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Letting go: insurers increasingly are turning away from direct ownership of real estate. (Industry Strategies: Asset Management).

In November 2002, John Hancock Financial Services Inc. announced that it was selling three key home-office complexes in Boston, but expected to lease back the office space it was using from the new owners. By making this move, Hancock said it was following the lead of some other publicly traded financial-services companies in opting to lease space for its corporate headquarters rather than own and manage the property.

Although the transaction obviously would raise capital for the company, that wasn't the primary motivation, an official said. John Hancock, like other newly public companies, understands that the equity markets don't look favorably on real estate holdings. That knowledge, coupled with recently increased regulatory charges on these investments, has prompted some companies to retool their investment portfolios.

"As companies have demutualized, equities in general have become something that is not attractive to hold on a demutualized balance sheet," said Deborah McAneny, executive vice president in charge of real estate at Hancock, which provides a variety of insurance and investment products and services. "Publicly traded companies like stable, predictable operating income, and asset classes like equity real estate that have, over time, created good capital gains are not valued as much."

There's "pressure and logic" behind the 10-year-long, industrywide trend of exiting from direct ownership of real estate, said Bernard Winograd, president of Prudential Investment Management and chairman of its real estate investment advisory business, Prudential Real Estate Investors. Prudential Investment Management is Prudential's asset management business, which provides a range of investment products for institutional and retail clients, along with Prudential's general account.

"The kind of investment returns that you recognize from investing in real estate are not particularly advantageous for a public company," he said. "The accounting is unfortunate. The return consists of your current income, less depreciation, and the markets do not tend to give you credit for the capital appreciation component of real estate investing, which is a very large part of where the return comes from."


As a result, many insurers have sold the bulk of their equity real estate portfolios shortly before or soon after demutualizing--that is, converting from a mutual insurer into a publicly traded company, McAneny said. For example, Hancock began selling nearly $2 billion worth of real estate holdings in New England and elsewhere as soon as it began the process of demutualization in 1998. These sales included an office complex in Long Beach, Calif., for $20 million, and another in Phoenix for $5.1 million. "We just reinvested the proceeds from the sale of our equity real-estate portfolio in more stable, predictable, fixed-income vehicles that were more attractive as a publicly traded company," she said.

Hancock decided to sell the Boston properties that included the 62-story downtown office tower that has carried the company's name for three decades. The Boston Globe put the asking price for that at more than $1 billion. The two other Boston buildings that Hancock put up for sale included its former headquarters, as well as a building on Berkeley Street, which is topped by a landmark weather beacon.

In preparation for the sale, Hancock relocated back offices and moved many home-office tenants to different buildings. Space on numerous floors of the roughly 1.6 million square-foot tower was rented to outside tenants. In 1998, Hancock was leasing 54% of the office space in the tower, but by last fall,] that was down to 20%.

Then, in 2002, the company took advantage of the red-hot market in commercial real estate. The very volatile equity markets in the third and fourth quarters of that year saw a great inflow of capital into hard assets, with investors increasingly reallocating funds from the stock market into real estate, McAneny said. "Well-located trophy office buildings in strong long-term markets have been a huge recipient of that capital," she said. In this market, John Hancock felt its Boston buildings were well positioned, with excellent lease structures and long-term tenants in place. "So we said, 'Now's a good time-- there's a lot of capital coming in, there's a lot of capital looking for this type of an asset. They are premier office buildings in the great city of Boston,"' McAneny said.

Completion of these real estate transactions will leave Hancock with only a couple of small Boston properties that it has chosen not to sell for now, McAneny said.

Changing Direction

Prudential Financial's insurance company, The Prudential Insurance Company of America, is another insurer that has divested itself of major real estate holdings in recent years. Through the mid-1990s, Prudential was a big investor in equity real estate, both wholly owned and through joint ventures. In fact, the insurer once owned the Prudential Center in Boston, as well as a stake in the Empire State Building. But starting in 1997, the company launched a real estate sales program, which de-emphasized direct real-estate investments and was a precursor to demutualization in late 2001.

In its S-1 form filed with the Securities and Exchange Commission, Prudential reported that from Jan. 1,1997, to Sept. 30, 2001, it reduced the book value of its real estate and real estate-related holdings from about $3.4 billion to around $500 million. the company said it used the proceeds from these real estate sales to invest in public and private fixed maturities and shares in real estate investment trusts.

