April 15, 2024

Public pension funds make up some of the most important scaffolding around the commercial property market, with an estimated $6T invested in real estate assets around the globe, and as economic and investment patterns change with the times, these institutions face mounting uncertainties with growing implications for CRE.
A volatile stock market, the retirement of the large baby boomer demographic and even geopolitics contributed to what is expected to be the biggest single-year drop in funding ratios for retirement systems since the Great Recession, according to a report from the Equable Institute.
The gap between pension funds’ assets and the money they need to fulfill their obligations is estimated to be over $1T this year, and while experts say the funds are stable and meeting self-determined expectations for returns, they predict that these funds will pour even more money into the property market to cover their shortfalls.
“There’s more money being invested in real estate today than there was a decade ago, in part, because state pension funds are trying to hit their returns and they know that public equities and bonds aren’t the way to do it,” Equable Institute Executive Director Anthony Randazzo said. “Because the funding shortfall persists, there’s more pension fund money flowing to real estate generally, to try and solve for the funding shortfall.”
Commercial real estate’s record-breaking 2021, in which commercial property sales volume in the first three quarters of the year surpassed $462B, boosted property values to new heights and helped close the funding gap for pension funds as a group.
State and local pension plans’ unfunded liabilities were $933B in 2021 — a drop from $1.7T in 2020, according to the 2022 State of Pensions report by Equable Institute. The decrease was because of “a single year of exceptional investment returns,” according to Equable.
But in 2022, as return-to-office lags dampened the office market and interest rate increases and recession fears have kept a lid on transaction volume, that trend is likely to reverse. Equable estimates that unfunded liabilities will reach $1.4T in 2022 “due to market underperformance.” 
There are a number of ways that pension funds can make up for these shortfalls, including increasing contributions from members or the governments where they’re located. But getting a boost from the government is usually an unpopular ask and comes at the expense of other programs and services on which people rely.
Average annual contributions by state and local governments to their pensions have grown at a rate of 8% per year for a decade, Pew Charitable Trusts Public Retirement Systems Director Greg Mennis said. 
Those contributions were meaningful to the funds they bolstered, Mennis said, boosting five funds that had been in financial distress back into a more stable position, by Pew’s measurement. But they come with a cost.
“The flip side of that is that it’s taken a bite out of government budgets, and it’s crowded out services,” Mennis said. “And so, how state and local governments navigate the very uncertain economy and whether [they] can get to a place of bending the cost curve on pensions — I think those are the interesting questions to focus on going forward.”
For example, in New York City, five pension funds posted a loss of 8.65% for the most recent fiscal year, Pensions & Investments reported last month. The loss, which was the worst for the funds since the Great Recession, meant the public will be on the hook for fund contributions of $861M in fiscal year 2024, $1.97B in 2025 and $3.02B in 2026 to prop up the pensions, P&I reported.
Overall, states’ contributions to pension funds since 2010 have more than tripled, according to the Equable report, the result of states making up for continued funding shortfalls, but even with those greater contributions, the report’s authors say that the money coming in from employees and employers has not been enough to make up for consistently rising benefit payments to retirees. 
So, pensions increasingly turn to real estate, even though it can be viewed as risky, Mennis said, because it diversifies portfolios and the returns are typically higher than less risky investments.
Pension funds’ assets under management nearly doubled in the last decade, growing from $30T in 2010 to $56T in 2020, Nuveen Real Estate Head of Research for the Americas Donald Hall said. Over that same time period, pension funds increased their allocations to real estate by about 2%. Hall estimates, then, that pension fund capital in real estate globally is $6T, up from $3T a decade ago. 
“What you get is actually a bit more than a doubling in capital from pension funds into the sector over the last decade,” Hall said. 
Public pensions have an average 12.3% allocation to real estate, which is the highest allocation of all institutions, according to the 2021 Real Estate Allocations Monitor by global capital advisory firm Hodes Weill in conjunction with Cornell University’s Baker Program in Real Estate.
The company is still conducting its next survey, but all signs point to a continued increase in target allocations to real estate, Hodes Weill co-Managing Partner Doug Weill said. 
In the last year, the Indiana Public Retirement System has increased its allocation to real estate from 7% to 10%; the Texas Municipal Retirement System has gone from 10% to 12%; and the California State Teachers’ Retirement System, the second-largest pension fund in the U.S., increased its allocations from 13.5% to 15%, Hall said. 
Pensions are investing across strategies, from core to value-add to opportunistic, Weill said, giving them the “broadest investment objectives or set of objectives of all institutions.” 
On a five-year average, real estate has returned 8.4% for pension funds, according to Hodes Weill’s 2021 report. Real estate has been “a shining star” in institutional portfolios, Weill said.
“The yield on asset classes has changed over the last decade and there are continually increasing allocations to real estate by pension funds as a way to help them hit their required rates of return,” Nuveen’s Hall said.
But as the CRE market has changed, so have pension funds’ tastes within the property market. The lingering uncertainty about offices has impacted the way that pension funds view the property type. Many have similarly shifted away from retail properties too. 
Private real estate funds have 23% of their investments in offices, a drop from 34% in 2019, The Wall Street Journal reported, citing data from the National Association of Real Estate Investment Fiduciaries. Their holdings in retail space have fallen from 17% to 10% during that time, but investments in industrial real estate have risen from 18% to 31% over the same period.  
In an email to Bisnow, a spokesperson for CalSTRS said that the pension fund, which supports teachers across California, is “actively increasing its exposure in industrial, residential and specialty product types, such as life science buildings,” chalking the shift up to “changing consumer demand” driven by e-commerce and a housing supply shortage.
“Institutional capital has been gravitating for some time now to industrial, multifamily — especially Sun Belt multifamily — and the alternatives, including life sciences, data centers, medical office, senior housing and student housing,” Newmark co-Head of U.S. Capital Markets Kevin Shannon said.
In a July presentation to the board, Teachers Retirement Systems of Texas Senior Director of Real Estate Grant Walker told board members that prior to the pandemic, the pension fund had strategically begun to “over-weight” industrial and residential sectors in its portfolio and “under-weight” office, retail and hotel. 
“When the pandemic began, the impact of that really worked in our favor,” Walker said. The pension fund had also jumped in early to life sciences and studio real estate, something that, Walker said, was relatively new for large institutional investors. But those paid off as well, earning a 7.6% return in the first three months of the year.
The TRST did buy an office building this year — a brand-new property sold by Shorenstein where the pension fund will have its offices.
Real estate’s ability to generate returns when other investments are struggling has helped bolster its position in the portfolios of pension funds, but with the fears of a recession and its impacts on property markets still very much at the fore, there may be more shifts in the property types that they seek to invest in. 
Despite 2021’s outsized performance, a number of factors have pensions slowing down on their allocations in real estate over the last couple of months, Weill said, including market volatility and concerns about rising interest rates and cap rates. He anticipates that once the market’s volatility dies down, perhaps in the fall, that will pass.
“In a moment like now, even though institutions medium- to long-term are quite optimistic about real estate and they’re growing their portfolios, in the moment, their sentiment is negative or at least cautious,” Weill said. “Sentiment changes pretty quickly.”
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