The real estate sector remains in deep freeze, characterised by a lack of transactions even as the stock market rally continues unabated with the S&P 500 up 54% since March 9. This grim assessment comes from the California State Teachers’ Retirement System (CalSTRS), the second largest US public pension fund. It has a €8bn real estate portfolio that, on its own, is larger than most public and private pension funds.

“We are still down in a trough,” notes Christopher Ailman, CIO of the €81bn CalSTRS. “We may be able to see the light at the end of the tunnel, but it is really far away right now. There is a lot of commercial real estate debt that will come due in 2010. It will be interesting to see if any of the banks or traditional debt providers will step into this market. There is a lot of uncertainty that they will.”

The Townsend Group, the fund’s real estate consultant, echoed a similar view in its September 3 semi-annual report presented to CalSTRS’ investment committee. The report analyses the market in the first quarter of 2009, however, it also makes a number of forward-looking statements. “With unemployment rising, it is no surprise that office assets have suffered significant losses. We expect vacancy rates to increase as well.”

In the market overview section of the report, Townsend expects losses to continue across all property types: “Industry participants forecast a total un-levered return of -30% to -40% for core real estate from peak to trough. Managers globally are continuing to increase discount rates and assumed exit capitalisation rates while reducing NOI projections. Reported yields are low relative to risk-adjusted and inflation-adjusted historical averages. Mark-to-market requirements and a change in culture are resulting in much faster value adjustments than occurred in the 1990s.”

Pension funds have been quicker than real estate investment trusts (REITS) in marking-to-market. CalSTRS, which does not invest in REITS, announced a 40% write-down in real estate for the fiscal year ending in March. “We wanted to deal with what we thought was a realistic valuation of our holdings. This made us different to our peers,” says Ailman. “If you look at real estate trusts in the market, they have generally not dropped as much because of the uncertainty of not knowing where the transactions will price once they start moving. No one will know who is right until about a year from now. At the moment, we are not having price discovery which is key to unfreezing the market.”

CalSTRS does not expect further write-downs in its real estate portfolio. It is looking to acquire high-quality assets from distressed sellers, among them, developers and real estate managers with over-leveraged properties. While some are being forced to mark-to-market, sellers and transactions are scarcer than in March and April.

“What the Townsend report and CalSTRS are saying is that it is still early to talk about what sectors will improve quickly,” notes Ailman. The pension fund has not been immune from the market downturn. Historically, the fund has had a large core real estate portfolio. Core assets typically include fully-leased and occupied high cash-flow properties in the United States. Starting in 2006, CalSTRS started to sell part of its core property holdings, shifting more heavily into non-core tactical assets. As of March 31, 2009, CalSTRS’ tactical assets accounted for 50% of the real estate portfolio. These properties are based outside the United States and typically carry development risk. The shift had a negative impact on the real estate portfolio as the use of leverage is an integral part of most non-core strategies. In a declining market, leverage tends to further exacerbate any downward trends which is why the fund’s real estate assets did significantly worse than its overall portfolio. Land and urban investments generated the most negative returns.

The pension fund’s strategic allocation to real estate is 12%. During the height of the financial crisis, it climbed to as high as 15% as global equities dropped in value. Today, the target allocation to global equities is 54%, 6% lower than before, with 21% allocated to fixed-income, 12% to private equity and 1% to liquid instruments (cash). “The shift we are making is to slowly lower our target allocation to global equity and move in the direction of inflation-sensitive assets. We will do this based on market opportunity over a course of four years.” Calstrs, which has 833,000 members, manages a third of its assets internally. In the US, 30% of its equity assets and 20% of its fixed-income assets are managed actively, while in developed countries 50% of equity assets are managed actively. The pension fund completed its tri-annual asset-liability valuation earlier this year.

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