As public sector pension plans have looked to supplement falling yields from bonds and equities, real estate has emerged as a top choice for alternative investment. Preqin — a large consulting company that specializes in alternative assets, such as real estate, private equity, and hedge funds — issued its latest Real Estate Spotlight report that shows pension funds around the world continue to be key investors in the real estate industry. As of September 2016 public sector pension plans had $681 billion invested in real estate, the largest amount of any category of institutional investor covered by the report.
Private sector pension plans, on the other hand, have allocated $340 billion in the asset class, the report says, though there are slightly more private sector plans dipping to the real estate markets. Preqin finds that 15% of all institutional investors investing in real estate are public sector pension plans, which is second only to private pensions at 19%.
Furthermore, roughly nine out of 10 domestic and international public pension funds currently invest in some kind of real estate. Meanwhile, domestic public pension giants CalPERS and CalSTRS made the list of the top five largest global pension funds investing in the asset class, accounting for $27 billion and $26 billion of overall holdings, respectively.
Real estate is an attractive investment for pension plans because they are managing funds that have long-term commitments, and real estate tends to be an asset to hold for the long-term. However, pension plans also are managed several steps removed from the taxpayers that ultimately bear the responsibility for investment losses. And it’s impossible to define risk tolerance for a multi-generational group of taxpayers. Thus there is a limit to the degree of diversification that a public plan should take on and there are strong arguments for public plans weighting heavily less risky assets in their portfolios.
It may be that for most plans real estate is one kind of long-term assets to hold that is acceptable for a multi-generational taxpayer sense of risk tolerance. But while the pattern of favorable returns to real estate may persist for some time, there are certain risks funds should be aware of.
- First, high-risk/high-volatility instruments — such as global real estate — will have fluctuating returns that swing between high yields and substantial losses.
- Second, funds should also not be so overly exposed to real estate that large swings domestically (think housing crisis) will by themselves drive annual returns down dramatically and subsequently drive up unfunded liability amortization payments.
- Third, since past performance is not necessarily a guarantee of future results, pension plans need to ensure that their investment staff are capable of understanding the complexities and non-liquid nature of real estate as an alternative investment class.
As Morgan Stanley put it “[t]here are no “bulletproof” deals, but portfolios can be monitored and managed for risk.” The consulting company reminds us that real estate is inherently cyclical, suggesting that it should be constantly monitored for risks. Fore more effective results investors are advised to monitor property sector exposure, including such property characteristics as geography, risk classification, life cycle of the asset, investment structure, and type of external management company.
To read the Preqin’s full report, go here.