Property values: real estate property yields real returns for endowments.

REAL ESTATE IS A MODERN AMERICAN OBSESSION. WHAT THE NEIGHBORS got for their house is a leading suburban backyard barbecue topic.

According to the National Association of Realtors, in 2005, 69 percent of American families owned their own house. In other words, a lot of people know a little about real estate. Although the average Dick and Jane know little about the commercial market, where institutions of higher ed would traditionally invest their funds, this area of real estate has also performed well. You might say the real estate conversation has filtered down to the fraternity-party level.

Administrators are talking about the wealth to be had in real estate, too. According to the National Association of College and University Business Officers' 2005 Endowment Study, the average university endowment posted 9 percent average returns for that fiscal year. The top-performing asset class for endowments over $1 billion in the period? Public real estate. This investment category returned an average of 36 percent for IHEs, on average.

The report lists public real estate as the second-best asset class, behind natural resources, for smaller endowments, which reported a 27 percent return on public real estate investments. By contrast, the largest endowments earned 9 percent in U.S. equity in the last fiscal year. Despite these stellar numbers, the overall allocation to real estate remains small, at 3 percent for all endowments--but that's up from just less than 2 percent in 1996. With a total of $299 billion tracked in the NACUBO database, that 3 percent represents a hefty $9.3 billion invested in real estate.

What's What in Real Estate Investing 

Alternative investing in general is becoming a bigger part of investment policy for more colleges and universities today. Real estate is just one of many asset classes that fall into that "alternative" category, which includes pretty much everything that is not stocks, bonds, or cash. (See "Alternative Investing 101," p. 66.)

As for real estate investment categories to consider, the commercial market is divided geographically, by industry segment (retail, office, warehouse, etc.) and by type of property:

* Core real estate is high-quality property, usually centrally located office buildings with major corporate tenants, with most space occupied, generating stable income and a good rate of return.

* Opportunistic real estate includes troubled buildings to be torn down or overhauled, or raw land that will be developed. * Value-added real estate involves buying buildings that are inexpensive but need some work, then working with a developer to upgrade them and lease them to new tenants.

In addition to endowment investing, many IHEs acquire real estate as an investment that supports the campus without pushing out its borders. Such properties may add off-campus housing options, promote community economic development, or act as an option for future campus expansion. These holdings generate revenue to offset other operating expenses, grow the endowment, and further the mission of the institution in interesting ways.

Public or Private?

Institutional investors, like IHE endowment managers, distinguish between public and private real estate investments. Public investments are those made into funds registered with the U.S. Securities and Exchange Commission, usually in the form of real estate investment trusts (REITs). These pool investors' funds, invest in commercial real estate, and pass on the income.

Because they combine money from several investors, REITs can offer greater diversification than other types of real estate investments, a key advantage for smaller endowments that may not have the assets to diversify otherwise. The shares trade on the stock exchanges, so buying and selling them is much easier than buying properties outright.

National Association of Real Estate Investment Trusts (NAREIT) research has found that the majority of university endowments invest through real estate investment funds managed by outside managers or through real estate investment trusts. Of 108 IHEs reporting investments in real estate, seven have bought properties outright, 27 invested through REITs, and the remaining 74 used private real estate equity funds.

Abby McCarthy, senior director of industry information and statistics at NAREIT, makes the case for REITs in this way: "If you want an asset class that has good diversification benefits, that will generate good returns and reduce risk, then real estate and REITs are the way to go."

An institution's size may well determine what decision is made. "Larger endowments tend to approach the market differently than small endowments," says Michael K. McMenomy, global head of Investor Services at CB Richard Ellis Investors in Los Angeles, which invests in real estate for its own account and for pensions, endowments, trusts, and other large investors. Larger endowments tend to concentrate on specific niches, such as high-rise office buildings in a handful of central business districts, he explains. They typically want the investment management firm to invest in these projects alongside of them.

Smaller endowments, on the other hand, will usually invest in pools organized by a real estate investment company. These pools are limited partnerships that operate for a set time period, say five to seven years. "The fund manager has complete discretion relative to the investment management agreement and the strategy therein," McMenomy says.

