Pension funds maintain enthusiasm for real estate.

Their interest isn't dulled by lackluster returns so far

In the 1960s and 1970s, most pension funds invested in bonds, and bonds only. Some funds began investing in stock in the 1970s.

By the late 1980s, however, most pension funds were deep into the concept of diversifying assets, also sometimes called "asset allocation." Real estate -- a class of investment completely different from stocks or bonds -- came into vogue.

The concept was this: More important than exactly which stocks, bonds or real estate a pension fund invested in, was that the fund have the proper mix of assets, which should include real estate.

A blend of investments -- stocks, bonds and real estate -- would tend to be more stable than any single class of investments.

In particular, when stocks go up, real estate goes down, and vice versa. "Real estate returns are negatively correlated to the stock market," observed Sol Rabin, director of investment research for TCW Realty Advisors in Los Angeles, and one of the country's leading experts in real estate investments.

For pension funds, the idea of stability is important: Most pension funds -- due to regular, annual obligations to retirees -- prefer a steady return to a more spectacular but erratic performance.

Local governments in the mid-1980s began to grant authority to city and county pension fund managers and boards to invest in real estate. "In the City of Los Angeles, we had a charter amendment in 1985 that authorized the city pension funds to invest in real estate as equity ownership," recalls Richard Goss, investment manager for Los Angeles Department of Water & Power employees, a $2 billion pot of money.

The County of Los Angeles pension fund -- a $12.5 billion coffer -- began in 1988 to consider real estate investing, under the leadership of investment board chairman Norman Johnson.

For the real estate industry, the change of attitude in pension fund managers would have seemed to be a dream come true: There is an incredible $3 trillion locked away in private and public pension funds in the United States, and the huge cache only grows every year, as corporations, governments and employees reserve a fraction of their annual income for the golden years.

"It is the largest pool of capital in the world," said Rabin of TCW.

But for pension funds, the initial foray into real estate has, generally speaking, been an unhappy experience. The late 1980s turned out to be perhaps the worst time in the postwar era to test the real estate waters.

Some pension managers are disappointed. "I would have not been so eager to run into if, I knew then what I know now," said Gary Mattingly, general manager of the Los Angeles Fire & Police pension fund, a $4.5 billion operation. "There are heavy administrative and legal costs."

Mattingly is operating under a policy that the Fire & Police fund should have 10 percent of its assets invested in real estate, a target he has about half-way reached.

For Mattingly, some of the high costs were the result of a mortgage on an office building in New York City the pension recently purchased. The building's owners have not been able to make the mortgage payments, and so the Fire & Police fund is taking over ownership of the structure.

"We'll come out of it OK, but the legal costs are quite high," said Mattingly. Real estate values are down about 20 percent in the last year, he said.

Still, Mattingly is not all negative on real estate. "In fact, I wonder if now is the time to buy," he said. "Pension funds are long-term investors. If you could buy now at these depressed values. . . ."

At the city employee pension fund, a $3.3 billion pool of money, about $100 million has been invested into real estate, according to Oscar Peters, assistant manager for the city employee pension fund, which is separate from the Fire & Police fund or the DWP fund.

The results for the city employee fund, while not spectacular, have been good, said Peters. "We have invested in different pools of properties, diversified by investment style and geographic location," he said. Thus, while the Fire & Police fund owns some specific buildings, the city employees tend to be co-investors in pools of properties.

Peters added, "Our returns are coming in as expected, although we are starting to see some negative appreciation. But we are getting our income."

At the huge county employee pension fund, the first steps into real estate have also been a bit troubled. "We have been less than thrilled with our returns in real estate, and the write-downs in the real estate industry," said Charles Conrad, fund administrator. So far, the big county fund has about 6 percent of its assets in real estate. It has withdrawn some investment in real estate mutual funds.

Still, Conrad said the county fund, in some ways, may get even more aggressive in real estate investing, by teaming up with developers and owners to actually build structures, rather than passively investing in existing property.

"In the future, you are going to see pension funds teaming up with frontline entrepreneurs and developers. We are being approached by people we never used to see -- because we are the only people in town with capital to invest," said Conrad.

By his reckoning, that means pension funds will be able to demand higher returns -- something in line with the demands of elected office holders, who are eager to decrease the contributions to public employee pension funds that come from city and county budgets.

(Interestingly, the county pension fund bought the Pasadena office building in which it is housed.)

Conrad also said such entrepreneurial investing by pension funds will be good for society and the economy, because pension dollars will go to real, productive investments that will create wealth for society. Buying existing IBM bonds does not create true wealth for anybody, he noted.