Pension Fund Increases CMBS Allocation

SAN FRANCISCO-San Francisco City and County Employees’ Retirement System this month increased its investment in CMBS through a new Fidelity fund. The pension fund also took steps to balance its portfolio, which has become overweight in core and industrial assets.

With regard to the CMBS market, the fund has committed $25 million to the Fidelity Real Estate Opportunistic Income Fund L.P. The fund will invest primarily in high yield real estate debt securities and instruments backed (directly and indirectly) by commercial property. Some of the capital will be invested in residential mortgage-backed securities and subordinated securities of real estate CDOs, according to staff and advisor memos.

The $25-million commitment will be allocated to the 5% “opportunity” segment of the SFERS Fixed Income Portfolio. Fidelity is currently one of SFERS’ two managers for high yield CMBS, managing $220 million as of the end of December for the Retirement System. A staff report says the primary difference from its existing CMBS investments is that the Fidelity Real Estate Opportunistic Income Fund provides more investment flexibility in terms of allowing investments in real estate whole loans and corporate real estate bonds as well a modest use of leverage.

In recommending the investment to staff, Angeles Investment Advisors states in a memo that Fidelity’s real estate debt team has successfully navigated the recent environment for fixed income debt, which has seen spreads widen dramatically as general credit conditions deteriorated and demand for structured fixed income instruments has declined. “Fidelity’s credit analysis led the team to avoid most new issuance in the CMBS market since 2005, focusing more on seasoned issues,” the memo states. “These seasoned issues have not experienced the dramatic spread widening observed for new issues since 2005.”

Also in March, SFERS made initial moves to balance its real estate portfolio, which has become overweight in Core and Industrial holdings. The portfolio became overweight in Core in July when its 80% interest in AMB Partners II was transferred from the Value sector to the Core sector last fall after that fund’s development piece had matured and the other fund assets had stabilized to the point where their returns would be lower.

The reclassification increased the percentage of its portfolio devoted to core assets to 62% when it should be closer to 20%, according to memos from staff and advisors. To shift some of the funds back to the Value sector, SFERS has decided to transfer its interest in AMB Partners II to AMB Institutional Alliance Fund III. The move also will give it more flexibility to liquidate its interest and shift some of its interest away from Industrial, giving the portfolio more balance in that respect as well.

SFERS originally invested $50 million with AMB Partners II in February 2001 to invest in the repositioning and development of logistics industrial properties. The initial investment required a 50% co-investment by AMB to achieve alignment of interests. In late 2002, SFERS invested approximately $38.2 million to increase its position to 80%. With the transfer, SFER’s 80% stake in Fund II will become an approximate 27% stake in Fund III. SFERS investment policy has a 20% guideline limit when investing in any one vehicle.

As of the end of 2007, Partners II held an interest in 32 properties with 9.9 million sf of net rental area and a 95.7% occupancy rate. SFERS position is valued at $433 million. The since-inception return as reported by AMB is 20.9% before promote fee, development and priority distribution. This return is comprised of a 9.4% income return and a 10.8% appreciation return. The internal rate of return on an annualized basis based on cash contributions and distributions for Partners II since inception is 18.4%.

The net total return of Fund III since its inception is 14.4%. The 12-month gross return ending Dec. 31 was 11%. These returns reflect that nearly two thirds of the properties have been acquired in the last two years and that the investments are in value-add properties that require repositioning and leasing to reach stabilization.

Staff and advisors recommend contributing Fund II to AMB Institutional Alliance Fund III because they believe the US industrial market will continue to outperform the other types of institutional real estate product, and because they believe the assets in AMB Partner II still have long term upside given the lease rollovers between 2008 and 2011. “Given the turbulence in the capital markets, slowing of the economy and housing declines, industrial properties are…a favorable property type to continue to own for the foreseeable future,” states a staff report on the issue,” states its report to the board.

Moreover, they say the “proposal offers SFERS flexibility, market pricing, and substantial sale cost savings uniquely available because the transaction would be structured as a contribution rather than a third-party sale. These savings come from not incurring prepayment penalties, sale brokerage fees, transfer taxes and the like in amounts that may approximate $12 million.”