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RETAIL DEAR FOR PENSION FUNDS

Investment goals unmet due to sector’s high value

BY DONNA MITCHELL

Pension funds have always been an important part of retail real estate finance. They’ve helped fund such landmark projects as Mall of America and, more recently, the 1.3 million-square-foot Short Pump Town Center, Richmond, Va., for example. But lately, thanks to the sector’s towering value, they have had to accept a smaller role in the business of retail property investment.

For the year through October 2003, pension funds acquired an estimated $473 million in retail real estate assets, an amount dwarfed by the $19.3 billion that REITs and private investors plowed into the sector at about that same time. The sum was also down from the nearly $880 million that pension funds had invested for all of 2002, according to New York City-based research firm Real Capital Analytics.

“[The funds] are underinvested compared to what they could be,” said Steven Roulac, CEO of The Roulac Group, a San Francisco-based investment strategy advisory firm.

And there is the suggestion of a lower profile for pension funds in other areas too. The funds had planned to invest $14 billion in the commercial real estate property market during 2003, according to a 2002 survey by William Maher, director of North American investment strategy for LaSalle Investment Management, a Chicago-based pension fund advisory firm. But by late October, pension funds and their advisers had made just $6.5 billion in acquisitions, according to Real Capital Analytics.

Pension fund managers acknowledge not having met all their investment goals, but point out it’s not for lack of trying. ING Clarion Partners, for one, has fought aggressively to deploy its pension fund clients’ money into retail real estate but has often come in second or third in the bidding process, says Charles Grossman, a managing director at the New York City-based pension fund advisory firm. Even pension fund giant TIAA-CREF has been elbowed out of several major deals.

“We’ve been actively bidding on every major retail property, without much success,” said Kathleen M. Nelson, managing director of TIAA-CREF’s $40 billion mortgage and real estate portfolio, $6 billion of which is invested in retail real estate. TIAA-CREF, which has invested in shopping centers since 1948, was instrumental in financing a significant number of U.S. regional malls as they were being built, including the 1 million-square-foot Wolfchase Galleria, Memphis, Tenn., and the 1.5 million-square-foot Park Meadows, Littleton, Colo. It also helped fund a $12 million renovation of the 670,000-square-foot Scottsdale Mall, South Bend, Ind., in 1994.

As of early November TIAA-CREF had deployed $225 million in direct property ownership, less than half of the approximately $500 million it invested in 2002, says Ronald Bernhard, director of TIAA-CREF’s mortgage real estate division.

The main culprit is a more crowded field of competitors, say industry professionals. Private wealthy investors are getting paltry yields from stocks and bonds, so they are turning to retail real estate. REITs that are expanding aggressively have helped to further swell the ranks of capital providers looking to buy high-quality retail real estate assets. The private investors are a particular challenge, because they are willing to borrow much more heavily against the properties targeted for purchase, thereby gaining more bargaining power than pension funds.

“Our clients have not been prepared to leverage as high,” said Grossman, noting that pension funds are willing to borrow against a property up to 50 or 60 percent of its value, compared with the 70 to 90 percent leveraged by private investors.

Such an abundance of capital chasing shopping center properties contributed to another deterrent for pension funds: sliding cap rates. These dropped from nearly 10 percent to about 8.7 percent between the first quarter of 2002 and the third quarter of 2003, according to Real Capital Analytics.

“With cap rates where they are, we could not compete,” said Nelson.

However, some industry sources say pension funds might appear underinvested simply because they are less familiar with the types of properties that have been particularly hot for the past three years.

“In the mall sector they go way back,” said Terry Brown, president and CEO of retail real estate developer Edens & Avant, which specializes in grocery-anchored centers. “But in the grocery-anchored [shopping center] sector, almost all of these relationships were forged in the last five years or so.”

Since 1997 Edens & Avant has attracted investment from the New York State Teachers’ Retirement System, the State of Michigan Retirement System and the JPMorgan Fleming Strategic Property Fund, a pension trust fund.

Pension funds have had to make room for yield-hungry investors before. The funds helped fuel the rapid expansion of retail real estate in the 1970s when the Employee Retirement and Income Security Act (ERISA) mandated that they diversify their holdings beyond stocks and bonds.

Meanwhile, the Nixon administration allowed owners of real estate to depreciate their assets over a shorter time period than in the past. That practice, called accelerated depreciation, drew hordes of new investors (often non-real-estate professionals). They used the tool to report losses on real estate properties and ultimately offset taxable profits in their non-real-estate businesses, says W. Rob Hannah III, founder and CEO of Tax Strategies Group, a Chicago-based real estate investment firm.

“It was frenzied,” said Randy Pottle, a CalPERS investment officer who oversees the pension fund’s core retail real estate investment program. “The prospectuses that Wall Street issued showed that taxable investors were generating tax deductions in addition to receiving income and distribution.” CalPERS owns a $12.1 billion equity portfolio, of which $2.4 billion is in retail. The tax advantages attracted a lot of less-sophisticated investors to the public trusts, and such excess capital chasing after a limited supply of retail real estate drove up pricing, said Pottle.

Things are slightly different now. Sure, new investors are still chasing retail real estate investments, but they are doing so for more substantial reasons. The 1980s drew a lot of quick-profit-seeking investors to retail real estate, but these days just about all investors are looking to real estate as a means of securing their future. Pension funds need a stable source of income as their beneficiary group ages and begins to collect benefits, Grossman says. Likewise, aging Americans, especially high-net-worth individuals, are looking to preserve their nest eggs with investments that deliver long-term capital growth. That is why market players do not expect the demand for retail real estate to abate anytime soon.

Given these market conditions, pension fund investors are divided into two camps. There are those who believe that current market conditions will tarry awhile and are thus willing to pay more for shopping centers, and even to increase their debt commitments on the properties. Then there are the ones who believe that the markets are going through a cycle and who, therefore, remain selective about their real estate purchases and debt leveraging.

But pension funds have not been completely pushed to the sidelines. TIAA-CREF, for one, has been more successful with its lending programs, such as the TIAA-CREF REIT Fund mezzanine lending program. This has enabled it to invest in retail real estate by way of debt, says Nelson. In early November the pension fund estimated that it would lend $1.2 billion in retail mortgage debt by year-end 2003, up significantly from 2002’s lending total of $800 million, according to Bernhard.

And pension funds continue to form joint venture partnerships with REITs to own trophy regional malls. In December 2002 General Growth Properties finalized a spate of joint venture acquisitions with pension funds. It bought the 926,000-square-foot Florence (Ky.) Mall with the Teacher’s Retirement System of the State of Illinois; it also purchased the 919,000-square-foot First Colony Mall, Sugarland, Texas, and the 1.4 million-square-foot Glendale (Calif.) Galleria with the New York State Common Retirement Fund.

And despite being outbid by new investors in 2003, pension funds are raising their investment targets for retail real estate in 2004, observers say. Whereas pension funds on the whole invest about 15 percent of their funds in real estate, Roulac and others feel they should go much higher, to between 25 percent and 40 percent.

As such, the funds are a long way from giving up on acquiring more retail real estate.

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