I’m not a real estate expert, so maybe I just don’t understand. I don’t understand why defined benefit pension plans consider mortgages on real estate investments to be normal, or even desirable.

The root of what confuses me is that defined benefit pension plans invest long in debt in their fixed income portfolios, while at the same time investing short in debt in their real estate portfolios. In so doing they pay the mortgage lender a credit spread significantly more than the credit spread that is available on their investment grade fixed income investments. At the total portfolio level, to the extent that your long and short debt positions cancel, today you are paying in the range of 250-300 bps in friction…this being the total of the credit spread that mortgage lenders demand and the investment management fee that fixed income managers charge. On a typical real estate investment with mortgages equal to 50% of value, this reduces your return by 1.25% to 1.5% of your gross property equity.

At the NSAHO Pension Plan, we don’t invest less in fixed income to compensate for our reduced use of real estate mortgages. Instead we access non-mortgage leverage through several derivative exposures. For example, we get large cap US equity exposure using derivatives, and therefore don’t need to tie up cash in this area. The cost of this “leverage” is that the derivatives underperform what one would expect from a physical US equity exposure by LIBOR or some similar short term rate. Accessing leverage with derivatives is easy for us because we are already accessing leverage in this way to implement a few other strategies, such as “portable alpha”. However a different way of avoiding the friction of mortgaged real estate could be to simply invest less in fixed income, so as to neutralize the risk/return impact of getting rid of your real estate mortgages.

To view Calvin Jordan’s white paper, join the debate.

Calvin Jordan is chief executive officer for the Nova Scotia Association of Health Organizations (NSAHO) pension plan.