© Copyright 2000 Rogers Media. The following article first appeared in the May 2000 edition of BENEFITS CANADA magazine.

Real estate now

Some of Canada's largest pension funds are now allocating 10% or more to real estate investments.

There's good reason for smaller funds to follow suit.

By Philip Gillin

Many of Canada's defined benefit pension plans have been committed to real estate as an investment class for a considerable period of time. During the bull market of the 1980s, funds were introduced to various real estate vehicles. But exposure to real estate, as a percentage of total assets, remained relatively low. While many institutional investors made excellent real estate investments, some acquisitions did not perform to expectations. That was due to projected investment yields which were highly dependent on aggressive rental and future value increases.

During the real estate bear market of the early 1990s, pension fund real estate portfolios remained static as other asset classes came into favour and the markets consumed an over-supply of real estate inventory. But since 1995, allocation to real estate by pension funds of all sizes has increased, and renewed confidence in the asset class has been established.

Real estate assets held by trusteed pension funds have grown from about $7 billion in 1991 to $15 billion in 1998 (see "Real estate growth," page 30). This strong increase in real estate investment continued into 1999 and 2000. Canadian pension funds are now the most active purchasers of income producing properties and real estate companies.

Why has this been happening? Historically, the inclusion of real estate in an investment portfolio has a strong conceptual and actuarial foundation. Real estate has proven to provide multiple benefits to the fund manager--diversification, yield support, capital appreciation potential, inflation protection and immunization.

A principal attraction of real estate has been the diversification that it provides relative to equities and fixed income investments. An analysis of long-term total returns of the Russell Canadian Property Index versus return indexes for stocks and bonds clearly indicates that there is limited correlation between real estate returns and the return of these other asset classes. As a result, including real estate in a portfolio provides plan sponsors with return diversification, thereby reducing risk.

Although it is clear that a diversified portfolio like the Russell index provides the benefits of return diversification, the dilemma faced by plan sponsors is that few plans can actually own a portfolio comparable to the index. To maximize the benefits of diversification requires the ability to diversify the real estate investment by property type depending on market opportunities and conditions.

Large funds that can support in-house real estate expertise accomplish this by directly acquiring numerous properties of varying types in diverse markets. For smaller funds with limited in-house real estate investment expertise, real estate investment trust (REIT) units and pooled vehicles offer the opportunity to participate in diversified real estate portfolios on a unitized basis.

To date, REIT units have not played a significant role in pension portfolios. That is due to the small cap nature of the REIT market in Canada, as well as concerns about the potential liability of unitholders for uninsurable liabilities. Pooled vehicles continue to be an option of choice for many funds because these vehicles are managed by professional advisers and usually provide a wide range of diversification.

PREDICTABLE RETURNS

Traditionally acquired for its income and capital growth potential, real estate provides stable and predictable income return characteristics similar to bonds--albeit without the fixed coupon element. On a long-term basis, real estate income returns have proven stable.

Since 1992, the income yields on investment property acquisitions have provided a significant yield premium compared to long-term bonds (see, "Commercial real estate and government bonds," right).

Real estate can enhance portfolio yield through property cash flow alone. This reality has not been lost on pension plan sponsors and their advisers. Unlike the real estate markets of 10 years ago, current real estate investment yields are no longer highly dependent on future rental and value increases. The ability of a property to sustain, improve or enhance its current cash flow is more critical to the analysis than its potential to increase in value based on projected inflation rates.

In analyzing real estate investments today, a realistic assessment of the risks to future cash flow--resulting from major lease expiries or capital expenditures--is essential. Pension plan investors are taking a more active role in individual property selection, often purchasing assets directly or through an asset manager. The ability of the asset manager to analyse, measure and predict such risks to income is critical to the real estate investment decision. As a result, their compensation is now more closely linked to income performance.

The ability of properties to retain tenants and maintain strong cash flow, either through superior building quality or market dominance, is a decisive factor in acquisition. Pension plan investors have become competitive buyers of high-quality real estate by foregoing some initial yield in return for long-term sustainable cash flow.

