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Volatility at Home, Opportunity Abroad

When the nation's largest pension fund has emerging markets on its radar screen, the investment world takes notice. During a daylong meeting in August, members of the investment committee for the California Public Employees' Retirement System (CalPERS) poured over formal plans to substantially increase the fund's stake in global real estate markets.

Why the shift? Call it the convergence of continued volatility in the U.S. and the need for a more global, long-term diversification strategy, with the former accelerating the latter. And the level of financial commitment to this new frontier is significant.

At the end of the first quarter, CalPERS held real estate in emerging markets valued at $992 million out of its total $23.6 billion global real estate asset base, or 4%. But under the new plan drawn up by CalPERS' investment advisor Pension Consulting Alliance (PCA), the fund's emerging markets real estate portfolio would increase nearly fourfold to more than $4 billion over the next three to five years.

“Pension systems are going global in the search for additional return,” says Christy Fields, a managing director of real estate at PCA, whose 22 clients include the largest pension systems in the U.S. and Canada representing $689 billion in total investments held by plan sponsors.

“To some extent you want your investments to reflect the broader investable universe, so the U.S. pension funds are starting to look at the larger global real estate investment universe as the space in which they can invest and reduce their home country bias in the face of more core-like returns in the U.S.,” says Fields.

Investing in emerging markets is not without its risk. Geopolitical relationships are often on a knife edge, and data is still scarce on historical returns generated by commercial real estate investments in emerging markets.

Still, it is hard to ignore the dramatic economic growth in many of these countries. In India and China, for example, gross domestic product (GDP) is projected to grow by 8% and 9.8%, respectively, from 2008 to 2012.

PCA is recommending that CalPERS invest up to 20% of its international real estate portfolio in emerging markets, such as India and China, and up to 5% in so-called “frontier” markets, or those with less developed economies and corporate regulation, such as Bulgaria and Croatia.

Still, the CalPERS board of directors likely will not see the full extent of the plan for another six months. Why the delay? International investing brings with it a whole new set of variables that require a lengthy due diligence period.

Overseas movement mounts

James Clayton, research director for the Pension Real Estate Association (PREA) based in Hartford, Conn., is closely tracking the overseas investing trend. PREA's investor members have total assets of approximately $3.6 trillion of which $268 billion — or 7.5% — were held in private real estate equity at the end of 2007. The balance was invested in stocks, bonds and cash.

In terms of total allocations for commercial real estate heading into 2009, Clayton says PREA's members see little change. This is according to PREA's annual plan sponsor survey, which reflects data collected in late 2007 and early 2008. “Volatility in the U.S. markets is causing many of the funds to look globally as well for broader diversification,” says Clayton.

CalPERS is not alone in its quest for diversification. The second largest pension fund in America — New York-based Teachers Insurance and Annuities Association-College Retirement Equities Fund — is stepping up its international real estate investment focus. In August, TIAA-CREF opened its first international office in London. Previously, the fund entered into joint ventures with local partners to build its $4 billion portfolio in the U.K. and Europe.

“We believe that having our own local, dedicated and experienced investment professionals on the ground will add to our understanding of these markets,” says Tom Garbutt, managing director and head of TIAA-CREF Global Real Estate.

Paul Wilson, formerly with Invesco Real Estate and now director of real estate investment management-Europe for TIAA-CREF, says the fund has invested about $600 million annually in real estate in the U.K. and Europe over the past few years, and also is exploring opportunities to open an Asian-based office in the future. The moves are all designed to increase the fund's global real estate allocations, says Wilson, though he is not divulging specific targets.

Meanwhile, a new tactical plan introduced to trustees of the Teachers' Retirement System of the State of Illinois in August includes a major global real estate component starting in 2009, says Mike Barletti, real estate investment officer for the fund.

The system manages $4.7 billion in real estate assets, or about 12% of its total portfolio. Trustees are expected to see the heavily revised five-year investment plan in February 2009.

