Light-weight pension funds bulk up on real estate.

Although their informational literature and year-end reports may tout how well the stock market's revival drove returns in 2004, pension funds didn't neglect to bulk up on real estate last year and in the years prior.

That trend will see no respite in 2005, as pension fund allocations for real estate continue to soar ever higher, up to as much a whopping 812% projection of some fund's total value in 2005.

"Many pension funds right now consider themselves under-weighted in their allocations for real estate," said Steven A. Kohn, president and principal of Sonnenblick-Goldman, and architect of a number of joint ventures between real estate operators/developers and major institutional investors, such as Prudential, GE's pension fund, Principal Global Investors and CalSTRS.

"Traditionally, pension fund real estate allocations have been somewhere around 4%, but current targets can be as high as 8% to 10%. The increase reflects the attractive ness of real estate as compared to other investments, such as stocks and bonds."

And while those stocks and bonds are creeping up in their returns, the immediacy of real estate's yields are especially important to pensions for whom the number of collecting constituents is consistently rising. Such is the case for the New York State Teachers' Retirement System (NYSTRS) whose investment overview states that "as a result of the increasing number of retirements, this monthly expenditure has increased from $275 million in 2002 to $350 million today." That fund considers equities to be one of the more attractive asset classes, yet the fund's strategy includes boosting its real estate holdings in 2005 to 8%, a number well above its current 6.8% real estate allocation.

"Real Estate is playing a more critical role in a fund's ability to deliver competitive current returns," said Mike McMenomy, pension fund advisor in CB Richard Ellis's Los Angeles office. "That current return is necessary to provide cash flow to address the payments for a growing retirement class."

"It's our expectation, based on discussions with existing and new clients, that pensions will be increasing their real estate holdings in 2005."

Unlike NYSTRS, and going against the trend of upping real estate targets, the California Public Employees' Retirement System (CalPERS) has actually lowered its target from 9% to a still lofty 8%. The target decrease however doesn't represent diminished interest in real estate from CalPERS, one of the biggest pensions in real estate.

According to Al Fernandez, a senior portfolio manager at CalPERS, the pension's decision to lower the target had more to do with the competition and pricing of property these days rather than the attractiveness of real estate as an asset class.

"The fact that we set it down to 8% really means that it's tough finding the right kinds of deals in which we can enter," Fernandez said. "Right now we're at about 7.1%, to have it at 9% puts us a little too far away to be realistic. We just can't add that much in a year. While the target is down our range has widened up to 12%." Broader range allowances for asset allocation may enable pensions to invest in more property nowadays, but in a strange scenario in 2001, they actually curtailed real estate investment just when the asset class was poised to take off.

In the wake of the stock market's 2001 decline, when interest rates were heading to rock bottom rates, and real estate was becoming the investment of choice, pensions found themselves suddenly overstocked in real estate. Well, on paper at least. Because of the sudden decrease in the value of stock, real estate--because of the stasis or increase in its value--came to represent a greater percentage of pension funds' assets.

"They were literally handcuffed when stocks went down, they couldn't jump on the trend to load up on real estate when it was much cheaper," said a source at L&L Acquisitions, a real estate investment firm that has entered into a number of joint ventures with pension funds.

"It took them a while to fix that and up the allocations. CalSTRS was the first to do it and, once they increased their real estate allocation, it made it easier for everyone else to follow."

As pensions began changing their allocations in real estate throughout 2002 and 2003, opportunity funds like Walton and Blackstone had already swooped in and gobbled up Manhattan property when 20% returns were still possible. Now that cap rates have significantly compressed in the past couple of years, the tables have reversed, with opportunity funds getting out of the market and pension funds entering in strength.

"Unleveraged internal rate of return requirements for core investments--high quality, stabilized assets--are currently in the 7%-9% range for pension funds," Kohn said. The source at L&L noted that opportunity funds would want a 2 in front of those numbers to invest. Even getting within the 7%-9% IRR is a challenge in the current Manhattan market however.

Pension funds' ability to use less or even no leverage hasn't given them a one up against a field of ferociously aggressive investors either.

"If Joe Moinian is going to buy into 3 cap, the pensions can't handle that kind of competition," said Tim Welch, a national investment sales broker at Cushman & Wakefield. "If the city is a tough entry point for them though, they'll just move to other locations nationally."

That's exactly what many pension funds are doing. According to Fernandez, CalPERS is focusing on many different types of real estate including retail, industrial, single family and office on a national scale.

"We haven't done much in Manhattan lately," he said. "We've found more opportunities in other cities."