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New demands from pension fund investors.

A new sense of partnership is emerging between asset managers and their pension-fund clients. The tension that currently crackles between institutional investors and their outside managers is likely to result not in divorce, in most cases, but in a redefinition of the relationship. Fund sponsors are demanding more participation and a greater role in decision making--as well as greater control over the asset managers themselves.

New pressures on assets managers reflect pension funds' feeling disillusioned with real estate, to judge from speakers at the Pension Real Estate Association's Spring conference in Beverly Hills. Some asset managers are being fired, although they represent only a small fraction of the industry. More frequently, managers are being called on the carpet for a perceived failure to alert their clients to poorly performing buildings or missed opportunities to sell problem properties. And fees are undergoing intense scrutiny.

The dissatisfaction of pension funds with real estate is clear from a recent survey of 1,538 pension fund sponsors by Greenwich Associates of Greenwich, Connecticut. Thirty funds have left commercial real estate altogether, while up to 120 plan to terminate their managers outright. "I don't think the pension funds trust their asset or plans managers [to do a good job for them]," said Greenwich Associates' Rodger Smith.

From rage to reality

Yet the mood of recrimination seems to have mostly passed. Sponsors of U.S. pension funds, which doubled their real estate holdings in the past five years to a total $100 billion, seem to have acknowledged that their real estate portfolios are performing poorly and have lost up to 30 percent of their value across the board.

At the same time, fund sponsors are not uniformly negative about property markets. The Greenwich Associates survey showed a revealing split in attitudes, with 31 percent of fund sponsors saying they planned to withdraw some capital from real estate and another 22 percent seeing good prices and opportunities in the down market. Those figures suggest that some fund sponsors have an entrepreneurial eye for value-added deals.

Many fund sponsors also blamed themselves for not taking a more active role in decision making. "Our job right now is how to cope with what went wrong in the '80s," said Charles Grossman of the New York office of Jones Lang Wootton Realty Advisors. George Philip of the New York State Teachers Retirement System said he and his fellow sponsors "should be involved in the entire process, including pricing," rather than simply rubber-stamping the decisions of their asset managers.

At the same time, Philip said he "would like to get a better handle on what an asset manager does." He described the '80s as a period of "too much chasing" after buildings "without a real handle on the asset class." In the future, he said, pension-fund sponsors will be "a far more knowledgeable group, who will assume much more responsibility. We see ourselves as much more involved."

Specifically, Philip said, that involvement will take the form of greater participation by fund sponsors in "buy/sell" decisions, as well as "a good deal more ongoing participation in asset management." Fund sponsors must look after their own interests, he added. "I don't think plan sponsors can rely on asset managers solely to protect their interests. It's up to sponsors to protect themselves; they can't be passive."

Asset managers also at fault

Some consultants and asset managers acknowledged the need for more localized attention to individual properties. Blake Eagle, president of Frank Russell Company's real estate consulting group in Tacoma, said some fault lies with managers and consultants. Instead of a business of serving tenants, he said, "real estate became an investment commodity."

Asset managers also have the unenviable task of explaining the sudden, across-the-board devaluation of commercial real estate, which consultants had marketed intensely to pension funds in the 1980s on the basis of resilient values and high historic returns.

John McMahan of San Francisco-based Mellon/McMahan Real Estate Advisors, Inc. acknowledged that it can be hard to make fund sponsors understand why an office building purchased for $16 million "is not going to be worth more than $4 million for the next few years."

The method, he said, is to "show that if the present value of the future income stream is no more than $4 million, you take the sale at $4 million."

And how does he explain to clients the larger question of declining real estate values? "I tell them it's a combination of overbuilding and declining market demand. We are restructuring the way we do business in this country," he explained.

Douglas A. Tibbetts of Equitable Real Estate Investment Management, Inc.'s Atlanta headquarters said that "one of the biggest problems is to convince clients to spend more money not less, on troubled projects." Advisors convince clients to spend that money, Tibbetts said, by explaining that a positive investment is sometimes necessary to keep properties competitive, as markets slowly recover.

Not every advisor was willing, however, to hear blithe assurances from managers that "all will be well." Nori Gerardo of the Portland-based Pension Consulting Alliance asked bluntly: "What is so different in management organizations today [that] mistakes won't be repeated?" If too much money was chasing buildings in the '80s, she added, "how can you do a better job now?"

She did not seem satisfied by the claims of consultants and asset managers who spoke of their knowledge of pricing and regulation. "'We did it wrong before, now trust us,'" she

McMahan of Mellon/McMahan said that asset managers should "challenge traditional assumptions of the past," adding that there is "nothing sacred in terms of an individual property. Everything is to be evaluated under one set of criteria, its returns."

Susan Hudson-Wilson of Aldrich, Eastman & Waltch of Boston argued that asset managers need to base their decisions on solid research and reliable numbers, not their gut feelings. "The stock guys don't ask their clients to trust them and the bond guys don't rely on faith. These professionals prove and re-prove their worth every day in the Wall Street Journal.

