The role of REITs in a pension real estate allocation

By John Keefe

Real estate investment long has been viewed by pension plans, also known as defined benefit (DB) plans, as a core asset in their opportunity set of investments to provide portfolio diversification and to meet future retirement obligations.

In fact, according to the Pension Real Estate Association (PREA), pension funds have increased their investments in real estate in every year since 2000, and more than 40 percent of pension funds intend to increase their investment allocation to real estate over the next few years.

Rise in Real Estate

“Institutional holdings of REITs have expanded in conjunction with increased real estate allocations over the last five years,” says Michael Acton, director of research at AEW Capital Management, a $41 billion real estate manager. AEW recently celebrated the 12-year anniversary of its flagship REIT fund, as well as the two-year mark for its global fund.

As part of a general move away from conventional stocks and bonds by U.S. institutions, real estate rose in 2006 to 6.9 percent of total assets of pension plans—up from 6.05 percent in 2005, PREA reports. Looking forward, more than one-fourth of funds in their survey anticipate steering more assets to real estate in 2007. The median target allocation to real estate is 8 percent.

In fact, pension plans are increasingly using REITs as part of their real estate allocation. A 2006 survey by Pensions & Investments of the top 200 DB plans found that, on average, plans increased investments in REITs by 4.2 percent within 12 months on a market adjusted basis.

“The catalyst for pension funds rethinking their asset mix was the crash in the technology stocks, but now much bigger forces are driving it forward,” Acton says. When a plan is frozen and new accruals are reduced or vanish, “Future liabilities become more certain, and in that environment, sponsors don’t need a growth orientation to the portfolio,” Acton says. REITs are particularly beneficial to use in these plans because of their liquidity.

Providing Broad Diversification

The use of REITs in a pension plan helps build a diversified portfolio, which reduces risk. “The largest institutions can invest in real estate through any strategy they choose, but with so many aggregate dollars to invest, they often go to the public markets as a way to get their money to work quickly,” Acton says. “At the other end of the scale, smaller investors can’t easily make several direct investments, and a REIT portfolio is a better way for them to get broad diversification.”

Consider a pension plan that has decided to allocate $50 million to real estate, which Acton says is a typical mandate size. To pursue a private program, a plan could invest in from six to 10 core open-end funds, wind up with a stake in 500 or 1,000 properties, and wait six months or more to be invested.

Through a public REIT approach, the same allocation could be assigned to an active manager for a diversified portfolio of perhaps 30 to 40 different REITs, with indirect exposure to 15,000 properties. Moreover, the funds would be deployed within a few days. Acton also points out that REITs offer a wider range of property types than commingled private funds. “You can buy old-fashioned cash flow, or there are plenty of opportunities if you want something snazzier,” he says.

The details of a Greenwich Associates survey suggests even greater potential growth ahead for REITs. In 2006, 53 percent of all funds owned some part of real estate. However, while 72 percent of public pensions and 62 percent of endowments held real estate, only 39 percent of corporate plans owned property assets. Even among the largest, and presumably, most sophisticated corporate plans—those with assets over $5 billion—fewer than 60 percent were participating in real estate.

Telling the Story

Simple statistics don’t tell the whole story, says Michael Giliberto, managing director and director of real estate portfolio strategy with J.P. Morgan Asset Management. “When institutions started moving capital into real estate in the early 1990s, REITs had some problems gaining acceptance in the pension real estate market, but I think that battle largely has been won,” he says. “As long-standing real estate investors, we have embraced REITs as a way to bring more diversification and liquidity to an illiquid asset class.”

While the capital markets behavior of the two assets may look different on the surface, the underlying business of REITs and direct real estate investment are equals. “In many cases, the properties that REITs own and operate are literally the same properties owned by direct investors,” Giliberto says.

He points to a shopping center joint venture owned 50 percent by JPMorgan’s private institutional clients and 50 percent by Simon Property Group (NYSE: SPG). “The properties are operating in the same markets. Common sense would say that REITs and private funds should have similar cash flows, and indeed they do.”

How Pension Plans Use REITs • As a proxy for direct real estate investing • As a tactical asset allocation tool • To gain international real estate exposure • To gain exposure to a property type that might be difficult to invest in directly • Some small plans use REITs as the only means by which to gain real estate exposure Source: Investment Insights: Real Estate Investing the REIT Way, Barclays Global Investors

Global Markets

Institutional interest in REITs has exploded in markets outside the United States. Large property markets are open to securitization and public ownership for the first time. According to J.P. Morgan Asset Management, there are new, liquid investment opportunities in France, Germany, the United Kingdom and all of Asia, making diversified global REIT strategies a strong choice for both new and seasoned investors.

Although institutions’ holdings of REITs have generally risen in line with pension plans’ real estate investment in the U.S., a new force—the securitization of the global real estate industry—will probably shift growth in REIT holdings to a higher gear. “The global real estate securities markets are on a rapid growth curve,” says Jacques Gordon, global strategist for $44 billion La Salle Investment Management, citing new legislation enabling REITs in Asia and Europe.

Moreover, just 6 percent of the world’s real estate is currently securitized, says Joseph Pavnica, real estate portfolio manager at ABN AMRO Asset Management. “U.S. pension funds are shifting some of their domestic REIT allocations in the global direction.”

However, investors note that some U.S. advisors are not well grounded offshore. “I wanted managers that had feet on the ground in Asia and Europe,” says Gary Childs, head of real estate for the Oregon Investment Council, which manages $4 billion in real estate for the Oregon state employees’ pension plan. “However, when I interviewed U.S.-based managers, I saw many had just opened the door to investing overseas,” he says. As a result, out of three REIT managers, Oregon hired just one U.S.-based firm.

“The opportunity set is suddenly much larger in the global market,” Acton says. “If you were starting a real estate program from scratch today, you would probably choose a global strategy rather than something country-specific. For one thing, you would greatly reduce your ‘entry-point risk.’” He says that real estate is not cheap any place around the globe, so a great way to get started is with an allocation to the whole basket.

Overall, many institutions, both in the U.S. as well as abroad, are jumping to add real estate into their pension portfolio. “Because REITs are liquid and transparent, we tell clients that for real estate, their first foray should be through securities,” Gordon says.