STATESIDE: The closed-ended challenge

One way or another, the transition among US plan sponsors from defined benefit, or traditional pension plans, to defined contribution, or 401(k) plans, is going to change real estate funds as we currently know them.
Much of this is predicated by the rapid growth of DC plans, which ballooned by 98.6 percent from 1999 to 2012, according to the Investment Company Institute. Meanwhile, Casey, Quirk & Associates has reported that DC plans, which currently represent $4.4 trillion in assets, are projected to grow to $7.7 trillion by 2020.
As the DC market increases, the universe of DC-oriented real estate products also is poised to expand significantly over the next few years. There currently are just four or so DC-oriented private real estate products in the marketplace, although four to five additional real estate managers are developing new products that allow for daily liquidity and daily valuations. Plans are to get those offerings – typically structured as a fund of funds that invests in open-ended core and value-added funds but also includes cash and REIT allocations – to market in the next six to 12 months.
With the proliferation of such products, open-ended core funds are likely to benefit as plan sponsors continue to shift from DB to DC plans. Within the DB market, open-ended core funds already have been on the upswing since the global financial crisis, after many pension plans that suffered heavy losses from their investments in opportunistic vehicles subsequently shifted their real estate strategy to be more heavily weighted to core. Moreover, the need for more liquidity and cash flow by a number of pension plans has driven up demand for open-ended core funds even further. 
Closed-ended funds, however, are another story. “DC transactions occur continuously, so you need to have access to the asset class on an ongoing basis, not just once every five years or so,” said Laurie Tillinghast, executive director and DC specialist at UBS Global Real Estate’ US business. “It would be very difficult operationally for closed-ended funds to work their way into use in target-date funds.”
Some of the largest plan sponsors have addressed that situation by unitizing the investment funds of their DB plans to allow their DC plans to co-invest, although such an option is limited to the larger end of the plan sponsor market. Overall, however, demand for closed-ended funds is likely to decline in tandem with the gradual contraction of the DB market. 
As new employees at institutions are enrolled in DC plans, new participants will stop coming into DB plans, which would significantly reduce new funding sources. “That would drive investment allocation to more cash-intensive assets,” said Lennine Occhino, a partner at law firm Mayer Brown. “That probably would drive plan sponsors to eventually wind down and invest less and less in closed-ended real estate funds.”
Such a wind-down appears troubling for closed-ended fund sponsors. After all, private and public pension plans make up a substantial portion of the capital that is raised in closed-ended funds and were among the most active allocators to private equity real estate funds in 2012, according to the 2013 Institutional Real Estate Allocations Monitor produced by Cornell University and advisory firm Hodes Weill & Associates.
One silver lining is that new sources of capital, particularly foreign institutions, are coming into closed-ended funds. Whether those new capital sources will be able to plug the gap that may be left by pension plans, however, is still uncertain.
Meanwhile, despite the seeming incompatibility of closed-ended funds and DC plans, real estate managers can work with their plan sponsor clients to find potential ways for closed-ended funds to access DC capital. After all, open-ended funds and DC plans initially appeared pretty incompatible as well. 
The earliest DC-oriented private real estate products, which were launched a decade ago, enabled individual plan participants to invest directly in existing open-ended core funds. That proved to be somewhat problematic, since participants were only able to move money in and out of those vehicles on a quarterly basis. 
The Pension Protection Act of 2006, however, paved the way for plan sponsors to use professionally-managed target-date funds – the option that is attracting the lion’s share of DC assets – as the new mechanism for including private real estate funds in DC plans. Instead of investing directly in an open-ended fund, participants would do so indirectly through the target-date fund. Since then, real estate managers such as Prudential Real Estate Investors, JPMorgan Asset Management and UBS have been developing private real estate products that are compatible with target-date funds and also support daily deposit and withdrawal activity. 
Similarly adapting closed-ended funds to the DC market would be more challenging, but not impossible. To determine if such a product could in fact be operational, both managers and their clients will need to make a firm commitment, backed by a lot of thoughtfulness and resources, to the effort. And while it’s uncertain that such a product ultimately will come to market, it’s clear that the evolution of private real estate funds within the DC space is far from over.