FEATURE: A pendulum in motion

As market fundamentals continue to improve, institutional investors are looking both up the risk spectrum and overseas to increase returns and diversify their real estate portfolios. While investments in the core and core-plus sectors remain popular for some limited partners, many investors are getting more comfortable with the asset class and more open to expanding into the value-added and opportunistic spaces. Throughout 2013, numerous investors have increased their non-core allocations along with their real estate portfolios in general, hoping that allowing for greater risk will make for greater returns.


Although reluctant to indicate any one trend among their clients, real estate consultants agree that investors that see the most recovery in the market are those willing to bump up real estate allocations and take bigger risks within the asset class. “Some clients use real estate as an income-oriented investment because other investments are producing historically low rates of returns. During the last two to three years, these investors have given real estate a bigger allocation,” says David Glickman of Pension Consulting Alliance, which works with some of the biggest pension plans in the US including the California Public Employees’ Retirement System (CalPERS), the California State Teachers’ Retirement System (CalSTRS) and the Oregon Investment Council.

With many investors searching for higher yields, real estate consultants are finding more ways to put their clients’ capital to work. Though there are differences in investor targets, both in terms of the risk spectrum and the map, the activity of institutional investors over the last year shows a few clear trends—the inclination towards riskier investments, greater participation from foreign investors in the US market and increased interest in commingled funds. Confidence in the real estate market still is not where it was 10 years ago, but both the evidence and the professionals suggest the pendulum is swinging back.

Riskier business  

In the latest installment of its Great Wall of Money series last month, property services firm DTZ reported that four-fifths of the newly available capital targeting commercial real estate in 2014 would pursue non-core strategies. Furthermore, that capital is dominated by an opportunistic risk-return appetite. This increased attention to non-core real estate is corroborated by the findings of PERE’s Research & Analytics division, which found that $10.7 billion was raised for opportunistic real estate funds in the third quarter alone.

Indeed, many public pension plans throughout the US have been upping their non-core allocations and investing in riskier strategies. Roy Schneiderman of Bard Consulting, which also advises pensions such as CalPERS and CalSTRS, believes this tendency will become a moderate trend going forward. “Investors are looking for more risk than they were three to four years ago, but less than 10 to 15 years ago,” he says. “The pendulum is swinging slightly back, but we aren’t yet near the level of opportunistic investments made at the beginning and middle of the last decade.”

Examples of such an upswing in the non-core sector became prominent throughout this year. Most recently, PERE covered the decision by historically core-focused Massachusetts Pension Reserves Investment Management Board (Mass PRIM) to double its non-core target from five percent to 10 percent of its portfolio. The plan, approved in August, also included an option to increase the allocation to 15 percent. With a long-term overall real estate target of approximately $5 billion, the increase has given Mass PRIM an additional $250 million of capital to invest in non-core real estate.

In Wyoming, the State Loan and Investment Board (SLIB) put the advice of consultant RV Kuhns and Associates to work, investing approximately $250 million in additional non-core commitments. Though the non-core increase was approved in 2010, Wyoming did not begin investing until August, hitting its $250 million target and 3.5 percent non-core allocation through two commitments in less than two months. The SLIB approved a $150 million commitment to Northwood Investors’ Northwood Real Estate Partners (Series IV) in August and a £82.5 million commitment to M&G Investments’ M&G Real Estate Debt Fund III in October. These investments not only exceed the $250 million suggestion, but board documents indicate that Wyoming would invest an additional $200 million in non-core over the next few years in order to maintain its target.

Mass PRIM and Wyoming represent instances of a trend spreading across the US from pension plan to pension plan. In April, the Los Angeles City Employees’ Retirement System unveiled a plan to invest $225 million more to real estate over the next three years, primarily in opportunistic and value-added funds. In July, the Teachers’ Retirement System of the State of Illinois earmarked $600 million for real estate over fiscal year 2014, aiming to remedy its underweighted 40 percent non-core allocation with additional commitments. Meanwhile, the Orange County Employees Retirement System allocated $250 million more to riskier real estate investments in June, while the Ohio Police and Fire Pension Fund decided to devote $110 million to non-core in September.

Professional perspective   

Consultants and general advisors have different explanations for this greater attraction to non-core. Mark Grinis, global real estate investment funds leader at Ernst & Young, suggests that riskier investments often come from LPs with experienced investment staffs. “Certain staff and professionals among investor groups have backgrounds that make them more comfortable with risk,” he explains. “Often times, these are present in larger pension plans with larger staff. They have the capacity to look closely at the future and take a little bit more risk.”

Mitch Roschelle, US real estate advisory practice leader at PwC, thinks the tendency to take risk stems from a simple need to balance out real estate portfolios from a yield perspective. “On the one hand, you can take on incremental risk to enhance returns but, on the other, I see investors adding to core allocations because of the stability to those assets,” he says. “It’s really about balancing all of those risks appropriately.”

Ed Garcia of Russell Investments has witnessed clients move up the risk spectrum when they begin to appreciate the way real estate is performing in relation to other parts of their portfolios, such as fixed income and private equity. “I’m sensing investors are getting a little more comfortable with the level of risk in real estate because they see what’s going on in their other asset classes and they turn back to real estate and see the difference,” he explains.

As a portfolio manager at Russell, Garcia has seen a shift in the way investors view real estate portfolios over the last few years that makes them more inclined to make non-core commitments. “If they were looking at real estate alone two to three years ago, they’d be safe and secure in core,” he says. “But now that they’re concerned about other markets, any real estate sector looks like a pretty good place to be.”

