A US Pension Fund
Assesses the Real Estate Markets
Mary Beth Shanahan, Public Employees
Retirement System of Ohio
Mary Beth Shanahan recently talked to
AFIRE members about real estate investment from the perspective
of a US Pension Fund. Shanahan is assistant investment officer
for real estate with the Public Employees Retirement System
of Ohio (OPERS).
OPERS
The Public Employees Retirement System of Ohio has around
$55 billion in assets, about ten percent of which are currently
in real estate. The real estate portfolio is comprised of
about 60 percent directly-owned properties, 20 percent REITs,
which Shanahan described as common stocks bought on the
open market, and 20 percent various other types of debt,
including single family mortgages, commercial mortgages
and entity-level debt owed by public and private operating
companies. The 60-20-20 mix, she said, matches her benchmark,
so she described the portfolio as neutrally weighted at
the moment.
As far as technique, Shanahan said the fund invests only
through separate accounts. "We lever off of our managers'
experience," she said, noting that her own staff is
only ten people. But the fund does retain discretion she
said, "We make the buy decision, we make the sell decision,
and any major property decision involving capital or litigation.
We generally don't get that involved in leasing decisions,
but we keep a fairly close eye on our portfolio."
The significant players to whom the fund's investment managers
respond include "first and foremost" the members
of the retirement system, she said, who number half a million
and include current employees, retirees and inactive employees
of the state and local government employers. Shanahan described
a mindfulness of the fact that she and her staff work for
"the widows and orphans of the state of Ohio,"
something about which she said she is very serious. They
try to remember, she said, that it takes 37 typical OPERS
members, working their entire lifetimes, to earn $1 million.
Although $1 million is less than a rounding error in the
context of the $55 billion fund, she said, the thought of
those 37 people is something they try to keep in mind when
they're negotiating a purchase price, a sales price, or
fees, for instance.
Many pension systems are facing the prospect of aging membership.
The inevitable result for these funds will be the need for
increased liquidity as more dollars are needed to pay benefits
than are taken in from member and employer contributions.
Shanahan predicts this will make real estate more visible
and more important to the funds because of its natural liquidity.
For instance, REITs currently yield around 7.25 percent,
she said, a level pension funds can't get from other, lower
yielding asset classes.
Six members of the fund's board of trustees are elected
by the fund's members, and the three remaining board members
are the State Auditor, the Attorney General, and the State
Director of Administrative Services, which means the board
is comprised of "lay" members, Shanahan said.
In recognition of this composition, the members have engaged
consultants through the years to help them assess strategies
and come up with asset allocations. OPERS is thus now an
asset allocator, like most public funds, Shanahan said.
The current allocation target for real estate is nine percent,
with a range of five to 13. Still, she said, both the board
and the consultant realize that real estate is an illiquid
market and that it's sometimes difficult to keep up with
other more liquid markets.
The explicit allocation approach, however, has led to what
Shanahan said another speaker had called a "denominator
effect." To explain, she described a period a couple
of years ago when, for about two years running, she had
awakened every morning needing to put a billion dollars
into real estate investments "just to keep up with
the equity market. I didn't know how I was going to do it.
We accomplished a good deal of that but every other pension
fund in the country was doing the same thing, and so the
market became very overheated."
She noted that investment managers had been concerned that
if the equity market turned they'd all be over-allocated
in real estate. "Well, guess what happened? Now, many
funds are over-allocated in real estate, and my understanding
is that several of the larger funds are totally out of the
market. So there is no capital. Just by standing still and
not losing any money, I went from having nine percent of
the fund in real estate to having 10.2 percent."
Opportunities
Because of the denominator effect, Shanahan said, there
are huge opportunities in US real estate in the next 12
to 18 months. A lot of pension funds are out of the market,
but Shanahan agreed with one of the day's earlier speakers
that the fundamentals will be strong - there are still very
good rental streams, very good tenancy, and prices will
be getting cheaper, she said.
She said that in her own portfolio she has tried to retain
enough flexibility within the allocation so that "if
we find a killer deal, I've got room."
Investment Style
Shanahan described OPERS' investment style as contrarian.
"We like to look for opportunities that other people
aren't interested in or aren't interested in yet."
The fund focuses on realized return, which means that the
investment horizon is generally three to seven years.
The fees are structured so that OPERS' advisers make money
when the fund makes money, generally after OPERS sells.
Shanahan noted that the fee arrangement reflects an unusual
philosophy, but that the arrangement provides a reality
check -- it has a dampening effect on appraisals yet motivates
people to sell.
Elaborating on OPERS' contrarian approach to investment,
Shanahan reported that the fund is moving away from some
of the typical cities - like Boston, Washington, New York.
"Those are great cities that have all had a great run,
but I think the opportunities over the next couple of years
are going to be elsewhere in cities that are not so near
the coast."
In response to a question about whether Columbus (Ohio)
was such a promising location, Shanahan said probably not.
"It's a great place to live and raise children, but
you can't make as much money there in real estate as you
can other places."
Shanahan advocated REITs long term, because for institutional
investors they're a preferred means of investing. She offered
the view that in general, institutional trustees who aren't
real estate experts are going to be more comfortable with
paper, which she said she believes will nudge along the
growth of securitization.
OPERS, she said, currently owns a billion dollars in common
stocks in REITs. She expects the return to be in the 12
to 14 percent range, a little bit better performing than
typical US real estate and much less labor intensive.
Calling for caution, however, she noted that "there
are management issues with a lot of the REITs, and I really
think we need to wait for the next generation of professional
managers to come along."