Even the Pennsylvania Public School Employees Retirement System is jumping on the overseas bandwagon. It recently invested $400 million with Boston-based Beacon Capital in a commingled fund that plans to invest up to 50% of its capital in office buildings in Western European markets, including London, Paris and Luxembourg.

The new international flavor of pension fund investments is not surprising to Lennine Occhino, who focuses on pension investments as a partner in the Chicago-based law firm Mayer Brown. “The U.S. markets have become less desirable, so the pension funds are looking more broadly at their real estate allocations. We continue to see a lot of new funds in the pipeline focusing on non-U.S. opportunities, including emerging markets such as India, China, Mexico and Brazil,” says Occhino.

New players enter the game

Sensing a new source of returns and eager to tread into new markets, many pension systems across the country are now exploring their own international initiatives.

One major new entrant is betting big on the future of real estate. The Washington, D.C.-based Pension Benefit Guaranty Corp. is seeking two or three strategic partners to help it invest up to $2.5 billion in private equity and real estate. The prerequisite? They must be global players. The PBGC is a federal corporation that guarantees payment of basic pension benefits earned by 44 million American workers and retirees participating in more than 30,000 private-sector defined benefit pension plans.

Even smaller plan sponsors are jumping on the bandwagon. In July, the board of the $10.7 billion Hawaii Employees' Retirement System was presented with alternative and international real estate investing strategies as a precursor to a broader initiative to commit funds in 2009. Though the specific strategies were presented in closed session, the plan's board is expected to consider their adoption later this year.

Dallas-based Lone Star Funds recently closed two new international investment funds, including a $2.5 billion real estate fund. The Washington State Investment Board, the Oregon Investment Council, and the Dallas Police and Fire Pension System were all investors. As a private player, Lone Star is mum about its specific strategies, but it has a track record of investing in distressed real estate in emerging markets across Europe and Asia.

Waiting for a U.S. uptick

As the value of commercial properties falls and sales activity in the U.S. drops dramatically during this credit crunch, pension funds largely remain on the sidelines domestically. But the current pricing standoff between buyers and sellers nationally isn't the driving force in pension funds' global strategy, insists Michael McMenomy, global head of investor services for Los Angeles-based CB Richard Ellis Investors.

“Yes, there is still a bid-ask gap, but that does not cause pension fund capital to go to other parts of the globe. That capital is being invested in other parts of the globe to satisfy the diversification needs of pension systems to build a globally diversified real estate portfolio,” says McMenomy.

CB Richard Ellis Investors manages about $42 billion in assets for institutional clients in North America, Europe and Asia. Pension funds are long-term investors by nature, not short-term opportunists, so their decision to go global is hardly a knee-jerk reaction, emphasizes McMenomy.

Given the unsettled real estate market conditions in the U.S., he says pension funds will move at a more deliberate pace before deciding to open the domestic acquisition spigots again. “Their capital is still targeted to real estate, it's just going to be put to work a little slower,” says McMenomy.

In fact, he believes prices of U.S. commercial real estate could drop further in the months ahead. “You can argue that there could be a better asset value for an acquirer one, two or three quarters out than might exist today.”

Fields of PCA says that many pension funds will remain hesitant to park their money in U.S. real estate until the market stabilizes. “That is one reason some of the plan sponsors are looking to broaden their geographic exposures. Some of these emerging markets like Brazil, Russia, India and China could absorb a lot of capital.”

Despite the many challenges, the continued focus by pension funds on real estate investments in emerging markets is on a fast track, but the U.S. funds have a lot of catching up to do.

“The whole notion of cross-border investing comes with a lot more comfort with European capital because it has been occurring for many years there,” says McMenomy. “U.S. capital is a little slower to the party given where we sit on the globe, and there is the notion of getting comfortable investing in markets thousands of miles away.”

Ben Johnson is a Dallas-based writer.

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