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Managing for today's pension fund investor.

About a year ago, TCW Realty Advisors assumed management of a new office building that featured a spectacular atrium waterfall whose beauty made quite a splash--all the way across the floor and into the elevator cabs.

"We were told we had to do roughly $50,000 of work to keep it from spraying water onto the floor and in the elevator cabs," explained Boston-based TCW Partner and Director of Portfolio Management Timothy Shine.

TCW didn't want to turn off the waterfall, but didn't want to pay $50,000 to repair it, either. "It didn't make sense to turn off the waterfall and lose the amenity value, but it didn't make sense to pay $50,000 to fix it," said Shine.

Instead of money, the firm's property manager used creativity to find a solution. He hired a designer to reconfigure the water flow away from the elevators. "The designer had to put forth twice as much brain power, but it saved me half the money," said Shine.

New pressures to perform

The ingenuity of the TCW manager is the kind of property management pension funds and their advisors are looking for in a market where commercial real estate values and rents keep declining. For the year ending June 30, 1991, total returns for the NCREIF/Russell Company index of pension-fund owned commercial real estate were -1.1 percent.

The declining returns for pension fund investors in commercial real estate have placed the validity of the asset class under fire and have put property managers under the gun. "During times like this, the whole property management business comes under greater scrutiny that it does during good times," says Michael Herzberg, CEO for Ferguson Partners Limited, a Chicago pension fund advisor.

Without appreciation and resale gains to offset low rents, pension funds are looking toward income streams to make investments work. What does that mean for property managers working with pension funds and advisors? More work, said James Flynn, vice president of asset management for Copley Real Estate Advisors, Boston.

"The more problems you have, the more of a skilled property manager you need. I would argue that you'll see more opportunity in the office market. As people become dissatisfied with performance, they tend to blame property managers, so you're going to get turnover in the management of troubled properties," he predicted.

As real estate markets worsen, investors' fears surface. Pension funds have tried to soothe concerns by assuming an even more active role in property management, suggested Kevin McCall, a regional director with Aldrich, Eastman and Waltch, L.P. (AEW), Boston.

Pension fund advisors used to joke that monthly report packages went to pension funds where they sat on a shelf, unread. "Now, the reports up to the company, couldn't be more important," said McCall.

"Some of our clients are getting very deeply into property performance, asking us for reports not only on leases in place, but on prospective tenants. They want to see what your traffic is like, if you're beating the bushes hard enough. They're looking at reporting more carefully because they've lost confidence in the asset class," said McCall.

And the contents of those reports grow ever more complicated. To gain an edge with pension fund investors, property managers have to be able to deal with zero-balance accounts, wire transfer payments, bank reconciliations and two dozen expense pools for 200 tenants, said Shine.

Heightened emphasis on service

To keep tenants in place and cash flows coming, pension funds, like most investors, are demanding heightened tenant retention efforts--more in-office visits, more discussions about tenant needs, more hand-holding, and more knowledge of tenant businesses, said Nori Gerardo, managing director of the Pension Consulting Alliance, Inc., Portland.

"Across the board, there's an emphasis on understanding your tenants and servicing them to death," she said.

Even though they may invest fewer funds today, pension funds still need to hold returns steady in the investments made yesterday. And retaining tenants is still the best way of maintaining real estate returns. "The number one way we think we can hold value is to keep our properties occupied," said Shine.

TCW's pension fund clients have boosted occupancy rates by negotiating directly with existing and potential tenants. "Knowing you can get up from the table with the landlord and have an immediate deal helps the deal come out," said Shine. "They [tenants] actually sit down with the owner--granted with the broker in the same room. It gives them the warm and fuzzies."

Extending credit to worthy existing tenants and to those who need a rent-free window to get out of a competitor's lease early has also worked for TCW's pension fund clients.

TCW also grants leeway to creditworthy tenants that just need a break. For instance, a tenant with a big contract coming up might be given a rent-free window. "The majority of the time it works to our benefit," said Shine.

The other side of the equation

But lease income is only half the profit equation. With rental income falling in many markets, cutting expenses to bolster profit looks good to many pension fund investors.