"Trust doesn't fly in the big, wide world of asset classes that chew up 40 to 60 percent of the portfolio. It's high time our asset class gets with the program."

Paying too much for too little

Fees are a particular point of friction these days between asset managers and fund sponsors. Fees, commonly 75 to 125 basis points of the asset value, are about twice those charged by stockbrokers for their services.

Such suggestions seemed to offend Timothy J. Heise, the head of New York-based J.P. Morgan Investment Management, Inc., who said the comparison bordered on the irrelevant; stockbrokers handle transactions, while asset managers "are essentially running a business." He pointed out that appraisals alone took an enormous amount of time in commercial real estate, while there is no question on the value, at any given moment, of stocks and bonds.

Still, New York States' Philip complained that asset managers are "making money whether we do well or badly." Greenwich Associates' Smith said some fund sponsors "think asset managers have taken unfair advantage."

Joseph Russo, investment director in AT&T's Investment Management Organization, said that managers are "not disciplined or incentivized [enough] to sell properties." Instead, managers appear to favor a strategy of buy-and-hold.

While Russo did not say so, he implied that some managers might be holding on to real estate to collect their management fees rather than looking out after the interest of their investment clients.

"No one says the manager shouldn't make a fair profit, if investors make a fair return. The perception is that managers are making a lot of money," said Smith.

To reform the fee structure, Benjamin G. Gifford of the O'Connell Group of New York suggested the "elimination of transactional compensation," including the up-front fees that some managers charge when properties are purchased. Also suggested was the "unbundling of services" into different itemized services with itemized fees.

Philip questioned the structure of fees, and called for "an incentive-based fee structure, to incentivize [managers] to maximize value and sell at the appropriate time." Although Philip declined to be very specific as to how he would reformulate fees, he said the performance of real estate would be one of several criteria.

McMahan of Mellon/McMahan concluded the issues surronding fees are a "surrogate" for "a deeper angst" that fund sponsors feel about real estate and market conditions.

Reform, not replacement

Despite the frustrations that some plan sponsors are feeling toward asset managers, they generally seem reluctant to fire their managers. In evaluating managers, Philip said he ranked "chemistry" first, "credibility" second, and "performance" third. However, he advised the plan sponsors to ask some direct questions of their managers: " 'When things got worse, why didn't you sell? Were you afraid of the loss of the asset management fee?'"

Gifford concurred, saying he had terminated managers "for the inability to communicate, not just on performance."

Barbara Cambon of Institutional Property Consultants, Inc. of San Diego stressed the importance of client relationships. Consultants and asset managers, she said, "can no longer manage sending a quarterly report and touching base [with their clients] once a year for dinner." She suggested that asset managers meet regularly with clients, acknowledge their mistakes, and provide an "honest assessment" of the portfolio and the markets.

And asset managers, sensing the discontent of their clients, are trying to find ways to save their lucrative pension-fund accounts, including offers to become co-investors with their clients and share the risk.

"Managers' capital should be at risk," Eagle said. "If an investment is good enough for pension funds, it should be good enough for managers."

David Glickman, president of Dolphin Advisory Corp. of Chicago, said co-investment would bring new "credibility to asset managers," and cited the success of the Zell/Merrill Lynch Fund, which has several pension fund participants.

Critics of coinvestment, however, observed that securities firms rarely coinvested with their clients; why should asset managers?

Still in the asset mix

Fund sponsors who want to stay in real estate may also seek greater safety by avoiding direct ownership. Many speakers at the PREA conference alluded to the current fashionability of real estate-based securities, such as collateralized mortgage obligations (CMOs) and real estate investment trusts (REITs), as a substitute for direct investment in real property itself. Such a trend "would be bad news to hands-on managers," said Greenwich Associates' Smith.

But if some fund sponsors are running for cover, other investors are seeking opportunities. McMahan told fellow advisors to "believe your research and be willing to move forward, even if other people are not."

Richard Kately of Chicago's Heitman Financial concurred with the emphasis on research. "We will tell asset managers, do the deal. That's what it takes in today's market. Don't be afraid of being accused of making a bad deal down the road."

O'Connor Group's Gifford said there are "very few compelling investments out there, and those are the ones we should be focusing on."

J. Richard Rosenberg of Callan Associates in San Francisco urged investors and asset managers not to follow simplistic ideas that some markets are "good" and others "bad." "We hate to see redlining of markets and opportunities," he said. "At the right price, there is always a good deal."

[Morris Newman is a Los Angeles-based freelance writer, the Los Angeles correspondent for Progressive Architecture, and senior editor of California Planning & Development Report.]
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Title Annotation:Asset Management; evolution of the asset manager-pension fund sponsor relationship
Author:Newman, Morris
Publication:Journal of Property Management
Date:Sep 1, 1992
Previous Article:Effective employee appraisals.
Next Article:Lease-analysis programs.

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