Pension funds are striving to hit their target allocation for commercial real estate, even as some move their bars higher than before.
“Since the global financial crisis, we have seen a very steady increase in real estate allocation. “Institutional allocation has increased by 20 percent to 30 percent, or 200 basis points of total asset exposure,” says Denise Martin, head of business development at PGIM Real Estate. However, while real estate target allocation is still growing in the space, the pace of those growths is now slowing slightly, he says.
The pandemic also created some demand to deploy capital which is fueling a spurt in investment activity. With many things closed and everyone retreating, 2020 was a tough year, followed by a significant amount of portfolio rebalancing. The stagnation in new investments led to a huge jump in 2021, with record amounts of capital raised.
“Hands down, I think you can attribute that increase (in allocation) to the challenging search for yield that we’ve seen over the last 10-plus years. As bond yields have come down, the appeal and appetite for higher-yield options, especially real estate, has further driven an increase in target allocation for real estate,” says Martin. Real estate also serves an important purpose within institutional portfolios as a diversification that protects against market volatility; A source of permanent income that helps pensioners to meet their financial obligations; And as an inflation hedge.
“Generally speaking, most funds are increasing their allocation to real estate, which includes real estate among other sectors,” agrees Eli Randall, chief strategy officer at CREXi, a commercial real estate market and technology platform. For example, CalPERS and CalSTRS recently increased their allocation for real assets from about 13 percent to 15 percent. “It may sound small, but in those dollar amounts it’s huge,” he says.
According to the Pension Real Estate Association (PREA) 2022 Investment Intention Survey, the average current allocation for real estate for institutional investors globally is 8.9 percent with an average target allocation of 10.1 percent. The targets are similar for North American-based investors, with an average current allocation of 8.9 percent and an average target of 10.3 percent. “Increased capital allocation on top of an under-met allocation is contributing to this general influx of capital while pursuing institutional-quality deals,” says Randall.
Pension is fast on total return
The NCREIF asset index generated some eye-popping total returns north of 20 percent in 2021. According to PREA Q1 2022 Consensus Forecast Survey In the US commercial real estate market, pension funds are fairly bullish on their outlook. The four main asset types—office, industrial, retail and apartment—are expected to reach 9.5 per cent in 2022, then 8.0 per cent in 2023 and 6.9 per cent in 2024. Survey respondents expect industrial performance to lead in 2022. An overall return of 14.8 percent, followed by apartments at 12.1 percent, retail at 5.4 percent and offices at 5.0.
Although pension funds tend to have very strong research teams, some of those return expectations feel a bit optimistic relative to recent history, notes Randall. “I’m inclined to listen to them for this, but what may be missing in some of those statistics is the actual inflation-adjusted returns. So, there might have been some pretty luscious returns, but how far would they outpace inflation? It is also important,” he added.
Above-average expectations for performance could be fueled by strong rental growth in sectors such as industrial and multifamily. However, investors across the board are paying attention to how competition is affecting cap rates and asset pricing, and pension funds are no exception. For example, the latest Green Street Commercial Property Price Index for March shows that the all-property index is up 22 percent year-on-year, despite some slowing in 2022. Ryan Swehla, Co-CEO of Gresda Partners, a commercial real estate investment firm based in Modesto, Calif.
Trends in Pension Capital Flows
While real estate allocation has increased, investor appetite for various strategies has waned and flowed between closed-end funds, which are more toward value-added and opportunistic, and open-end funds, which are core and core. -Plus target risk profiles, Martin says. By about 2016, both core and value-added strategies were benefiting from an increase in allocation. The announcement of Brexit in 2016 created some uncertainty and resulted in a slight drop in core fundraising and new core fund formation.
From 2016 to 2020, capital inflows into NCREIF ODCE Fund were hovering around net neutral or slightly positive. “Recently, inflows into ODCE funds have been decidedly positive and we are seeing a slight split of interest between higher yield strategies and more fundamental underlying strategies,” says Martin. He further added that the market has an ironclad effect with capital flows at both ends of the risk spectrum driven by appetite for both growth and earnings.
Another big change that’s important to note is the explosion in demand for real estate loan strategies, notes Martin. “Historically, there was an appetite for high-yield loans among real estate investors. Within their equity real estate portfolio, many institutional investors will look to high-yield debt as an alternative way to execute their real estate strategy, he says. In the last five years, there has been a high demand from customers for Core Debt and Core-Plus Debt. PGIM Real Estate has seen investors adding increasing amounts of low- and medium-yield real estate loans, either as a high-yield option within a fixed-income portfolio or as a diversified facility within a traditional real estate portfolio. In form of.
Industrial and multifamily are clearly the preferred property types of late. However, pension fund investment strategies continue to span the traditional four categories—office, industrial, retail, and multifamily. While pension funds are wary of specific sectors, there is more interest in non-traditional sectors such as self-storage, manufactured housing, senior housing and single-family rentals. “Five years ago, no institution was allocating meaningfully in the single family rental market. Today, it is a very strong and growing part of the institutional landscape,” says Swehla.
Pension funds are also willing to invest in secondary and tertiary markets, such as Boise, Fresno and Nashville, in search of yield. One of the challenges to investing in smaller markets has traditionally been the lack of large assets, as well as the risk of exiting from owning the largest assets in the market. Gresda Partners focuses on “institutionalising” the secondary and tertiary markets by aggregating smaller assets valued between $10 million and $50 million to offer the scale and diversity that appeals to institutions.
“The story over time is that pension capital and institutional capital are reaching more and more places that were previously non-institutional,” says Swehla. Part of what he says is driving pensions into new asset types and smaller markets. “There is so much capital allocated to real estate that they have to be more and more creative about where they are allocating it,” he says.