Prudential still invests in property, but through the vehicle of Prudential Real Estate Investors, which now treats the insurer's general account as any other client. More than 90% of PREI's revenue comes from third parties, Winograd said. "We advise on investing in real estate in the United States and around the world--about 20% of the business is overseas," he said. Prudential has been in this business since 1970 with the formation of its first product giving pension-fund investors a commingled vehicle that allowed them to invest in a diversified set of commercial real estate properties. Now, it's grown to be a multiproduct offering that invests in a wide range of commercial real estate activities throughout the world, all of them equity related, Winograd said. An overwhelming majority of investors are pension funds, either in the United States or abroad, he said.

These days, Prudential Insurance also invests in commercial mortgage loans through Prudential Mortgage Capital Co. As of Sept. 30, 2001, Prudential held about 12% of its general-account portfolio in mortgage loans, essentially unchanged from Dec. 31, 2000, and 1999, the company reported to the SEC. As of Sept. 30, 2001, Prudential's portfolio held about 1,100 commercial mortgage loans with a carrying value of $13.1 billion and $2.1 billion of residential and agricultural loans. Those values are gross of a $178 million mortgage loan-loss reserve, the company said.

The 5-year-old Prudential Mortgage invests in full loans on behalf of Prudential Financial's general account. But it also originates loans packaged and sold into the securitization market, and it originates loans for housing agencies such as Fannie Mae. "What we try to do is offer the borrower the opportunity to comparison shop in one place, with different terms depending on what kind of loan they want," Winograd said.

In terms of real estate ownership, Prudential Financial still owns its half-million square foot headquarters in Newark, N.J., as well as some other buildings used for home-office functions. Aside from properties used for the international division and Prudential Securities' operations, the company owns 16 properties and leases 21. It recently bought a building in Korea to house Prudential Life Insurance Co. Ltd. (Prudential of Korea). Also, Prudential has purchased an 80% beneficial interest in a 38-story office, residential and retail development that recently was opened as the home of Prudential of Japan and Gibraltar Life.

Still Buying

Like Hancock, Northwestern Mutual Life Insurance Co. capitalized on the robust commercial real estate market in 2002 to sell a number of its real estate holdings. Unlike Hancock, however, Northwestern Mutual remains firmly committed to an active role in real estate ownership. For one thing, mutual insurance companies such as Northwestern don't have to weigh the opinions of stock analysts when it comes to their equity real estate holdings, conceded Mason Ross, executive vice president and chief investment officer for Northwestern Mutual, headquartered in Milwaukee.

But another reason many insurers might be better off divesting themselves of their properties, Ross added, is that many stock companies and some mutuals sell more variable products than they do general-account products, and variable products usually are backed by publicly traded investment instruments that can be valued every day. When a policyholder cashes out a policy or moves it from an equity pocket to a fixed-income pocket, it can only be done if a company has publicly traded assets in those different pockets, he said. So as these companies increasingly enter the variable business, equity real estate won't fit the bill, he added.

Northwestern Mutual, whose products include investment, life and disability products, sells mostly participating policies. "We're a little unique that way, in that we're not as skewed to the variable as others are and thus there's a better fit to have commercial real estate in our portfolio than other companies may find for themselves," Ross said.

Equity real estate offers solid cash flow compared with other kinds of equities that provide a return only when sold, he said. Real estate also tends to smooth investment performance. It has "a negative correlation with other asset classes, so when other things are going down, real estate may be going up and vice versa," Ross said. For example, over the past five years, Northwestern Mutual's real estate equity portfolio has shown a return of about 11.9%, while over the same period, the return of the Standard & Poor's 500 stock index was 1.4%.

Having a good surplus and long-term policy owners allows Northwestern Mutual to invest funds for a long period of time. "Real estate is the kind of thing that you do generally stay with for a long period of time because you can't trade in and out on a daily basis, and it adds an element of performance to the portfolio that individual policy owners can't get on their own," Ross said.

He said that his company is among the most active in the insurance industry in real estate equity transactions. Real estate plays a "very significant role" in his company's portfolio, Ross noted. For one thing, the company views it as a valuable fixed-income investment. Northwestern Mutual, like many other mutuals and stock insurance companies, is an active commercial mortgage lender, with mortgages representing about 25% of its fixed-income holdings.

Real estate equities also form a critical piece--about 6.5% to 7% of invested assets-in Northwestern Mutual's general-account investment portfolio, Ross said. Properties are acquired or developed through a network of company staff. "We have eight offices around the country that do real estate equity and real estate mortgage work," Ross said.

