Capital Keeps on Flowing

REAL ESTATE MARKETS IN THE U.S. have received major flows of equity capital from private and public pension funds in the past 12 months, and will probably receive even more over the next year. Those investments already have driven up many property prices and REIT share prices. I believe this trend will continue despite deteriorating conditions in space markets.

Why will capital keep on flowing into real estate just as market conditions are worsening? Because pension fund managers are desperate to find investments that will provide them solid yields, and real properties are their only candidates. Therefore, many pension funds are raising the percentages of total capital they intend to invest in real properties, either directly or through REITs.

As funds shift more capital into real estate, demand for quality properties will rise, driving prices of properties and REIT shares upward.

The Pressure to Earn

Pension funds set actuarial yield rates designed to help them fund their future payout liabilities. If the capital in any pension fund produces current yields exactly equal to its current actuarial rate, the pension fund does not have to add money to its capital base. If its investments produce yields higher than the fund's actuarial rate, the surplus yield can be added to the organization's net income, thereby expanding profits.

But if the pension fund's capital produces current yields lower than its actuarial rate, the deficit must be made up from other current earnings of the organization, reducing the firm's net income. That has been happening a lot in the past two years because funds set high actuarial yield rates in the stock boom of the 1990s. But capital losses in pension stock portfolios and low bond interest rates have depressed actual yields. Pension managers are being pressured by corporate executives to re-allocate their capital to higher-yielding assets to stop this drain on corporate earnings.

A Good Prospect

Most stocks are paying meager dividends and their appreciation prospects for the next two years, and perhaps longer, are dim. Bonds are even worse because their current interest rates are very low. If those rates rise, that will drive down the capital value of bonds, offsetting their higher interest payments. This leaves quality commercial real estate as the only major investment paying substantial current dividends and exhibiting significant appreciation in the past two years.

True, the balance of supply and demand in commercial space markets has deteriorated sharply in those same two years because of business contraction in the recent economic downturn. National vacancy rates are currently more than 15% for office space and 10% for industrial properties, and have risen notably for apartments. So rents are falling, and that already has begun to reduce yields.

Nevertheless, total yields on commercial real estate, both current and prospective, are much higher than those for stocks or bonds. The stock market continues to show considerable volatility since a modest recovery after Sept. 11. Stock experts are advising pension funds that total yields on stocks may not exceed 5% for two to five years. So real estate properties with reasonably strong occupancy rates, creditworthy tenants and modest rates of lease expiration in the near future offer much better near-future yield prospects than stocks or bonds.

Until now, pension funds have kept capital allocations to commercial real estate around 4%, representing $308 billion of the $7.7 trillion in assets held by private pension funds and government pension and insurance funds at the end of 2001.

Pension funds now own about 6.8% of all U.S. commercial real estate. If they raised their commercial real estate allocation to 10%, that would shift $462 billion additional dollars into real property markets. (These calculations leave out foreign pension funds, which also are pursuing a lot of U.S. real estate.)

Hypothetically, if pension funds spent just 25% of that total buying REIT shares, that would add $115 billion to a REIT-share universe now valued at under $150 billion.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C.

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