, but rental income will likely generate the majority of real estate returns going forward. “The most core-oriented investors over the last two years have made the most money,” adds Krivinskas, whose firm advises pension plans such as the New Jersey Division of Investment (NJ DOI) and the Employees Retirement System of Texas. In contrast, those focused more on value-added or opportunistic strategies, which typically yield higher returns, have not benefited as much because of the slower turnaround in values and rental income for non-core real estate.
In many cases, core valuations are back to where they were prior to the global financial crisis, according to Jack Foster, head of real assets at Franklin Templeton Real Asset Advisors, the New York-based real estate, infrastructure and real resources investment platform of Franklin Templeton Investments. “The stability of long-term leases has had a big impact on where real estate returns have been,” he says. “When you buy core real estate, that stability becomes increasingly important, especially in the context of the clear volatility of other asset classes.”
Hard core
Indeed, for a number of pension plans, strong returns in real estate are tied to an investment strategy heavily focused on core. In February 2011, CalPERS adopted a new five-year strategic real estate plan that called for investing at least 75 percent of its real estate portfolio in core US properties. The plan also directed the pension system to reduce the number of external managers, with most new commitments going to five to 10 long-term partners via separate accounts.
“Real estate’s outperformance of the benchmark, due to relatively strong performance of the strategic versus legacy portfolio, affirms the real estate strategy,” noted Joe Dear, CalPERS’ chief investment officer, in a report on the pension system’s fiscal year 2012 performance last month. The strategic, or core, real estate portfolio yielded a 22.3 percent return, compared to a 9.5 percent return for the legacy, or non-core, portfolio.
Florida SBA, meanwhile, has had a core focus in real estate since it began investing in the asset class in 1981, and the pension plan attributed its real estate return of 12.75 percent for fiscal year 2012 to a $9.3 billion property portfolio that is 85 percent invested in core assets. “Core real estate has been attracting massive amounts of capital,” says Steve Spook, Florida SBA’s senior investment officer for real estate. “Despite compressed cap rates, they still offer very good income returns relative to other income-producing alternatives,” such as Treasuries.
For example, the National Council of Real Estate Investment Fiduciaries (NCREIF) Open-end Diversified Core Equity (ODCE) index, which consists of 18 open-ended core funds, had a gross return of 12.4 percent and a net return of 11.3 percent for the one-year period ending 30 June. This was down from the total gross return of 20.3 percent for the previous one-year period, but it was well above the negative returns for the two years prior to that, according to NCREIF. In contrast, 10-year Treasury yields were 1.8 percent at press time.
NCREIF statistics also show that investors continue to demonstrate a healthy appetite for core real estate, allocating $3.05 billion to the space as of 30 June. That is up from $2.41 billion at the end of the first quarter, but down from $3.26 billion at the end of the third quarter of 2011.
“Anyone who’s had a decent investment in core or core-plus assets will have a return of 10 percent or more,” with much of that return coming from income and yield compression, says Timothy Walsh, director at NJ DOI. The $69.42 billion pension plan had an estimated overall return of 2.26 percent versus a benchmark of 0.25 percent for fiscal year 2012. In a performance update last month, he cited the relative overweight of US versus international stocks as the single-largest factor in its outperformance and fixed income as another strong contributor.
Although NJ DOI’s fiscal-year return for real estate was not available as of press time, “we expect real estate to be a good portfolio diversifier and strong return generator for fiscal 2012,” Walsh says. The pension plan’s real estate portfolio, which currently represents 4.4 percent of its total assets, currently is invested about 25 percent to 30 percent in core.
Use of leverage
Along with the current appetite for lower risk, another contributor to returns is how much debt a pension plan has on the books. “Leverage can be your friend and it can be your enemy,” says Florida SBA’s Spook. “In a strongly rising market like this year and last year, had we been higher levered than what we were, our performance would have been even better. Of course, it certainly affected us on the way down too, back during the global financial crisis.”
