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CalPERS is slowly digging its real estate portfolio out of a big hole

CalPERS is slowly digging its real estate portfolio out of a big hole
CalPERS was a pioneer among public pension funds in investing in private real estate. Above, Ted Eliopoulos, CalPERS' chief investment officer. (Carl Costas)

The Achilles' heel of the vast CalPERS fund has been its real estate portfolio, but there are signs that the long-troubled segment is finally turning around.

Investment returns for the California Public Employees' Retirement System have been dragged down by its $27-billion investment in office buildings, housing developments, warehouses and shopping centers. By the fund's own admission, it was nothing short of a disaster area.

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The performance was so bad that it raised the question of why the nation's largest public pension fund even bothered with the volatile, high-cost sector in the first place.

But a recent study by consulting firm Wilshire Consulting Inc. found that the portfolio finally pulled ahead of its peers by a solid margin, posting a 15.5% annual return — compared with 12.7% for its benchmark — in the five years that ended June 30, an important milestone. Returns on CalPERS real estate were in the top 5% of big pension funds for the period, Wilshire said.

As part of the turnaround, the fund is moving away from such speculative investments as a 53-story Sacramento condo development that ran aground in 2007, in favor of a string of already-leased shopping centers and other safer bets. And it plans to slash the number of investment advisors by more than 75%.

"We're digging ourselves out of really negative performance," said Ted Eliopoulos, who ran the real estate operation for seven years before being named CalPERS' chief investment officer in 2014. "These are favorable numbers and a good sign our approach is working."

To be sure, the portfolio has a ways to go. Its performance over 10 years is a paltry 4.1%, far below its benchmark of 8.2% and in the bottom half of its peers.

But even CalPERS critics said the fund appears to be heading in the right direction.

"We're cautiously optimistic," said Craig Leupold, president of Green Street Advisors, a Newport Beach real estate research firm that has been critical of pension funds' approach to real estate investing in general and CalPERS' performance in particular.

The returns matter.

Charged with paying benefits to 1.7 million current and future retirees, CalPERS has the power to compel government employers to make up any shortfall in its fund. The pension plan was only about 74% funded at the end of June, according to a spokesman. In July, the overall fund reported returns of just 2.4% for its fiscal year, which ended June 30, far below its 7.5% investment target.

The bad year was mostly the result of a weak global stock market. The problem wasn't real estate, which rang up returns of 16.9% and placed it in the top 10% of its peers.

CalPERS was a pioneer among public pension funds in investing in private real estate, which was touted for its frequently high returns and its so-called diversification benefits, which allows its value to rise and fall independently of stocks and bonds.

Like investments in private equity, money poured into private real estate is expensive to manage.

Together the two sectors accounted for the bulk of the $1.2 billion in investment fees that CalPERS paid in its 2014 fiscal year, the latest annual fee statistics available. The fund plans to disclose soon how much it paid last year in private equity performance fees, which are expected to be even higher.

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CalPERS' real estate woes can be traced to the roaring market bubble of 2003 to 2006, when the fund dumped about $16 billion into so-called core investments — fully leased buildings in major markets — and committed more than $30 billion to high-risk, high-reward land developments; far-flung foreign markets such as India; and other speculative schemes, such as the complex redevelopment of New York's massive Stuyvesant Town housing project.

During those highflying days, CalPERS real estate managers, much like their private equity counterparts, were caught up in the so-called pay-to-play controversy in which investment firms paid millions to intermediaries, known as placement agents, to help win business with the fund.

Eliopoulos, a lawyer and former deputy to former state Treasurer Phil Angelides, was hired to take over the real estate portfolio in January 2007. His modest efforts to steer toward more conservative investments failed to head off a historic debacle.

Real estate everywhere crashed in the run-up to the Great Recession. A key benchmark fell 22.1% for the year that ended Sept. 30, 2009, and CalPERS real estate posted staggering losses of 48.8% in the same period.

In 2011, Eliopoulos instituted a drastically more conservative strategy, shifting about 80% of the portfolio into core properties, such as fully leased buildings in stable markets.

Last February, Paul Mouchakkaa, an executive with Morgan Stanley's real estate arm, was appointed real estate chief to succeed Eliopoulos, who had been promoted.

In an interview, Mouchakkaa said a strong market for real estate assets in recent years has eased the fund's shift from speculative to safer investments. "It's not a terrible time to sell," he said.

Mouchakkaa has been implementing another phase of the strategy: dramatically cutting back over the next several years on the number of investment advisors the fund hires to oversee real estate — to about 15 from about 70.

Mouchakkaa, an advisor to CalPERS during the recession seven years ago, said a lesson learned was "keeping things a little more simple."

He will be phasing out poorly performing funds, such as BlackRock Inc.'s Europe Parallel Property Fund II, which posted annualized losses 16% over the five years that ended March 31, and CBRE Strategic Partners Europe Fund III, which had annualized losses of more than 10% in the period.

He'll also be cutting out some better performers, including Centerline Urban Capital I, which posted 50% annualized returns on residential development during the period, because they no longer fit into the fund's strategy.

Nine managers will end up handling about 80% of the portfolio, led by GI Partners, a San Francisco firm that focuses on warehouses that will oversee 19% of the real estate investments. The rest will be given in smaller pieces to other managers.

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