The company focuses its ownership on three major property types: office, warehouse and apartments. "In terms of equity ownership, we've been most interested the last six or seven years in apartments and warehouses because they have more predictable cash flow and, unlike office buildings, require less capital to be reinvested in the business each year," Ross said. "We've generally shied away from new investments in retail over the last six or seven years, because that's been a difficult area--retailers have had a tough time, the concepts change from year to year and we're just not very enthused about it.

"What it does is give us diversification of our equities in a way that's not correlated with other equities available for purchase such as common stock," Ross said. "They are real assets as opposed to financial assets--they do perform differently than financial assets and there's less volatility of return with owned real estate than there is with public common stock or even private stock. So it does a lot of really good things for the portfolio."

Compared with a decade ago, even the real estate portfolio at Northwestern Mutual has shrunk a bit, Ross said. "It goes up and down over time as we find the market either a good time to buy or a good time to sell," he said. "We're real enthused about it and when we look around the landscape, we don't find too many other people that are doing it, for a lot of reasons," he said. "But it works for us."

The promising market for attractive, leased properties has been the driving force behind property sales for many insurance-company investors of late. In fact, Northwestern Mutual has just come off a very large sales year, Ross said. "It's not like we're getting out of the business," he said. It's just been a good time to sell and there will be a good time to get back in. So we've had a pretty active year ourselves in 2002."

Winograd said his crystal ball, like that of so many others in the real estate investment industry, is "unusually clouded" regarding the potential for profitability, economic activity and growth in 2003. For the first time in a long time, he noted, office-vacancy rates are rising due to a sharp drop in demand.

"That's an unusual situation in the history of the U.S. real estate market-- historically, the rises in vacancy have been driven by overbuilding rather than a sudden contraction of demand," Winograd said. "In fact, building has been falling and the amount of new construction being started is relatively small, with the exception of the apartment market. As a consequence, restoration of the markets to a healthy balance between supply and demand is waiting for something to happen that we in the real estate industry don't often have to wait for, which is an increase in demand for the product that is dependent upon the level of economic activity."

But two bright prospects are developing on the horizon, Winograd noted. One is the very low level of interest rates, which has left many real estate investors with strong cash flow in excess of their interest expense. Another is that with building contracting so sharply, as soon as there is a rebound in demand, the vacancy will be taken up pretty readily, he said. "So it's a cautious picture. It's not wonderful at the moment, but there are a lot of things that suggest that it will be turning around, and when it turns around, it will come back comfortably," Winograd said.

RELATED ARTICLE: Leasing, Not Buying

Many insurers choose to lease their corporate headquarters space corporate headquarters space rather than own.

* Cigna

* The MONY Group Inc.

* Lincoln Financial Group

* John Hancock Financial Services

* Nationwide Financial

A Lesson Learned.

Demutualization has spurred mutual insurers to sell off their real estate holdings as they take their companies public. But another impetus has been higher risk-based capital requirements on equity real-estate investments, said Bernard Winograd, president of Prudential Investment Management and chairman of its real estate investment and advisory business, Prudential Real Estate Investors. Industry regulators imposed those capital changes after the liquidity difficulties in the real estate markets in the late 1980s and early 1990s.

The industry had only to look to the case of Newark, N.J.-based Mutual Benefit Insurance Co., which was seized by New Jersey regulators in July 1991 when questions about its real estate holdings caused a "run on the bank" by policyholders. Mutual Benefit had assets then valued at $13 billion and liabilities near $1 billion. The company was the nation's 18th-largest life insurer, and its insolvency ranks as the largest bankruptcy of a life insurance company in U.S. history.

After a court-approved rehabilitation plan was put into effect, the company, along with the National Organization of Life and Health Insurance Guaranty Associations and a group of reinsurers, rebuilt its capital base and changed its investment profile from a high concentration of real estate-related assets to investment-grade corporate bonds. Mutual Benefit's business and assets were acquired by SunAmerica, which was later acquired by financial services giant, American International Group.

A major part of the problem, critics said at the time, was that insurance companies had become far more complex than they had been a decade earlier. While insurers were always invested in real estate, the introduction in the 1970s of variable-rate life insurance, variable-rate annuities and other savings vehicles--in which the interest credited to a policyholder's account was tied to market rates-- forced insurers to seek higher returns themselves by investing in higher-risk real estate.
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Author:Bowers, Barbara
Publication:Best's Review
Geographic Code:1USA
Date:Mar 1, 2003
Previous Article:The regulatory web. (Regulation: The Big Picture).
Next Article:Hired help: insurers are expected to embrace third-party asset management more fully. (Industry Strategies: Asset Management).

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