Real Estate Investing and State Budgets' 'Day of Reckoning'

by: Brad Case

The TV show 60 Minutes broadcast a segment on the looming crisis in state budgets, caused mainly by underfunded pensions. In fact, "crisis" may be too weak a word: as financial analyst Meredith Whitney said in the segment,

I think next to housing this is the single most important issue in the U.S., and certainly the largest threat to the U.S. economy.

The 60 Minutes segment focused on over-generous pension obligations, but a major part of the reason for the crisis is that, for decades, state and local pension funds have failed to get the investment returns they needed to grow their pension assets adequately. Pension fund investments in the real estate asset class are a good example of this failure.

Pension funds tend to invest in real estate either by buying buildings or by sinking money into private real estate investment funds. Direct investments aren't necessarily bad, because pension funds can get higher returns by jacking up their leverage--and they understand that, in doing so, they take on higher risk. But over the last 20 years--and especially over the last decade--pension funds have chosen a worse option: private real estate funds.

The historical data show that the returns on private real estate funds have been terrible. For example, core private real estate funds--the most common choice for pension fund investments--have provided net total returns averaging just 4.06% per year over the last 10 years, 4.72% over the last 20 years, and 5.91% over the last 30 years. After inflation, that's just 1.74% per year over the last 10 years, 2.20% over the last 20 years, and 2.67% over the last 30 years.

Meanwhile, publicly traded equity REITs have provided net total returns averaging 9.83% per year over the last 10 years, 11.39% over the last 20 years, and 11.28% over the last 30 years. After inflation that's 7.51% for 10 years, 8.87% for 20 years, and 8.04 for 30 years.

The implications of such huge differences in returns are absolutely amazing. Over the last 10 years, an investment in publicly traded REITs would have been worth--after fees and inflation--1.67 times as much as the same investment in core private real estate investment funds. Over the last 20 years, the REIT holding would have been worth 3.54 times as much, and over the last 30 the REIT investor would have 5.23 times as much.

Yet pension fund allocations to publicly traded REITs are tiny, averaging around 9% of the real estate portfolio--and many pension funds have no strategic allocation to publicly traded REITs at all.

I've written other articles pointing out the poor returns of private real estate investment funds and the much superior returns produced by publicly traded equity REITs (here). Actually, many pension funds would do well to keep some of their real estate portfolio invested in private real estate investment funds, because having both public and private holdings moderates the volatility of the overall portfolio (here). Even one-fourth or one-third invested on the public side would be a major improvement. But the way most pension funds have done their real estate investing over the past several decades hasn't worked. They've dug an enormous hole, and 60 Minutes is right: the day of reckoning really is at hand.

Disclosure: Author is long Vanguard REIT Index Fund and ING Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.