Time Capsule – 1982: Put 25% into real estate

Pension fund sponsors currently have a golden opportunity to take an unhurried, penetrating look at real estate investment: to determine whether to make the investment at all, and if so, to set the size of the investment and choose the type of real estate vehicle.

The opportunity is especially ripe at the moment because there is an ideal combination of a wide selection of vehicles and, with many indicators suggesting market softness, some considerable time in which to make decisions.

Interest of Canadian pension funds in real estate has been slow developing. In the 1940s and 1950s, conventional wisdom had it that long bonds were the obvious pension fund investment vehicle. After all, they were long term instruments and they were safe.

During the 1960s, there was a shift in thinking. Common stocks had produced spectacular returns a decade earlier, they had an even longer term than bonds, and they were thought to provide better inflation protection. This was becoming an important factor as inflation began to edge up from its “normal” 2% annual rate.

As events turned out, from the mid-1960s to the mid-1970s, stocks had difficulty producing a positive nominal return, let alone a positive real return. As a result, during the last half of the 1970s North American pension funds began to study seriously an asset class which European funds had for many years employed as their basic defence against unanticipated price and wage inflation: direct investment in income-producing real estate.

The most frequently quoted wisdom to support pension fund investment in real estate today centers around four rates of change: 11.9%, 9.9%, 7.9%, and 5.5%. These numbers represent the annualized 10-year return on a dollar invested in December 1969 in: 1. The Prudential Property Investment Separate Account 2. The S&P 500 Stock Index 3. The Consumer Price Index and 4. The Solomon Brothers Long Bond Index. Relative to stocks and bonds, real estate was clearly the winning investment class of the 1970s.

Is timing right?
More than one observer has commented that pension funds are making the same timing mistake today, with their move into real estate, as they made in the late 1960s and early 1970s with their move into common stocks.

Are pension fund managers like generals always preparing to fight the last war? Not necessarily.

A solid case for placing up to 25% of a pension fund’s assets in real estate can be made without resorting to the simplistic “11.9%, 9.9%, 7.9%, 5.5%” rationale. There are two central points to it:

1. In comparison with all assets held by institutions and individuals in Canada, pension funds are over-weighted in stocks and bonds and under-weighted in real estate. Yet, given that pension liabilities are long and sensitive to inflation, real estate assets match them very well. In addition, pension funds can exploit their tax-exempt status through direct ownership of real property more readily than by owning common stock.
2. A 25% investment in real estate makes an excellent hedge against inflation. In a deflationary environment, long term bonds will perform best, offsetting the poor real estate results likely to occur here. In a mixed environment, a 50-50 split between equity and debt securities is probably the most appropriate hedged position, with the equity portion split equally between common stocks and real estate. The debt securities would be split evenly between long and short term instruments.

If all Canadian pension funds had placed 25% of their assets in either direct real property or property-backed variable rate securities, that investment would today represent some $15 to $20 billion. It has been estimated that non-fixed-rate investment in real estate today by Canadian pension funds is about $2.5 billion, or some 3% of total assets.

Out of this $2.5 billion, direct property ownership accounts for about $600 million, investment in publicly traded real estate company common shares $300 million, open-ended real estate pools $400 million, and the remainder in debentures backed by real estate.

Why the gap?
Why are Canadian pension funds some $15 billion “short” in real estate investments?

Most obviously, investing in real estate is a new idea for the majority of Canadian pension plans and their trustees. As with common stock some 15 years ago, so with real estate today: it takes time for the idea to catch on.

Only slightly less obvious are the problems of acquisition, maintenance and disposal. Acquisition, maintenance and disposal of bonds and stocks, whether done in-house or by an outside investment manager, holds no mysteries. Not so for an office building, a shopping center or a warehouse. Each property is unique, not easily divisible, and illiquid.

Finally, there are the regulatory requirements of real estate investing for pension funds. Although they are currently in the process of being brought into line with reality, nevertheless the rules on “qualifying” and “non-qualifying,” on “real estate baskets” and “non-real estate baskets” continue to be a source of consternation and confusion.

Where do we go from here?
Adam Smith’s “invisible hand” lives on. Where there is demand, supply is never far behind. In the last several years about 20 vehicles either have been introduced or will be shortly—all with the purpose of funneling pension fund money into Canadian commercial and industrial real estate.

While each of these vehicles is unique, in that each is sponsored by a different organization, with it’s own investment objectives, acquisition and disposal strategies, property management approaches and fee structures, each generally falls into one of two main categories.

Large financial institutions with in-house real estate expertise (and usually with an existing pension investments business) have introduced open-ended pooled real estate funds for their clients. Typically, this type of fund is started by seeding it with a property portfolio from the institution’s own property assets. Once started, the asset base is expanded by acquiring outside properties. Investments into these funds can be made at any time at unit values calculated on the basis of the appraised value of the fund properties. There is some liquidity, as investors can “cash in” their units, although usually there is a caveat that the vehicle sponsor has the right to control the rate of divestment.

Sales of open-ended pooled fund units were brisk in 1981 and we estimate there are now some $400 million of pension assets invested in this type of vehicle. With its typical features of no plan sponsor involvement, ease of acquisition, rapid diversification by property type and location, and “brand name” financial institution backing, this type of vehicle is attractive, especially to the mid-side and smaller pension fund market.

In the last year or two, there has been a distinct tendency towards “specialist” investment management structures for pension assets. The rationale for this shift has been the view that the “best” common stock manager, the “best” foreign securities specialist, the “best” bond specialist, the “best” asset shift specialist, and, more recently, the “best” real estate specialist, will not necessarily be found under the same roof.

While the “specialist” products offered in real estate are, by definition, not as easily characterized as the open-ended pooled funds, they do tend to have some common characteristics. Many are “closed” vehicles: subscriptions are solicited for a defined period of time (say 3 months) for a specified dollar range (say at least $50 million but no more than $100 million.)

Some invite continuous pension fund involvement by permitting the pension fund to decide if it wants to participate in specific properties; others do not solicit this involvement. Some of these vehicles have closely defined investment policies such as “Western Canada properties only” or “purchase under-utilized properties, upgrade, and resell.”

Where the open-ended pooled funds are offered by larger insurance and trust companies, the “specialist” funds are coming from property management firms, investment counseling firms, and smaller, more specialized financial institutions. With the overall trend towards investment management specialization, the “specialist” funds will continue to add significantly to the more than $1 billion already invested in this type of vehicle.

Buy real estate now?
The absence of any suitable real estate investment vehicle for pension funds in Canada is now a thing of the past. This doesn’t automatically make now the right time to move 25% of your pension fund into real estate. With both stocks and bonds pressed for some time now, many observers feel the prospects of a recovery for these two traditional investments make them attractive. At the same time, poor economic growth, high interest rates, and a rash of ambitious property development programs in the last few years have combined to slow and even halt the steady rise in real property values in many areas.

These factors provide pension plan sponsors (especially those portfolios which are under-exposed to real estate investments) with the best of all worlds: a wide choice of real estate vehicles and a “time window” in which to evaluate them. The careful, deliberate acquisition of real property assets over the next few years through one or more of the new real estate vehicles is likely to be one of the most important and productive strategic decisions that pension funds can make today.

In 1982, Keith Ambachtsheer was a principal in Pension Finance Associates, Toronto

From the May/June 1982 issue of Benefits Canada.