Some of the nation’s largest pension funds are starting to back away from trophy properties in the most expensive real-estate markets over concerns a new bubble is inflating.
After property prices crashed during the financial crisis, pension funds—among the biggest investors in commercial real estate—turned their investment strategies away from risky speculative projects and toward properties considered “core,” well-leased buildings that are seen as low risk due to their stable income, in cities such as New York, Washington and San Francisco.
But strong demand for a limited number of buildings has boosted prices of big-city skyscrapers so high they are approaching record levels. That has prompted pension funds such as the giant California State Teachers’ Retirement System and the Texas Municipal Retirement System to look elsewhere. To make matters worse, income produced from the buildings hasn’t risen as quickly as valuations have, compressing capitalization rates, a measure used by real-estate investors to estimate the annual return of income-producing properties.
“Major coastal markets have seen significant price appreciation that has not coincided” with increases in either occupancy or rental rates, says Mike DiRe, director of real-estate investments for the California teachers’ fund, known as Calstrs. “We believe the reason for this pricing increase” for the buildings in these markets “is a significant demand for core assets from private and public buyers along with overseas investors.”
In May, a 36-story Manhattan tower at 750 Seventh Ave. sold for $485 million with a capitalization rate of 4%, according to Real Capital Analytics. A similar 44-floor building nearby, at 1540 Broadway, sold for $355 million with a 6% capitalization rate in 2009. Meanwhile, a J.P. Morgan real-estate fund last week bought a pair of downtown Seattle office buildings at what brokers say are among the highest prices on a per-square-foot basis ever paid for the downtown area. Both of the buildings have an occupancy rate of more than 90%. “We have found that the highest-quality assets tend to stay leased when times are tough and command the strongest rents in times of recovery,” said Douglas A. Schwartz, a managing director with J.P. Morgan Asset Management.
An index of commercial-property values by Green Street Advisors, which is tilted toward high-end and trophy buildings, has risen more than 45% from its 2009 lows and is only 10% below its all-time highs. Although the index has been flat for the past two months, the run-up nevertheless raises questions about whether the surge in prices is getting ahead of sluggish economic fundamentals.
In a business plan posted last month on its website, Calstrs said its real-estate fund is “concerned some markets have a mini bubble in pricing.” In the future, the fund will target real-estate assets that “are in need of capital infusions to cure short-term leasing challenges” because they are selling at relatively low prices, the business plan says.
Others are cutting back or slowing down on commercial real estate, including the California Public Employees’ Retirement System, the nation’s largest public pension fund. Acknowledging that safer commercial-real-estate opportunities are getting scarce, Calpers’s investment committee this week voted to reduce its real-estate allocation target to 8% from 10% until the end of the year.
In March, the Texas Municipal Retirement System announced its first real-estate investments wouldn’t include traditional core investments in top cities. The $18 billion fund is splitting $200 million between two funds: one that invests in senior and student housing and medical offices, the other in office buildings in secondary cities such as Minneapolis and Portland, Ore.
Not all funds are worried about a bubble. Townsend Group, a pension consultant, says pensions and other large investors have committed $9 billion to funds that invest in core assets, but the fund managers have yet to invest that money. Townsend said the cash sitting on the sidelines for lack of an attractive opportunity is the most in many years. In some cases, pension funds are sticking with trophy assets in part because the recent upheaval in capital markets has scared them off from anything but the most stable assets.
Pension funds’ rush into core properties picked up after many were badly burned by investing in more-speculative developments. Calpers, for instance, wrote off nearly $1 billion for a 2007 investment in a busted land project. The retirement fund, along with Calstrs and a Florida public fund, together wrote off about $850 million in equity invested in a sprawling Manhattan apartment complex.
During the previous boom, many pension funds preferred buildings that had short-term leases because there was more profit potential. While that was a riskier bet, “they viewed partially occupied buildings as having more upside because a strong economy would allow them to raise rents,” said Chris Macke, a strategist with CoStar. Today, however, “there is a large premium paid for stability,” Mr. Macke says.
Hermes Real Estate Investment Managers Ltd., a British pension fund with £5.8 billion ($9.5 billion) in assets, is making its first U.S. real-estate investment with a $150 million allocation to a fund run by Hampshire Real Estate Co. That fund is avoiding Manhattan, Washington and other major cities. In those areas, said Chris Taylor, chief executive at Hermes, “pricing is looking quite stretched.” Instead, it is focusing on retail-oriented properties in North and South Carolina, Georgia and Florida. (credit, c. karmin, wsj)