Jon Peterson is a contributor to Real Estate Southern California, from which this article was excerpted.

Many of the major pension funds around the country are not investing in real estate the same way they did several years ago.

“You would never see a pension fund in the old days of the late 1980s and early 1990s invest directly with a real estate developer. This is something that is clearly happening today and will continue to occur in the future,” says Robert Brunswick, president and CEO of Newport Beach-based Buchanan Street Partners, a real estate investment firm.

Buchanan Street Partners is part of this strategy. It will invest in $1.5 billion worth of real estate in 2007. It has a value-added investment strategy teaming up with developers like Houston-based Hines and Orange County-based Birtcher Development.

Firms like Buchanan have helped form a bridge to direct the flood of capital that pension funds have spilled into the market. In fact, pension funds have allocated so much capital into real estate that the old investment strategy would never have allowed them to reach their targeted real estate allocation. Returns have also forced pension funds to look at different ways to invest in real estate. The yields on core assets are now at historical low levels. Some apartment and industrial properties are being purchased at cap rates in the 5% or lower range. The talk is that they won’t be moving up anytime in the near future.

The old way of thinking for pension funds investing in real estate was to first set up a core portfolio. This would be achieved by investing in some of the top performing open-ended commingled funds that have a core strategy. The next plan would be to invest in either value-added commingled funds or, if the pension fund is large enough, to create a separate account strategy with a single real estate manager. However, many pension funds are no longer doing this.

The Townsend Group is a leading pension fund consultant around the country, representing some of the major pension funds that are investing in real estate. One of these is the Teacher Retirement System of Texas. Earlier this year, the pension fund had approved a new real estate allocation and moved its targeted allocation for the asset class from 3% to 10%. This will mean that the pension fund will have $11 billion worth of capital that could be invested in real estate over the next four to five years.

“The pension fund is going to have to look at some different kinds of real estate strategies to reach its allocation level,” says Rob Kochis, a principal with the Townsend Group who is working on the Teachers account. “Some of this has already happened and newer strategies will be considered in the future. One of the strategies being considered for the future is a public REIT investment program.”

At its late July board meeting, Texas Teachers looked at various strategies that went way beyond the norm. One of these was to invest in a co-investment fund that will participate in the acquisition of Las Vegas-based Station Casinos. “This is something that would most definitely be considered outside the box,” Kochis notes. “We think that it is a good investment opportunity. Station Casinos has a solid position in Las Vegas. It has three or four new developments under way. It also owns 400 acres, some of which could be used to expand into California.”

There are many avenues that pension funds can look into when investing in real estate. “In our database there are 483 commingled funds that we are tracking for a possible investment for our pension fund clients,” Kochis notes. “They are mostly non-core funds. This is the way of the future. There is now very little interest in separate accounts and many managers are having a hard time buying properties in this format at acceptable returns.”

The decision earlier this year by Employees Retirement System of Texas to invest all of its real estate capital in global REITs is reflective of what is going on in the industry. At the end of 2006, the $24.6-billion pension fund made the decision to create a new asset class for real estate and private equity investments. They would split a 15% allocation.

In May, the pension fund chose to distribute all of its real estate allocations into a global REIT strategy. This means that there will be around $1.8 billion of capital that will be invested over a five-year period.

This situation is very unique for the pension fund industry. It hasn’t happened very often that a new real estate investor has decided to put all of its capital into a single strategy. There are several reasons why the pension fund decided to do this. This strategy will give them instant access to real estate investing. It would take a much longer time to invest $300 million on an annual basis for direct acquisitions, and the pension fund will know the value of its portfolio on a daily basis. This isn’t the case when investing in privately held real estate, as stocks can be traded quickly, while direct property is held for many years.

Mercer Investment Consulting is an active player in consulting pension fund clients with their real estate investments because the company sees how difficult it is to be a player in core assets today. “It’s really hard to be placing capital in core on direct equity real estate,” says Allison Yager, a Mercer principal. “Those assets are fully price and the yields are at a very low level.”

Yager doesn’t think that it’s correct to totally eliminate core from the equation. “There is still a place for some core assets to be part of a portfolio,” she notes. “It just shouldn’t be the total focus early on.”

The New Jersey Division of Investment has invested in lower amounts of core in its first two years of its real estate investment program. It has proven to be a positive impact on its IRR returns. The pension fund created its real estate program in fall 2005 with a targeted allocation of 4%. The pension fund is led in its real estate investments by director Bill Clark.

The original plan was to have it split up with 60% core and 40% tactical, or non-core, investments. The pension fund changed this to become over allocated in none-core for at least the first couple of years. It would then be changed back to the 60-40 split when the returns for core investments become more attractive. This has proven to be a wise decision. New Jersey has a real estate portfolio valued at $2.2 billion that has produced a 45.7% gross IRR and a net IRR of 36.7%. The breakdown of the portfolio is 62% tactical and 38% core.

The pension fund recently made even more commitments to non-core strategies. At its July board meeting, the pension fund looked at making commitments to five new commingled funds, with total investments of $400 million. Not one of them was considered a core fund. There were two international funds, a hotel investment fund, a value-added fund and two opportunity funds.

One of the commingled funds is the RLJ Real Estate Fund III. This is a $1-billion commingled fund being managed by Bethesda, MD-based RLJ Development. The amount of potential commitment from New Jersey is $75 million. The investment strategy is to buy Marriott- and Hilton-branded hotels in urban and dense suburban markets around the country, with gross IRR returns on the fund projected to be 19%.

Long-time investors like California State Teachers Retirement System are also changing the way they invest in real estate. The pension fund, at its own July board meeting, added public real estate to its real estate investment strategy. Public real estate has the opportunity in the future to make up 0% to 30% of its real estate portfolio.

The public real estate strategy for CalSTRS will be to invest in public real estate in the US and internationally. This figures to be a part of the pension fund’s growth in its real estate portfolio. Its real estate assets are now at $15.8 billion, and by the end of 2012 it’s projected to be at $28 billion.

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