Most of the pension funds invested in private
real estate are defined benefit plans. However,
PREA recognises the growing role of
defined contribution (DC) plans in the US retirement
market and the scarcity of private real estate
products serving the US DC market. It engaged
Joan Fallon to research factors relating to private
real estate investment options for US DC plans.
Joan Fallon was both designer and portfolio manager of one such product, the TIAAReal Estate
Account, offered by TIAA-CREF as one of its
defined contribution offerings.
Fallon’s analysis appears in a work entitled ‘Private
Real Estate Fund Options For Defined Contribution
Plans’, ©2004, Pension Real Estate Association.
“Because the audience for the paper consisted of
plan sponsors, investment advisers and consultants, its scope needed to be broad,” explains Fallon. The scope of her work ranged from identifying which products currently serve the market, if any, quantifying the DC market and the demand for a private real estate DC product, to identifying the separate issues plan sponsors and investment advisers would have to consider.
Fallon surveyed the entire population of US openend co-mingled funds to determine which were
serving the DC market. She determined that there
are only two such funds currently being offered, the
TIAAReal Estate Account, with approximately
$6bn (€4.6bn) in DC assets, and the Principal US
Property Account, with approximately $1.2bn in
DC assets, which is offered by Principal Financial
Group. These accounts amount to about 2% of each firm’s total DC assets. Fallon observes: “This 2% figure is an important statistic. It is the result of the decisions of several hundred thousand individuals to direct some of their defined contribution assets to each of these private real estate options. “Applying this percentage to the entire US defined contribution market of $3.9trn produces a potential market demand for private real estate of $78bn, indicating that this market is significantly underserved,” says Fallon.
TIAA-CREF and Principal have addressed the
two features of private real estate thought of as
problematic – daily unit values and liquidity. Both
firms appear to be using similar methods to calculate
a daily unit value, frequent independent
appraisals for every property, daily accrual of net
rent and a daily price for any publicly traded assets
each may own. They take different approaches to
provide liquidity, however. Liquidity for participants
in the TIAAReal Estate Account is made
available by a guarantee from the TIAAgeneral
account for which Real Estate Account participants
pay a small fee. Principal, on the other hand, relies
on the assets of its account for liquidity, bolstered
by a line of credit. Fallon adds that “each product
has deposits from hundreds of thousands of defined
contribution investors, with varying degrees of risk
tolerance, with differing views of the real estate
market which lessens the risk of mass withdrawals”.
In the defined benefit (DB) context, the role of
private real estate has long been recognised. Real
estate provides diversification benefits to mixed
asset portfolios. To illustrate the impact of adding a
private real estate product to an average DC portfolio
(which would contain no private real estate),
Fallon modelled a hypothetical private real estate
fund and two DC portfolios, one containing an
average asset allocation and one to which a small
private real estate allocation has been made.
Returns were calculated for three different time
frames, five 10, and 15 years, each ending in 2003.
Varying time frames were chosen for comparison
sake. During the five and 15 year time frames, one
or more investment types were performing below
historic averages, for example, stocks and bonds
produced below average returns during the recent
five year time frame and real estate performed
below average during the early 1990’s which is captured
in the 15 year time frame.
All of the returns are gross of expenses. For the 10
and 15 year periods ending 2003, the “hypothetical”
real estate account influences the average DC
portfolio in a similar manner. Adding the ‘hypothetical’”
real estate account to the ‘average’ portfolio
produces a slightly lower return compared to the
real-estate-free portfolio return. On the other hand,
adding the hypothetical real estate account to the
average DC portfolio reduces the volatility of
returns and increases the portfolio’s return per unit
of risk, both positive results.
For the five-year period ending 2003, adding the
hypothetical real estate account to the average portfolio
produces a higher return compared to the realestate-
free portfolio return, lower volatility, and
increases the return per unit of risk, again positive
results. Fallon observes that “private real estate
provides diversification benefits regardless of the
time frame”.
Plan sponsors desiring to add real estate to their
DC plans may find public funds more appealing.
Fallon suggests: “The pros and cons of each alternative
be considered before making such a
Private real estate funds available to the broad DC
market would provide greater diversification benefits
and less volatility than funds which invest in
REITs and other public real estate companies. The
advantages which public real estate products would
bring to the DC market would be investor familiarity
with public market pricing and higher returns,
on average, than the private alternative.
The disadvantages of a private real estate alternative
would be complexity, and, most likely, somewhat
greater cost than a public product.The disadvantages
of a public alternative would be return
volatility and duplication of some REIT exposure.
Jack Nowakowski is head of research at PREA