Market Data

Pension Funds Compete with REITs and CMBS for Market Share

After being stung by the severe real estate downturn during the early 1990s, pension funds gradually have increased their investment in institutional real estate. But other players, primarily real estate investment trusts, continue to gain on pension funds. Pension funds owned 11.3 percent of the institutionally owned commercial real estate debt and equity in 1992, according to data collected by Lend Lease Real Estate Investments, formerly ERE Yarmouth. This figure declined to 9.8 percent in second-quarter 1998, despite an increase of $19.1 billion in investment by pension funds since 1992.

In second-quarter 1998, institutional investors (pension funds, REITs, commercial banks, savings associations, life companies, and foreign investors) controlled $1.6 trillion in commercial real estate, split between $349.5 billion in equity investment and $1.2 trillion in debt.

REIT Competition
REIT equity ownership increased from 4.9 percent in 1992 to 41.4 percent in 1998. During this period, pension fund equity ownership declined from 43.7 percent to 34.7 percent. Pension fund equity investment increased from $97.6 billion in 1992 to $121.4 billion in second-quarter 1998. However, during this period, REIT equity investment grew from $11 billion to a staggering $144.8 billion. Pension funds lost ground because REITs snapped up most of the newly created equity. However, this trend slowed in 1998 as capital became tighter.

Cyclical Events
Historically, pension funds have been major purchasers of commingled real estate funds. But due to wide fluctuations in the performance of commercial real estate, commingled funds assembled during the high point in the market cycle experience much different returns than those from the low point. Funds that invested in closed-end commingled real estate funds assembled during the mid-1980s had returns that did not meet expectations. Pension fund managers were expecting annualized returns in the 10 percent to 13 percent range. However, upon liquidation, annualized returns have been in the 5 percent to 9 percent range for the stronger-performing funds. The severe downturn in the commercial real estate market during the early 1990s sapped a significant amount of performance from these funds.

However, opportunistic funds that were started at the bottom of the real estate cycle during 1992 flourished. The most recent opportunity funds have been projecting annual returns in the 20 percent range.

Looking Abroad
With the low fruit scavenged by the opportunistic funds and REITs, some pension funds are looking abroad for real estate investments. The California Public Employees Retirement System has earmarked $100 million for Security Capital Global Realty, a $1.5 billion fund that will purchase real estate operating companies in Europe, Asia-Pacific, and Latin America. Expected annual returns are in the 15 percent to 20 percent range. Other pension funds have been slower to invest in international real estate funds.

On the debt side, pension funds are much smaller players. Institutional real estate debt held by pension funds has dipped from 3.9 percent in 1992 to 2.7 percent in second-quarter 1998. This translates into a decline in equity holdings from $38.1 billion in 1992 to $33.4 billion in 1998. The sharp decline in debt holdings was due to large-scale write-downs and sell-offs of commercial mortgages in the first half of the 1990s. In addition, Congress placed severe restrictions on pension fund purchases of commercial mortgage-backed securities through the enactment of the Employee Retirement Income Security Act.

The increase in CMBS issuance replaced the decreased level of pension fund lending. From 1992 to second-quarter 1998, the CMBS market’s share of total institutional real estate debt increased from 4.6 percent to 17.4 percent. In fact, many pension funds turned their mortgage positions into cash through CMBS securitization.

However, the commercial finance market went from a borrower’s to a lender’s market virtually overnight when the CMBS market crashed in September 1998. Due to this severe downturn, pension funds are being approached to finance high-quality projects at very attractive yields. But once this turmoil settles, CMBS again will offer the pension funds severe competition. Until then, opportunistic pension funds can utilize this anomaly to load up on high-quality mortgages.

The role of pension funds has diminished slightly over time due to the emergence of REITs and CMBS. However, because real estate offers solid returns and portfolio diversification, pension funds will not abandon this sector, but will remain a major institutional real estate player.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.

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