Plans To Reduce Exposure To Value-Add, REITs and Shed Some International Holdings
The nation's largest pension fund, the California Public Employees Retirement Fund (CalPERS), is close to deciding it's time to reduce its exposure in value-add and international properties, get out of REITs altogether and instead focus on core properties in the U.S.
CalPERS Investment Committee is meeting on Valentine's Day to consider recommendations for a new strategic real estate investment plan that would, among other things, have it:
- Investing more in private real estate equity,
- Focusing the majority of its portfolio in the U.S.,
- Splitting its program into two portfolios,
- Requiring a minimum of 75% of the overall portfolio to be Core, and
- Replacing its existing benchmark based in part on REIT returns with one based in part on a NCREIF Fund Index benchmark that specifically covers core funds and the effects of their cash balances and leverage on fund performance.
Given the changing role of real estate in the CalPERS portfolio, staff and its consultant, Pension Consulting Alliance (PCA), are proposing the revised plan. CalPERS currently holds more than $15 billion in real estate investments.
The plan emphasizes private equity over public funds, a strategy that would see CalPERS getting out of public holdings including REITs over the next three years. REITs currently represent 7% of its portfolio.
CalPERS' current plan targets 50% international investments. Under the new plan, it would limit its exposure in Western Europe and Japan, keep a small percentage in international growth markets such as Brazil and increase its U.S. holdings.
Under the new plan, CalPERS would split its real estate holdings into two portfolios. A legacy portfolio would hold all of its assets that do not fit within the new role of real estate and presumably would dwindle in size over time. A new portfolio would be established comprised of assets which fit the new strategy.
The new portfolio would be broken down into three sub portfolios (base, domestic tactical and, international tactical). The base portfolio would be expected to produce predictable cash flows; the domestic tactical would be an extension of its core program with focus on total return; and the international tactical portfolio would be expected to generate appreciation by capitalizing on growth.
Under the new plan, CalPERS hopes to reduce its overall risk profile by requiring a minimum of 75% of the portfolio to be Core
In documents being presented to CalPERS investment committee next week, Pension Consulting Alliance Inc. (PCA) said believes a focus on domestic core properties achieves the new role of the real estate asset class and reduces risk, as measured by volatility, in the overall portfolio. In addition, the proposed strategic plan also incorporates lessons learned from the previous downturn where CalPERS suffered substantial losses in the value of its real estate portfolio.
As previously described by the fund and PCA, the losses suffered in real estate were primarily driven by vintage-year concentration and an investment focus on non-core assets with high amounts of leverage.
"While PCA believes that the real estate asset class is likely to remain cyclical and CalPERS will, therefore, experience other periods of poor relative performance, PCA believes that with proper oversight and active risk management, a moderately levered core-oriented portfolio will better insulate CalPERS from such severe losses in the future," PCA wrote.
Based on the current make up of the real estate portfolio, the overwhelming majority of CalPERS' new investment dollars will, need to be focused on core properties. As such, the real estate portfolio will be in a period of transition for the next three to five years until it is aligned with the new goals, PCA said.
Wilshire Consultants, another CalPERS real estate consultant, also generally agreed with the new strategic plan. It said, it would reposition the portfolio to exhibit more stable, income producing characteristics and would reduce the portfolio's historical reliance on leverage to drive returns.
Wilshire did note though, that it has some concerns about the elimination of the REIT portfolio.
"While REITs are represented in the global equity program and would not be totally eliminated from the total fund, removing any REIT allocation from the real estate portfolio forces every other asset class to be the "bank" for the liquidity needs of the real estate program," Wilshire wrote. "Under normal circumstances, buying or selling equity or fixed income securities when real estate is managing capital calls is unlikely to be a significant issue. However, as was the case during 2008, there could be times when the real estate portfolio's liquidity needs places stress on other asset classes - thus, the total fund."
"Some of this concern would be mitigated by the transition to a greater focus on cash flow generation and stability," Wilshire added. "However, if REITs are eliminated from the real estate portfolio, CalPERS' need for accurate cash flow forecasts from all asset classes is increased. REITs also act as a means for staff to reduce asset allocation underweights for the real estate asset class. If [real estate] is 3% below target, for example, REITs can be employed to bring the asset allocation back in line far quicker than might be accomplished using direct investments."
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