Since early 1999, there have been at least 16 significant transactions where pension money was the source of capital. Ten of these transactions involved high-quality office buildings totaling over $1.4 billion. The British Columbia Investment Corporation recently acquired the Merrill Lynch Tower, a first class multi-tenanted office tower in Toronto, and SITQ Bureaux Inc. has acquired a 50% interest in the Sun Life Building in Montreal.

Other transactions involved major regional shopping centres totaling over $1.6 billion--including potential interest in Square One, Yorkdale and Scarborough Town Centre in Toronto, and 100% interest in the Guilford Town Centre in Surrey, B.C. To date, in 2000, pension funds are involved in more than $1 billion in additional office building acquisitions in Toronto and Montreal.

As pension plans look to fund their long-term liabilities, an asset class that offers attractive predictable income returns--together with the opportunity to realize capital gains--cannot be overlooked. With pension liabilities susceptible to inflationary pressure, the income available from real estate becomes attractive as rental streams, and therefore values, respond positively to inflation. Real estate offers an excellent alternative as government borrowings slow and the supply of long-term bonds is diminished.

DIFFERENT THIS TIME

Pension plan advisers and asset mix consultants have been seeking successful ways to diversify plan investments and reduce the long-term volatility of returns for decades. The conceptual argument on behalf of real estate is not new. While accepting the merits of real estate, plan advisers and trustees still retain memories of the development excesses of the 1980s and the calamitous impact on real estate values in the early 1990s.

What market conditions exist today that are convincing decision makers that the performance and liquidity problems of the past decade will not re-occur? The renewed confidence in the real estate sector results from a combination of several market fundamentals.

Supply and demand for most classes of real estate is in balance in major Canadian markets. Vacancy rates for all categories of space have fallen to single-digit levels and are forecast to remain there for the foreseeable future (see "National vacancy rates," left). The reduction in the unused inventory is dramatic and markets are at, or approaching, equilibrium levels of supply and demand.

On the demand side, the appetite for real estate products is driven by general economic conditions. For the major Canadian real estate markets, leading economic indicators such as gross domestic product growth, job creation rates, employment levels and retail sales have been strong and are projected to remain positive. This economic performance is maintaining high levels of demand for all types of space.

On the supply side, there are several factors constraining supply. First, in terms of the current real estate cycle, the Canadian market is still at a relatively early stage. Rental rates have not yet achieved a level that would support new construction actively. Second, in the current real estate market more conservative investment attitudes are prevailing (i.e. there is far less construction of unleased space). The reluctance by lenders to engage in the kind of exuberant lending of the 1980s has created a discipline that has curtailed the supply of speculative real estate inventory.

In the event of an economic downturn, demand will abate. But vacancy levels are unlikely to increase dramatically because there are only limited amounts of new unleased inventory under construction.

While the dollar volume of investment in real estate has grown substantially, the overall investment in real estate within the pension industry averages significantly less than 5% of total assets. This is because much of the new investment has been made by a relatively limited number of larger funds that have the ability to invest a meaningful amount, and take advantage of the asset class.

With conventional theory supporting an allocation of 5% to 15% of assets to real estate for maximum benefit, many of these larger pension funds have committed to increase their exposure to 10% or more. Smaller funds are currently looking at the various vehicles offered. To date though, this has not yet been a high-growth part of the market.

However, the logic which supports the selection of real estate as an element in the asset mix is equally as strong for smaller funds, and the market offers vehicles which will permit them to invest in diversified real estate portfolios.

With the current excellent real estate market, combined with the strong conceptual basis (including a meaningful investment in real estate in a diversified portfolio) pension fund sponsors owe their beneficiaries due consideration of real estate as an asset class.

Philip Gillin is president of Sun Life Financial Realty Advisors Inc., Toronto, a subsidiary of Sun Life of Canada.

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National vacancy rates

Renewed interest in real estate has everything to do with strong economic fundamentals. Vacancy rates have dropped considerably.

SOURCE: Colliers International

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