After a long period in which they were hardly touching real estate investments, pension funds have emerged as a dominant player in the sector.

With their pockets full of stock market winnings, many funds are taking a fresh look at real estate as an alternative to diversify their investment portfolios.

"Our board just decided to raise our allocation target for real estate investments from 6 percent to 8 percent," said Brad Pacheco, a spokesman for the California Public Employees' Retirement System (CalPERS), the nation's largest pension fund. "We were involved in a large number of major transactions last year and, in order to pursue further opportunities we're working on, we needed to raise our allocation."

CalPERS, which is seen as a weathervane for other public pension funds, purchased $2.3 billion in core real estate in 1999, raising its total real estate assets to $8.6 billion, up from $6.1 billion in June 1996. According to Pacheco, the fund benefited last year from the depressed values of REIT shares, which allowed it to acquire real estate assets at relatively low prices.

Needing liquidity and being effectively shut off from Wall Street, cash-strapped REITs resorted to selling off portions of their portfolio. And CalPERS was there to buy. In fact, roughly half of the property purchases that CalPERS made during 1999 were sold by publicly traded REITs.

Getting out of stocks

As the stock market has become increasingly fickle over the last six months, pension funds have been particularly attracted to real estate investments because they often offer better returns than bonds and are now less volatile than stocks.

"Until a year ago, the stock market offered better returns and there was not much interest in real estate," said Christopher Casey, principal and head of the Southern California region for Lend Lease Real Estate Investments, a subsidiary of Sidney, Australia-based Lend Lease Corp. that manages $38 billion in U.S. real estate assets. "Now there is an extremely high level of interest in real estate, because with steady low-double-digit returns, it is seen as a less risky alternative to the stock market."

Los Angeles has become a particularly interesting market for pension funds, according to Casey. Some of the best values are to be found here because the region is still behind in the cycle compared to other parts of the country.

"Los Angeles is at the top of the list, property-wise," Casey said. "There are a lot of opportunities here that you can't find anywhere else anymore. In Atlanta, Denver, or Phoenix, for example, there is starting to be some concern about overbuilding. In L.A., we're still in the first round of building and there is a good equilibrium between supply and demand."

Among the products that pension funds are looking for as core investments in Los Angeles are multifamily housing complexes and industrial properties. Both are in short supply, and are expected to stay in high demand as the local economy continues to perform strongly.

Pension funds are also looking to put money into new office or retail projects at infill locations. Such undertakings are called "enhanced return" investments because they're riskier than the typical pension fund deal, but they also offer higher potential returns.

According to Institutional Real Estate Inc., pension funds accounted for 53.8 percent of all commercial real estate acquisitions in the L.A. area last year, compared to just 36.6 percent in 1998. The most active fund advisors for these transactions included Lend Lease, RREEF Funds, J.P. Morgan Investment Management, and Douglas Emmett Realty Advisors.

Creating a balance

One factor driving pension funds into real estate is the need to keep their portfolios balanced. Most funds have a great deal of their money in the stock market, and because of the enormous run-up in stock values until recently, their allocation levels had gotten out of whack.

Because real estate didn't rise in value as fast as the stock market last year, pension funds' portfolio allocation to real estate became too low, relative to their stock market allocation. To rectify that imbalance, and restore the real estate allocation to its typical level of around 5 percent of the total portfolio, pension funds have been forced to pump much more capital into real estate investments than they have in the past.

"In many cases, the real estate portion of the portfolio fell as low as 1 to 2 percent," said Garrett Walls, vice president and regional head for the West Coast with J.P. Morgan Investment Management. "Because of the collapse of the real estate markets in the late '80s, most funds have been very reluctant to get back into it. Right now, we're just getting back to the level of real estate investment that we saw before the market fell apart."

As a result of the perceived risks of real estate investments, pension funds still have a much stronger preference for stocks, according to Walls. They prefer U.S. equities, which typically account for 60 percent of most funds' portfolios.

Real estate is usually part of the so-called "alternative investments" segment of a pension fund riskier assets that only make up a small piece of the total pie.

"It's the exotic stuff," said Walls. "It also includes venture capital investments, which have been a great place to be over the last three to five years, bringing in 20 to 30 percent in (annual) returns."

With both real estate and venture deals lumped together in the "alternative investments" category, these two asset classes compete to comprise the high-risk portion of a pension fund's portfolio. But as the market for initial public offerings has lost much of its luster this year, some of the enthusiasm for venture deals has waned. Consequently, real estate may prove again to be a more solid bet than the dot-coms. And that will be especially true if pension funds continue shifting more capital into real estate.

For reprint and licensing requests for this article, CLICK HERE.