How IHEs Invest in Real Estate

Most endowment funds are investing through REITs or private equity funds because managers view real estate as simply an asset class with favorable risk, return, and income characteristics. But many IHEs own land outright. In some cases, it is property acquired through donation that generates enough income and other benefits that it remains in the portfolio. For other campuses, real estate is an investment that also helps in the execution of the institution's mission and values.

For real estate gifts, having donation policies can help ensure that it works out in the institution's favor. The Kansas University Endowment of the University of Kansas, for one, accepts gifts of real estate under two conditions. First, it must be given free and clear of debt. Second, it must undergo an environmental assessment; if problems are found, it must be cost-effective to remedy them.

Finally, says Jen Humphrey, who works in communications for KU Endowment, "We check with the university to see if they have a use for it. If they do, we'll lease it to them. If they don't, we'll sell it."

The endowment foundation also accepts donations of mineral fights without the property attached, and it holds such rights in five states. In total, its real estate had a market value of $158 million as of June 30, 2005, making up 16.5 percent of the endowment's $955 million in assets.

The Kansas endowment owns farmland in 54 Kansas counties as well as in Oklahoma and Nebraska. Most of this acreage was donated and is leased to operating farmers to generate steady income. Two full-time staffers handle property management with the assistance of two regional banks. Humphrey says that farmland's low management cost and low operating risk makes it a better investment for them than, say, student housing, where maintenance, rent collection, and liability factors cut into returns.

That doesn't mean the endowment won't buy properties in town. Humphrey says that on occasion, property near the Lawrence campus comes on the market. The university may want it for future expansion, but the administration is not ready to commit now. The endowment buys the land and operates the properties until the university makes its decision. This offers a way for the foundation to support the campus.

While the KU Endowment staff is happy to own land, University of Nebraska-Lincoln endowment managers aren't so eager.

NU'S endowment receives about six or eight property donations a year, says Dorothy Endacott, director of Communications for the University of Nebraska Foundation, but almost all of those are liquidated. Less than 1 percent of the university's $1.3 billion endowment is invested in real estate, mostly through investment funds managed by outside money managers.

The land the foundation holds outright was given to it for academic use. One such property is a 145-acre arboretum northeast of Lincoln used as an outdoor classroom by students at the NU's School of Natural Resources. The other is a ranch in North Platte used for groundwater and surface water research.

Investments at Work

A.T. Still University, which operates four colleges on two campuses (one in Missouri, another in Arizona), has real estate ventures on each designed to be both long-term investments and sources of relationships to enhance student learning and faculty research.

In Kirksville, Mo., the university has schools of osteopathic medicine and health-care management, while in Mesa, Ariz., it offers programs in dentistry and health sciences. In Kirksville, the goal was to promote osteopathic medicine's strengths in managing the needs of a healthy, aging population by giving students practical experience. Located in north-central Missouri, the town was in need of economic development programs that would attract and retain residents. A continuing-care retirement facility adjacent to campus would help students learn and meet the town's needs now while creating a long-term asset.

In 1999, the university acquired 100 acres of land there, through a purchase that added to a property donation for the project. Since "A.T. Still is in the business of education, not in the business of running continuing-care retirement communities," says Elsie Gaber, associate vice president for University Relations, the school partnered with a St. Louis-based developer to build a 50-unit retirement residence. That developer was joined by state and local officials to develop a community center on the site. The land under these buildings is leased from the university. The buildings themselves will revert to ATSU at the end of the multidecade lease.

The income is small right now, Gaber says, but the amount of income generated and the underlying value of the land will increase as more of the property is developed and the Kirksville economy grows. And, she says, "This added dimension of the senior campus is attracting applicants and students who want to be a part of it," enhancing the medical school's reputation in geriatric care.

ATSU expanded into Mesa in 1995 to help meet the demand for health-care professionals there. It operates the state's only dental school, the Arizona School of Dentistry and Oral Health, while the medical programs at the Arizona School of Health Sciences educate baseball trainers and geriatric physical therapists alike.

Next to campus is the Arizona Health & Technology Park, which ATSU launched in 2001. The land is owned by the school and leased to the Alter Group, a real estate development firm. The firm handles construction and management of buildings used for campus offices, medical practices, and health care services businesses.

"We're not in the business of health care. We're in the business of training health-care professionals," explains Craig Phelps, provost of the Arizona campus. Among the park's tenants is the National Academy of Sports Medicine.