OPERS, she said, looks for investments where it is more
than a capital source, preferring arrangements in which
it can be a partner and in which it and the target have
what she called "goal congruence." In some cases,
the fund has made larger entity-level investments in public
and private operating companies. It may take a board seat.
The structure of these investments is debt, she said, but
it's callable if something happens to the company and it's
senior to the equity. She said the approach has worked well,
and it's a little bit different way to play the REIT game.
Property Types
Residential real estate has always been the core of OPERS'
portfolio, Shanahan said. Forty four percent currently is
apartments and industrial properties, up from recent years
"because we've been moving defensively." Explaining
that the stability has been the attraction, she noted that
apartments and industrial properties have traditionally
had stable returns, low volatility and relatively low capital
improvements.
She reported a greater willingness to venture into the industrial
market in recent years, mainly in port cities or cities
with barriers to entry. "I could not recommend industrial
somewhere like Columbus," she said, because of the
abundance of land and the lack of barriers to entry. She
described the dynamic in the Midwest and places like Phoenix
as one in which "as soon as occupancies hit equilibrium,
somebody builds again." Since it doesn't take any time
at all to build industrial, you effectively have no barriers
to entry.
Adding office and retail to OPERS' holdings of residential
real estate accounts for over two-thirds of its real estate
holdings, Shanahan said. On the topic of office space, Shanahan
said unequivocally that "right now I am not a fan of
office." Explaining a long-standing bias against it,
she said she views the event risk as "huge - office
is the one property type where you are truly at the mercy
of your tenants. [When] you lock in for fairly long lease
terms, if things go well, you can't move up. If things go
poorly, [tenants] walk out and you're left holding the bag."
The category, she summed up without enthusiasm, "scares
me more than any other property type."
In contrast, she said she sees great opportunities in retail,
but she pointed out the need to be "very, very, very
selective." OPERS, she said, has a fairly large retail
portfolio, "but it's a niche" - the fund owns
outlet malls in vacation destinations like Hilton Head,
Myrtle Beach and Park City, Utah. Shanahan said that while
it is true that retail requires periodic face lifts, in
such locations the customers change instead of the centers.
In these cases, they have fairly short lease terms and don't
necessarily need to reinvent the wheel every five years
because the patrons are new.
OPERS has been successful in the segment, but again she
stressed the need to be "super careful in retail."
Grocery-anchored retail is probably the safest, she observed,
"but everybody is buying it and so pricing is not quite
reasonable."
Shanahan described the remaining portion of OPERS' portfolio
(its "other" real estate investments) as a fairly
high proportion. A major component is hotels, where she
said timing and management are key. "You really need
to buy [hotels] at the right time and, as the saying goes,
the third owner of a hotel will make money." And with
hotels, maybe even more than with other real estate, she
said, the key is in the management. "You really need
to find the right management company to work with or else
your value will just disintegrate."
Addressing the contrarian approach, Shanahan said that just
a little bit of variation in an industry makes a big difference.
" If you can find an inefficiency, like hotels, a year
before anybody else does, and just start getting in there
and investing before other people, you have a huge advantage."
Q&A
Q. Why, in your recent allocation study,
did your consultants downsize the real estate portfolio
since you need cash to service the beneficiaries? Why didn't
they increase it? What were the internal discussions like?
The consultant
my board hired to do asset allocation looked at our programs,
recognized the successes, and got comfortable with our approach,
but, as with any fund, there's a debate about whether the
REITs are real estate or equity. Internally we had discussed
that and decided that we liked it in real estate because
we could use our expertise in managing it and that there
was a lot of transference of knowledge that would work both
ways on the real estate arena. The consultants took the
approach that we might be able to consider the REITs equity
somewhere else. So really nine percent makes sense because
you have assets that in other funds would be classified
elsewhere.
Q. What benchmark do you use to measure
yourself?
A. Unfortunately
we have had to develop a customized index. Even for the
properties we own directly, there is not a perfect benchmark
We use NCREIF because it is a standard in the States and
we contribute information to it and insist that all our
managers contribute to it. That's 60 percent of what we
do.
Twenty percent is a REIT index. We're currently examining
which REIT index is the most appropriate.
The last 20 percent of our benchmark is the Giliberto-Levy
index for mortgages, which again is not directly comparable
because its composition is different than what we own and
it doesn't encompass all the debt universe, but it's as
close as we've been able to get.
While there are those who don't think benchmarks are helpful
at all, it would be helpful to me to have a better one.
But a lot of what we do is private-market equity, and it's
illiquid. I don't know how we can ever come up with a benchmark
for that type of investment. I think we just have to come
up with something that people feel comfortable that has
credibility is reasonably accurate.
Q. Are you looking overseas at all for
real estate, and if not, why not?
A. I am looking
overseas, and I am starting to do it more seriously. It's
a question I have struggled with for years, though, because
of the risk-return relationship. By policy we don't use
leverage in our domestic portfolio. My sense is that with
core properties [overseas], at least in western Europe,
the only way to get competitive returns is through the use
of leverage. So I'm not sure that that's something that
would make sense for us.
Frankly, the idea of going in at a five or six cap rate
and adding on taxes, currency risks and political risks
is something I worry about.
I'm not sure it's justifiable. On the other hand, I don't
see how we could ignore 80 percent of the world market.
But if you move outside of western Europe, well I don't
know what cap rates to assign to buildings in Cambodia or
wherever. I just don't know how to price it yet.
Q. If you went outside the US, what kind
of returns would you require, because in conversations recently
I've noticed return expectations coming down slightly from
the 20 percent-plus level.
A. That's
a very good question. It depends on what our view is for
the US market, and then you'd have to add some. So probably
we would add at least a 200 to 300 basis point premium.
