Pent-up demand to deploy capital during the pandemic has driven a surge in new investment activity, with record amounts of capital raised in 2021. Now, pension funds are striving to hit their target allocations to commercial real estate, as real estate is considered a diversifier against market volatility within institutional portfolios, a source of durable income that helps pensions meet their financial liability to recipients, and a hedge against inflation.
“Pensions continue to increase exposure to debt and equity investments in the real estate sector, believing these investments are non-correlated to their more traditional investment allocations,” says Freedom Financial Funds CEO Michael Klein. “But will that prove to be the case?”
According to Dennis Martin, head of Americas business development at PGIM Real Estate, “Since the global financial crisis, we have seen very steady growth in allocations to real estate. Institutional allocations have increased by 20 percent to 30 percent or as much as 200 basis points of total asset exposure.” He adds that while real estate target allocations are still rising across the space, the pace of those increases is now slowing a bit.
Eli Randel, chief strategy officer at commercial real estate marketplace and technology platform CREXi, concurs. “Generally speaking, most funds are increasing their allocations towards real assets, which includes real estate, among other sectors.”
For example, both CalPERS and CalSTRS recently increased their allocations to real assets from roughly 13 percent to 15 percent, and while that percentage may seem small, Randel points out that in terms of dollar amounts, “it is very large.”
The Pension Real Estate Association (PREA) 2022 Investment Intentions Survey revealed that the average current allocation to real estate for institutional investors globally is 8.9 percent, with an average target allocation of 10.1 percent. Targets for North American-based investors are similar, with an average current allocation at 8.9 percent and average target of 10.3 percent.
“Increased capital allocations, on top of under-met allocations, is just contributing to this general glut of capital chasing institutional-quality deals,” adds Randel.
After the NCREIF Property Index conjured some total returns above 20 percent in 2021, the PREA Q1 2022 Consensus Forecast Survey of the U.S. commercial real estate market remained bullish on the outlook for pension funds. In summary, total returns across office, industrial, retail and apartments are expected to hit 9.5 percent in 2022, declining to 8.0 percent in 2023 and 6.9 percent in 2024. Survey respondents were particularly optimistic about the performance of the industrial sector in 2022, predicting total returns of 14.8 percent, followed by apartments at 12.1 percent, retail at 5.4 percent and office at 5.0.
Randel advises caution regarding such rosy expectations, pointing out that “what may be lost in some of those stats is real inflation-adjusted returns. So, perhaps there could be some very juicy returns, but how much they outpace inflation is also important.”
Strong rent growth in the industrial and multifamily sectors is likely fueling the industry’s optimism. Investors are observing, however, that competition is effecting cap rates and property pricing — and pension funds are no exception.
According to Ryan Swehla, co-CEO of commercial real estate investing firm Graceada Partners,
“Generally, return expectations have come down because people have seen how much interest there is, particularly in multifamily and industrial where so much capital has been allocated into those sectors that return expectations have stepped down a little bit.”
Martin opines that although real estate allocations have increased, investor appetites for different strategies have waffled between closed-end funds (focusing on value-add and opportunistic) and open-end funds (targeting core and core-plus risk profiles). From 2016 to 2020, capital flows to the NCREIF ODCE fund were hovering around net neutral or slightly positive. “More recently, inflows into ODCE funds have been decidedly positive, and we’re seeing a bit of a bifurcation of interest between higher yield strategies and more core baseline strategies,” he says.
Martin further observes that there is an uptick in demand for real estate debt strategies. “Historically, there was an appetite for high-yield debt across real estate investors. Within their equity real estate portfolios, many institutional investors would look toward high-yield debt as an alternative way to execute their real estate strategy.” But over the last five years, he says clients have demanded more core debt and core-plus debt. “PGIM Real Estate has seen investors adding lower- and medium-yielding real estate debt in increasing amounts, either as a higher-yielding alternative within fixed-income portfolios or as a diversifying feature within traditional real estate portfolios.”
Pension funds are also showing interest in non-traditional sectors such as self-storage, manufactured housing, seniors housing and single-family rentals. Swehla comments, “Five years ago, no institution was meaningfully allocating into the single-family rental market. Today, that is a very robust and growing part of the institutional landscape.”
Another trend among pension funds is investment in secondary and tertiary markets, like Boise, Fresno and Nashville. While a lack of large assets in these markets presents a challenge, as well as the exit risk that is created by owning the biggest asset in a market, Graceada Partners focuses on aggregating smaller properties valued between $10 million and $50 million to create funds that offer the scale and diversity that appeals to institutions.
Swehla concludes, “The story over time is that pension capital and institutional capital is getting more and more into spaces that were previously non-institutional. There is so much capital allocated to real estate that they have to get more and more creative about where they’re allocating.”
Freedom Financial Funds manages a private REIT and separate accounts through which it responds to the financing needs of real estate professionals seeking capital for construction, rehabilitation, repositioning, conversion or additions to commercial and residential properties in the Western United States. Freedom also offers build-to-suit financing nationally. In only five years, Freedom has executed more than $500 million in transactions and has remained steadfast throughout the CV-19 crisis. Freedom serves markets throughout the Western and Southwestern U.S. from its locations in California, Arizona, Oregon and Texas.