The next phases of the project, scheduled for 2007, will solidify the connections between ATSU students and the community even further. The Valley of the Sun YMCA and an acute-care hospital operated by Vanguard Health Services will be added, creating internship opportunities for students and as well as possible employment for alumni. As for the income from the land lease, Phelps says, "We see it being used to fund new programs, but also see a certain percentage going back into the endowment."

Commercial Real Estate Outlook

Although campuses are getting value from real estate now, will this continue? Market observers think it will, noting that the commercial real estate market is very different from the residential one.

The residential market is much more exposed to interest rate changes than the commercial market, says McMenomy, because individuals buying houses often borrow 80 percent or more of the value, while commercial properties are typically purchased with little or no debt. "Residential is all about affordability, and interest rates affect affordability," he says, adding that "residential has an emotional underpinning."

Commercial real estate is very much driven by income generated from rent. Tenants may be visiting faculty members using off-campus apartments, corporations leasing entire floors of downtown office towers, or agribusiness concerns renting farmland for their growing operations.

"Corporate leases are typically for 15 years," says NAREIT's McCarthy, "so the revenue is locked in." In other words, returns on a commercial property fluctuate less from year to year than returns on residential properties might. Demand for these properties tends to be driven by overall economic health rather than interest rates and family size.

Each market sector has its own outlook. The National Association of Realtors, which analyzes both residential and commercial market trends, sees a strong market for warehouse space (based on trade with China), rental housing (because so many units have been lost to condominium conversion), and hospitality facilities (as cities pick up convention business lost from New Orleans). The organization is less enthused about retail rentals, given that large blocks of space are coming on the market from the recent Sears-Kmart merger.

"There are submarkets within the U.S., and property types within those submarkets, that have challenges," McMenomy says. At the same time, though, "there's more and more knowledge, objective and otherwise, with which to make a decision." He says that information on historical performance, risk, investment styles, and operating strategies can help endowment managers make good decisions about whether to invest in real estate. And for those who choose this alternative investment, doing that legwork will help in finding good investment managers to work with and making the best real estate deals.

Resources

National Association of Real Estate Investment Trust, www.nareit.com The National Association of Realtors, www.realtor.org University of Minnesota's real estate office (extensive information about its properties and about property management in general), www.realestate.umn.edu

ALTERNATIVE INVESTING 101

The idea of profiting from real estate and other alternative investments is an exciting prospect. But are institutions of higher ed actually doing it?

The 2005 NACUBO Endowment Study showed that universities allocated a total of nearly 5 percent into alternative asset classes, excluding real estate and hedge funds. That's up from less than 2 percent in 1996. Real estate allocations increased from about 2 percent to about 3 percent during that period, and hedge fund allocations increased from nearly 2 percent to nearly 9 percent. Why art the interest in alternative investments?

The more an investment portfolio is diversified, the greater the potential return for a given amount of risk. Traditional investments, such as stocks and bonds, are tied to business cycles. Other assets, like venture capital, natural resources, and foreign currencies, move in different patterns. And some of these assets, like real estate and metals, act more as a store of value. That is, they may not appreciate dramatically in price in any one year, but they tend to at least match inflation over a tong period of time, All of these assets tend to be difficult to sell quickly, but endowments "have a tong-term time horizon, so they can handle it," says Marshall Greenwald of Symmetry Investment Advisors, a Chicago-based private equity fund manager.

Hedge funds act as alternative investments in some ways, because some hedge fund managers structure their funds to have a risk and return profile that is different from the rest of the market. But many hedge funds invest in stocks and bonds, and not art hedge fund managers try to manage risk. Hence, not everyone considers them to be an alternative investment.

In academic theory, the total investing universe includes anything that one could own. In practice, though, the odder the investment, the more trouble it can be to manage.

For example, the Ohio Bureau of Workers' Compensation invested $50 million of its insurance fund in rare coins, political memorabilia, and sports collectibles, an investment managed by a political fundraiser who had supported the elected officials charged with overseeing the fund. Some of the coin investments paid off, but others seem to have been lost--and none of this is making Ohio's taxpayers happy.

For IHEs looking at alternative investments, experts say, officials should ensure that the selection of assets and money managers would meet the institution's fiduciary responsibilities.

Ann C. Logue is a freelance investment services writer based in Chicago. She can be reached at [e-mail].