CalSTRS Real Estate Portfolio Still Feeling Effects of Global Financial Crisis
The $26.6 billion real estate portfolio of the California State Teachers Retirement System (CalSTRS) saw just a 1% average annualized return over the last decade, despite improved performance over the last five years, because the effects of the global finance crisis depressed the long-term results.
The data is contained in a new report by RCLCO Real Estate Advisors, CalSTRS’s real estate consultant. The report also looks at future real estate trends that will affect CalSTRS and other institutional investors, and expresses concern that a real estate downturn may occur in the near future.
CalSTRS’s 1% return for the 10-year-period is below its own custom benchmark of 5% for the decade-long time span ending September 30, 2017, shows the RCLCO report, which contains the latest long-term date available.
But the report notes that CalSTRS, the second-largest retirement fund in the US with more than $225 billion in assets under management, has achieved better results since 2012. The pension plan achieved a 10.8% return for its real estate portfolio for the five-year period ending on September 30, 2017, and 9.9% for the three-year period.
However, despite the improving performance, the investment results were 50 basis points below the fund’s custom real estate benchmark.
The RCLCO report said CalSTRS performed better in the last five years because it ended “an over-reliance on underperforming, closed-end, opportunistic, commingled funds,” following the financial crisis and “placed greater emphasis on retaining discretion within its portfolio by investing primarily through separate accounts and joint ventures, resulting in significantly better performance.”
CalSTRS’s real estate portfolio lost almost 40% of its value in the 12-month fiscal year ending June 30, 2009. After the decline, the retirement portfolio shifted away from speculative deals, such as buying undeveloped land, and put more emphasis on income-producing properties such as office buildings and multi-family housing.
Despite the improved performance, RCLCO officials cautioned that while the economy and real estate markets have been in recovery at least since 2011, real estate fundamentals are beginning to flatten.
The RCLCO report said that the consulting firm projects a 25% probability of a modest real estate downturn in 2018, even odds of a downturn in 2019, and increasing likelihood thereafter.
RCLCO CEO Gadi Kaufmann was even more blunt in a discussion before the CalSTRS Investment Committee on May 9, stating that CalSTRS should prepare for a downturn after a long real estate upcycle. He said CalSTRS should consider selling properties “that you don’t think you are going to love,” during a downturn, while valuations are still high.
“We don’t have the crystal ball, we don’t know when the downturn will hit,” he said. “We do believe cycles have not been eradicated from our economy, and that the US economy, the global economy, and real estate markets…. will suffer a downturn.”
Rising interest rates could accelerate the downward real estate cycle, RCLCO noted.
“The Federal Reserve has indicated that it will be raising interest rates several times this year, leading to a likely rising rate environment and putting additional downward pressure on real estate values,” it said in the report.
A key focus of the RCLCO report is what is known as CalSTRS’s $20.9 billion control real estate portfolio. This consists of pension plan separate accounts or partnerships with real estate external managers. CalSTRS is the only investor in those separate accounts with external managers or in partnerships with them and retains some control of what investments are made. This contrasts with CalSTRS’s investments in co-mingled investment funds with other institutional investors. In those funds, the external general partner of the fund retains investment control.
RCLCO officials detailed at the CalSTRS May 9 meeting that one of the challenges the pension system faces is the lessening of demand for office building space, which makes up 37% of the $20.9 billion control portfolio, the largest real estate asset in that group.
Greater acceptance of telecommunicating, an increase in co-working spaces, and more contract labor were all cited as reasons for a lower demand for office space.
RCLCO says in its report that CalSTRS might consider reducing its allocation to the office sector.
Another area of concern cited by RCLCO is obsolescence of suburban malls and power centers (outdoor shopping centers with at least three big box stores and other assorted retail and restaurants) due to ecommerce.
Retail makes up 19% of the controlled portfolio. The largest group in the controlled portfolio is housing with 26%. Other parts are industrial properties (12%), land (5%), and real estate receivables (1%). RCLCO suggests increasing the housing allocation, noting, as an example, a pent-up demand for rental housing in key markets.
It’s unclear how CalSTRS investment staff is dealing with the advice from its real estate consultant.
CalSTRS spokesman Michael Sicilia said in an email that pension officials would be unavailable for comment. The tape of the meeting shows that the CalSTRS Investment Committee met in closed session on May 9 to discuss its overall future real estate strategy.
The RCLCO report also showed that the $26.6 billion real estate portfolio makes up 11.7% of the overall CalSTRS portfolio below the 13% real estate target set by the pension plan’s investment staff.
CalSTRS Chief Investment Officer Christopher Ailman said at the meeting, the videotape shows, that the pension system is below its target allocation because it hasn’t always found the right pricing for real estate assets.
“The age-old problem is that we don’t want to chase targets, so the target for real estate is 13%,” he said. At the same time, Ailman noted, “I don’t want my team investing without regards to price—price matters.”
CalSTRS’s real estate portfolio’s largest concentration is core properties, which make up 63.5%, shows the RCLCO data. Value-add properties make up 15% of the asset class and opportunistic properties make up the remaining 21.5%.
CalSTRS also has a large unfunded commitment for its control portfolio. A total of $12.1 billion is committed but has yet to be invested because the right opportunities haven’t been found, noted the RCLCO report.
RCLCO said that the unfunded commitments, known in industry parlance as “dry powder,” should be used for acquisitions during the “bottom of the real estate cycle.”
The real estate consulting firm also noted that CalSTRS has a staff of just 12 real estate personnel, not enough to handle all opportunities. “In addition, due to its reputation and size, CalSTRS has the opportunity to participate in complex, attractive, and fast-moving transactions, but its human capacity does not always allow it to do so,” the report said.
RCLCO suggested CalSTRS should consider reducing its number of external real estate managers. The consulting firm notes that currently 80% of the real estate portfolio is allocated to the top 15 managers, while 20% is invested by another 50 managers. RCLCO notes: “Continuing to refine the list should have minimal impact on the total returns but significant impacts on staff capacity.”
The report said the top two CalSTRS real estate managers are Principal Real Estate Investors with $4.5 billion in assets invested for CalSTRS and CB Richard Ellis with $3.037 billion in assets invested. Combined, the two firms manage 30% of the CalSTRS real estate portfolio.
Examining the geography of CalSTRS $20.9 billion control real estate portfolio, RCLCO noted the largest concentrations were in Los Angeles (9%), Austin, Texas (7%), and Seattle, New York City, and Oakland, California, each with 6% allocations. More than 50% of the portfolio was in the western part of the US, RCLCO said. The firm said it was not concerned about over-concentration in that region.