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Realism: new criterion for RE portfolios.

To paraphrase a well known Latin adage, different times require different practices.

The boom days of the 1970's to mid-1980's, when real estate was a passive asset that effortlessly increased in value every year, are over. In the 90's, as everyone knows, values are down. Yet, some pension funds and their realty advisors still evaluate and manage real estate portfolios in today's environment with a mindset that is geared to the rising market of before.

Here's a case in point: A public employee, pension fund was having difficulty selling several low-rise office buildings aggregating about 200,000 square feet. The property had been acquired nearly nine years ago for about $20 million and was currently reported, or assumed, to be worth about $25 million. Conforming to the original business plan, the current pension fund advisor was determined to sell the property and assured the fund that it should get at least $25 million. The trouble was that initial offers, each rejected, hovered in the mid-teens.

Called in as consultants, we found out that the property suffered from several negatives: An occupancy rate 10 percent less than comparable buildings. Twenty-five percent of existing tenants were vacating at the end of their leases. Operating expenses were $.50 to $1 per square foot higher than comparable buildings. In addition, we found on-site management slow to respond to prospective and current tenants.

Yet the property had advantages. It was relatively new, well maintained and offered good access to the metropolitan area.

Eventually, we found out that the advisor's compensation was based almost entirely on the value of assets under management. Annual cash flow and proceeds from the sale of property had little impact on the advisor's earnings.

Our recommendation was for an independent appraisal and a new compensation plan that would tie in the advisor's compensation more closely to cash flow and the ultimate sales price. The outcome is that the property was reappraised at a more realistic $18 million, and a marketing program started that was focused on tenants.

As a result, occupancy rates grew 5 percent over the market average, rollovers decreased from 25 percent to 15 percent, costs got under control and brokers started showing the property to many more prospective tenants.

Significantly, the fund decided not to sell the buildings. The lessons illustrated by this case emphasize the need for both sponsors and advisors to be realistic and to understand and respond to changes in the market.

Real estate is no longer a passive asset. In order to manage changes effectively in today's market for the best interests of pension beneficiaries, pension fund sponsors and advisors must become more proactive in their planning and more effective in communicating with one another.

Updated strategies for the 90's for plan sponsors should include keeping up to date on all real estate assets owned by the plan, whether or not they are owned individually or in a commingled fund format. In order to keep a constant watch on the performance of all properties, sponsors also should be willing to hire additional staff or consultants as needed.

And, most emphatically, sponsors should design a compensation schedule for realty advisors with incentives for value enhancement.
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Finance; management advice for pension fund real estate portfolios
Author:Wedgewood, Ralph
Publication:Real Estate Weekly
Date:May 20, 1992
Previous Article:Keeping co-ops/condos financially sound.
Next Article:As the economy grows, the money flows.

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