Because real estate taxes account for 20 percent of overall costs, tax abatements are the number one way to save money, said Flynn. "In most cases, the building is worth less today than it was yesterday. So if you're not trying to get the taxes lowered, you're not doing your job," he said.

If you can hit a window where a jurisdiction hasn't yet raised its tax rate t6o balance falling property values, you can really save some money, Shine agreed.

TCW's clients have also relied on energy savings and recycling programs to cut costs. "If we have a building with old incandescent lights, we've gone back in and made a capital investment in the newer types of light fixtures that use less energy and give off better light," he said. "The overall savings can be substantial if you have a long-term perspective, as we do."

Larger property management firms have saved Copley money with blanket insurance policies, which are more cost-effective to pension fund clients than single building policies, Flynn said.

And AEW has a pilot program on tap that gives tenants a chance to select their own level of desired service. The pilot will "take an operating program to the tenant in an office building with proposed lower costs and a lower level of service, from which they could benefit if they choose to participate," McCall said. The service cut-backs might include washing windows twice a year instead of four times a year, he explained.

Still, pension funds want primarily Class A buildings, and they are careful not to go too far in cutting costs. After all, pension funds are in the game for the full nine innings, said Pual Saylor, president of Institutional Property Consultants, Inc., Atlanta. "They know cutting to look good this quarter is going to hurt you in the long run," he said.

A lowering of activity

Most pension fund advisors say their clients haven't changed their investment strategies as much as they've been striving to maintain the investments they already have. Investors are struggling to prop up underperforming assets; insurers are juggling to fund expiring financing; and plan sponsors are wrestling with an avalanche of withdrawal requests.

"A good deal of capital allocated to real estate is not going to be spent in this decade," said Saylor.

What money exists in being placed cautiously. "There's a move to defensive investing, a flight to quality," said Nori Gerardo.

What's being left behind by the pension fund flight? "Suburband office space," said Gerardo. "It has the highest vacancy rate, and there is increasing concern about being able to keep the kinds of tenants you need."

Copley's James Flynn sees two types of investment strategies among the pension funds in today's market.

"There is the type that recognizes it's a time to buy and not to sell, and there is the type that is afraid of real estate and has pulled back," he said.

About 20 percent of the pension funds in the market today hope to pick up bargain properties trading at a discount, while the other 80 percent are holding or folding. Those still investing favor residential and industrial properties over the harder hit office, research and development, and hotel markets, Flynn said.

Retail and industrial properties have also been the main focus for acquisition at TCW Realty Advisors, said Partner Timothy Shine. Even in an overbuilt retail market, site-specific properties offer good opportunities.

"We're also re-evaluating our acquisition strategy to take advantage of distressed prices," he added.

Ferguson Partners President Michael Herzberg also sees greater pension fund interest in multifamily properties, particularly in existing complexes. Industrial and regional mall properties also look good to his pension fund clients.

Robert E. Davis Jr., firm-wide director of real estate capital markets for Arthur Andersen & Co., Los Angeles, said pension funds are more conservative today. "They're recognizing that the world has changed," he said. The significant write-downs of 1990-91 left pension funds feeling skittish. They worry that investing in real estate today will lead to write-downs tomorrow, Davis explained.

When pension funds again become aggressive market participants, they will not all purchase regional malls and office buildings, he predicted. "They're going to broaden their investments into multifamily and into joint ventures with homebuilders to produce single-family homes," Davis said.

While many pension funds have slowed investment in commercial real estate in the past couple years, Herzberg senses a sea change. Over the next two years, he predicted, more pension funds will come back into the market and will increase their commercial real estate holdings.

However, concluded Herzberg, while pension funds may pick up the pace of their acquisitions in the years ahead, they're unlikely to return to the heady acquisition pace set in the 1980s. While real estate will undoubtedly retain its position as a pension asset class, the bonanza days are over.

Dona DeZube is a freelance writer based in the Washington, D.C., area. She specializes in articles on finance and pension fund investing.
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Author:DeZube, Donna; Goldbeck, Richard B.
Publication:Journal of Property Management
Date:Jan 1, 1992
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