Institutional Real Estate: Does It Measure Up?

There’s no question that real estate is an important investment in many pension funds’ portfolios. Some numbers: there are nearly 46,000 tax-exempt investment institutions in the U.S. that control more than $6.4 trillion of investment capital, of which $203.2 billion is invested in real estate. The real estate allocation of a fund ranges anywhere from zero to 15%, depending on the fund. Larger pension plans typically invest 7% to 10% in real estate, while smaller funds may have no allocation to real estate. Due to their size, smaller funds prefer assets with more liquidity, and many lack in-house real estate expertise.

Pension fund staff are not only asset managers for their investments; they’re also liability managers for their constituents, the plan beneficiaries. The investments need to generate returns greater than actuarial assumptions to meet future liabilities. That means that benchmarking against a known industry index is imperative in assessing the performance of an asset. It provides a historical understanding of performance compared to other asset classes, and is used to compare the fund’s portfolio to the market portfolio. Stocks and bonds are easily benchmarked by using industry standard indexes published daily in the Wall Street Journal. Benchmarking real estate, on the other hand, is more challenging.

The National Council of Real Estate Investment Fiduciaries (NCREIF) has tracked real estate performance for the last 20 years and publishes performance indexes (NCREIF Property Index of NPI), which are widely used for benchmarking real estate assets. Although the NPI has been criticized, when used correctly it can be a useful tool in decision-making. The pros and cons of the NPI are too numerous to debate here, however; suffice it to say it’s the most widely used index for private market data.

(A new benchmark currently being discussed is generated by UK-based Investment Property Databank (IPD). To read more on this topic, refer to “Is There a Better Benchmark? How the UK’s IPD stacks up against the NPI,” an article in the September 2000 edition of the Institutional Real Estate Letter, which can be ordered by calling 925-933-4040 or e-mailing circulation@irei.com.

An index may be obtained not only by property type, but also by sub-types (e.g., garden apartments) and by geographical regions. The total return is comprised of income (return attributable to a property’s net operating income) and capital appreciation (changes in market value) components. The universe of properties that make up the NPI database are those acquired on behalf of tax-exempt institutions and held in a fiduciary environment. At June 30, 2000, these properties had a combined value of $87,584.1 million.

According to NCREIF, the performance of the various asset types as of June 30, 2000 is as follows:

While real estate investment performance over the last several years has been lower than stocks, most research studies have concluded that real estate is less volatile, and thus a lower-risk investment. Real estate is a good diversifier in the pension plan portfolio, maintaining steady returns as a solid investment. Even low double-digit returns are attractive to funds, considering that most use an actuarial assumption of about 8% for liability planning.

However, investors remember the late 1980’s and early ‘90’s, when real estate was in a down cycle. Lessons learned in that period seem to have stuck, because the recovery since then has been sustained to remain so over the next two years. The overall market is in equilibrium and there’s a heightened sense of responsibility in the private market, born of bitter experience, to keep it that way. In short, there doesn’t appear to be a sign of significant overbuilding on the horizon and, as has been pointing out many times in recent years, over-all market fundamentals are still good.