While CalPERS currently is pursuing a core-dominant strategy, its real estate portfolio still comprised some 40 percent in non-core assets as of 30 June. Some say that the high amount of leverage the pension system still is carrying was a more significant driver of its real estate returns this year than its new core focus, which will take longer to have an impact given the massive size of its property portfolio.
Indeed, in a report to CalPERS’ investment committee in July, David Glickman, managing director at Pension Consulting Alliance, noted that CalPERS’ high proportion of investments in non-stabilised properties and the high amounts of leverage it took on during the real estate boom years exacerbated historical underperformance to the benchmark during the economic crisis. “Non-stabilised assets provide less income to insulate against valuation declines,” he wrote. “Increased leverage magnifies positive appreciation in upward market cycles and negative appreciation in downward market cycles.”
Other factors
While investment strategy certainly is an important component of returns, the bigger driver is an investor’s allocation decisions, says Peter Lewis, a senior consultant at Towers Watson. Real estate functions both as a diversifier and, if the pension plan pursues higher risk and higher return strategies, a return enhancer within a larger investment portfolio. However, “the overall benefit is limited by the allocation percentage,” he says. “It comes from artificially constraining the portfolio,” so that real estate typically represents no more than 10 percent of total assets.
“People invest in real estate not in an isolated silo, but rather in the overall context of what the rest of their portfolio is doing,” agrees Glickman of Pension Consulting Alliance. “The role for real estate is going to be driven by what the other 90 percent of the portfolio is doing, as well as what real estate is doing.”
In addition, whether a pension plan adopts a core or noncore-focused strategy, the property types and geographic markets that are targeted to execute the strategy also affect returns. “If you’re invested in multifamily over the last few years, you’ve done very well compared to other property types,” says Krivinskas. “Similarly, if you’ve been invested in certain overseas markets, you’ve done very well compared to those who have been more focused domestically.”
For example, many Asia-focused investment strategies have yielded better returns than those targeting Europe, since Asia was able to bounce back more quickly from the global financial crisis than the latter region. And within the US, investments in central business districts, particularly in New York, Boston, Washington DC, San Francisco and Los Angeles, have yielded far better returns than other urban or suburban markets.
Other variables include continued economic growth, which would further drive up core returns, and interest rates, which would lower returns if rates were to begin rising again.
The long view
Ultimately, however, those that track a pension plan’s real estate performance shouldn’t lose sight of the bigger picture. “It’s a real mistake to look at performance during individual periods,” says Lewis of Towers Watson. “You have to look at things over the longer term. Real estate is a cyclical business, and you’re going to have market corrections.”
In his report to CalPERS’ investment committee, Glickman expressed a similar sentiment. “In an illiquid asset class populated with multi-year partnerships, longer-term results are more significant than those of a shorter duration,” he wrote. The pension system’s fiscal year 2012 performance in real estate continued the upswing that began in the third quarter of 2010, with significant positive returns largely the result of unrealised appreciation.
Despite this improvement in returns, however, the real estate programme still showed poor long-term results, with net returns of -7 percent, -12.1 percent and 2.4 percent during the trailing three-, five- and 10-year periods, respectively, according to the report. These returns all underperformed their comparable benchmark returns.
Furthermore, real estate’s winning performance streak isn’t expected to last. “You won’t see as much outperformance in real estate compared to other asset classes going forward,” says Krivinskas. Given the cyclicality of real estate, “you’re just not going to see that type of outperformance for very long.” However, as pensions begin to chase returns more, he anticipates more capital going into noncore strategies, both value-added and opportunistic, domestically as well as internationally.
“I don’t think it’s time to be stocking up on core,” agrees Walsh of NJ DOI. “You’re taking a huge interest-rate risk. There are a lot of easier ways to get exposure to core markets, such as through public REITs.”
Foster of Franklin Templeton, however, predicts that a greater focus on core is here to stay. “Certainly, there will be moves into noncore for alpha,” he says. “Pensions need to see value and return growth. However, core will maintain a strong position in real estate, with money going into noncore as well – it just won’t fly in the way it did 10 years ago.”
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