For endowments and foundations, investments on the higher end of the risk spectrum are not a new trend. Known for their predilection to opportunistic fund managers, university and college endowments historically have committed to non-core real estate funds, and Marc Cardillo of Cambridge Associates says he has not seen this trend change among his clients.

“The interest is still largely in value-added or opportunistic funds,” says Cardillo, co-head of private equity research covering real estate and natural resource at Cambridge Associates. “We still have not seen any activity among our endowment clients in terms of allocating to core.” He adds that if valuations were to improve, his clients, which include Harvard University, Yale University and Columbia University, might consider entering the core sector in the coming years. 

Foreign exchanges  

A sense of recovery in the US market also is drawing interest from overseas, as more foreign investors look to the American market as a safe, reliable place to park their capital. Market professionals agree that this trend is going strong and will continue to grow throughout 2014. “If we look at global investors in the real estate asset class, we definitely see a continuing trend that’s gaining momentum, which is non-US investors being interested in US real estate,” affirms Roschelle.

In December, three announcements from major sovereign wealth funds demonstrated that non-US investors would be coming from across the globe to invest in American real estate in 2013. The world’s largest sovereign wealth fund, Norway’s Government Pension Fund Global, disclosed a plan to move capital into US real estate, eventually hoping to invest up to one-third of its target allocation in the country. Meanwhile, Australia’s Future Fund revealed a plan to invest $350 million with Boston-based Berkshire Property Advisors in an effort to expand its multifamily real estate investments in the US. Finally, a joint venture between South Korea’s $320 billion state pension fund, the National Pension Service (NPS) of Korea, and Chicago-based real estate investment firm Heitman acquired a 23-property US warehouse portfolio for a reported $575 million.

From a consultant’s point of view, Garcia has seen his international clients increasingly interested in committing to the US due to the low yield and lack of opportunity in their domestic markets. “When you look across the globe in terms of growth opportunities, it’s hard to overlook the US as one of the few developed countries that has had economic growth,” he says.

As Cambridge Associates works with some international clients in addition to its US endowments and foundations, Cardillo similarly has seen firsthand the growing interest of non-US investors. “Certainly with our Middle Eastern clients, the interest in the US remains strong,” he says.

Schneiderman has seen foreign money coming to the US at the institutional level and beyond in smaller transactions. “That’s the story for the next five to 10 years,” he says. “Up and down the real estate food chain, pricing is going to be affected by capital coming in from overseas – from trophy office buildings to single-family homes.”

As more foreign investors are placing bets on the US, more US investors also are moving their capital overseas with a particular trend in mind—lower risk. In September, the Florida State Board of Administration announced it would launch its first investments in international-focused property vehicles, with potential commitments of up to $200 million to such strategies over the next 12 months. Similarly, CalSTRS began developing a strategy for increasing its non-US property investments during its new fiscal year in July. Both pension systems decided to pursue core and value-added strategies.

Coming out of the global financial crisis, Schneiderman saw that his clients preferring to hunker down and stick with domestic investments. However, as the market has begun to recover, he sees investors looking outside the US borders with a more careful strategy in mind. “In the past, looking overseas had tended to mean looking for opportunistic returns,” he explains. “Now, I think people are willing to look more for core and value-added returns internationally. I think it’s something we’ll see more of, and we’ll see more product developed to meet that demand.”

Mix and commingle   

When structuring real estate portfolios, it appears many pension plans are choosing commitments to commingled funds over dedicated endeavors like separate accounts and joint ventures.  Some market professionals believe this to be a growing trend overall, while others think the difference is just a matter of investor appetite.

Over the last few years, Roschelle has seen an increase in fund managers tailoring investment strategies on behalf of specific investors. “It’s about listening to the needs of a client and developing a product that fits those needs,” he says. “If something isn’t in the fund structure and a manager can do a separate account for one investor, that’s just good business.”

CalPERS, which favors taking more control over its real estate investments through separate accounts, further demonstrated this strategy in 2013 with deals such as its increased investment with Singapore-based ARA Asset Management in August. Of course, the US pension giant paired its separate account commitment with another to the fund manager’s latest commingled vehicle.

In contrast, smaller pension plans that do not have the personnel to run separate accounts do prefer sticking with commingled vehicles. For example, endowments, which traditionally have invested through commingled funds, have not altered their strategy. “While endowments have been disappointed with the performance of their real estate funds in aggregate over the last 10 years, I don’t think that has led any of them – with a couple of exceptions – to abandon that strategy for direct investments,” says Cardillo.

Garcia agrees, adding that his clients have never inquired about abandoning commingled fund strategies in favor of more direct relationships with general partners. “By and large, managers offering commingled funds do not have anything to worry about as long as they can execute, deliver and have a good story to tell,” he says.

From an advisor’s perspective, Grinis believes this interest in commingled funds to be a rising trend related to the recovery of the real estate market. “The fact is that allocations for real estate will continue to increase and the pendulum will swing back to commingled funds from where it is today, just from the increased ease of execution, ability to put dollars to work and comfort with specific mangers,” he says.

Despite increased confidence in the market this year as compared to previous years, consultants still are wary about the safety of investors’ real estate portfolios, suggesting their clients approach the asset class wisely and with some caution. When asked what advice he would give institutional investors going into 2014, Glickman recalls Sargent Phil Esterhaus’ trademark saying on the ‘80s police drama Hill St. Blues: “Let’s be careful out there.”