Exclusive: Global Real Estate Returns to Decline, Consultant Warns

A real estate consultant to the largest US pension system has sobering news about the global real estate market over the next 10 years, predicting average annualized returns for investors worldwide will decline by more than half of what many investors saw during the 2011 to 2017 period

The returns over the next decade will fall to an average 4.8% annualized, down from the 10.2% average annualized return in 2011-2017, shows a consultant’s report prepared for the California Public Employees’ Retirement System (CalPERS).

The August 13 Pension Consulting Alliance report says despite the declining return expectations, capital continues to flow to the real estate asset class from institutional investors.

“Other long-term institutional investors, like CalPERS, who are primarily interested in the long-duration income streams, worry less about near-term slowing appreciation,” the report said. “Indeed, Chinese investors continue to buy up Hong Kong office towers despite current rental yields below the 10-year US Treasury bond as a means of sheltering capital, an investment objective completely divergent from that of CalPERS.”

PCA, which consults with the pension system on its $31.8 billion real estate portfolio, attributes the lower returns for investors to a reversal of the decade-long lowering of interest rates. “Monetary tightening is unlikely to have a major short-term impact on commercial real estate pricing, but it does likely mark the end of the era of very strong returns for the real estate asset class,” its report says.

The consultant is not the first firm to warn institutional inventors that the party is over for strong real estate returns.

Just last month, another consultant, RCLCO, told the California State Teacher’s Retirement System (CalSTRS) that real estate fundamentals could flatten.

The RCLCO report projects a 25% probability of a modest real estate downturn in 2018, even odds of a downturn in 2019, and increasing likelihood thereafter.

CalPERS and CalSTRS are the first- and second-largest pension plans in the US, respectively, with a combined assets under management close to $600 billion, which they invest across a spectrum of asset classes.

Looking specifically at the CalPERS real estate portfolio, PCA says CalPERS continues a “positive transformation” towards core income-producing real estate assets, which made up 77.5% of the system’s real estate portfolio as of June 30, up from 48% just three years earlier.

The report said efforts continue to transition the portfolio away from “legacy, non-strategic risks” towards “higher-quality, stabilized assets.”

Finding more of those core income-producing assets may not be easy for CalPERS. David Glickman, a PCA real estate consultant, told the CalPERS Investment Committee on August 13 that the competition will be keen.

“Unfortunately, for the kind of real estate you seek to acquire and increase your position, that’s the real estate that’s in the highest demand,” Glickman said. “There’s lots of different buyers, including retirement systems, sovereign wealth funds, and high-net-worth individuals and partnerships, who can buy those assets on different terms than you can afford to buy those assets. It makes prospecting difficult.”

The CalPERS real estate portfolio had lost more than 40% of its value during the financial crisis in the 12-month period ending June 30, 2009, losing money on speculative deals like undeveloped land in Southern California, among other investments.

Failed large real estate deals occurred even before then, such as plans to build twin 53-story buildings in downtown Sacramento that would have housed condos and a hotel. CalPERS abandoned the project in 2007, losing an estimated $60 million.

Following the end of the financial crisis, the system started the move away from legacy real estate assets.

While investment results have improved since the financial crisis, CalPERS has not been fully able to take advantage of the real estate boom over the last few years. It has put emphasis on finding core real estate assets in booming markets like New York City and San Francisco.

Still, PCA found that the CalPERS real estate portfolio underperformed its real estate benchmark over the one-, three-, five- and 10-year periods.

CalPERS real estate portfolio produced a return of 6.8% for the one-year period ending June 30, compared to the benchmark’s 7.1%; 7.2% for the three-year period compared to the benchmark’s 9%; 9.8% for the five-year period compared to the benchmark’s 10.4%; and a loss of 1% for the 10-year period compared to the benchmark’s 7.1 %

PCA attributes CalPERS underperformance to higher leverage levels for its real estate portfolio than its benchmark, higher levels of non-stabilized assets (CalPERS’s more speculative legacy portfolio) than the benchmark, and the location of some of CalPERS real estate assets (e.g., Brazil, Russia, and China). The benchmark does not track properties in those countries.

It also said CalPERS is seeing declining results more recently as part of the broader market moderation of real estate investment results. “Among core holdings, retail investments (regional malls and grocery anchored centers) to which CalPERS has a material overweight, showed a marked slowdown,” the report stated. “Returns from office and multifamily properties also softened.”

The report said that returns from industrial and data center investments as well as from the system’s emerging manager program, “offset the weaker-performing sectors to some degree.”

It also said the system’s legacy real estate investments, including international assets, continued to be “a drag” on performance.

Around 12% of CalPERS’s real estate portfolio is invested in international markets.

CalPERS total assets are more than $350 million. It has a funding ratio of 71%.