Chris Wood
Essentially, foreign investment in property by the UK institutions means American investment. Since the lifting of exchange controls in 1979, UK pension funds and insurance companies have built up a substantial holding of American real estate estimated in the mid-1980s to have exceeded £1bn. Despite its importance, however, the American real estate market has never been fully documented in terms of its structure. This paper outlines the activity of the major institutional groups in the USA not only with regard to land and buildings but also to mortgages, which are their largest commitment.
The United States’ real estate industry has a scale and dimension that parallels the dizzy heights of its architectural landmarks. A quick look at some of the statistics confirms this. New construction of commercial buildings each year in America proceeds at a pace that is greater than the combined real estate portfolios of all UK insurance and pension funds, while US corporations hold real estate estimated at $1,400 bn. Yet the sheer size of the US real estate market has discouraged universal studies: research has focused on its constituent parts. In this paper these disparate sources are drawn together in an attempt to give an indication of the size and structure of institutional involvement in the US real estate market.
The first hurdle to overcome in such a study is the differing pace of reporting by the institutional groups, which makes establishing a base year difficult. The reporting of pension fund asset holdings is particularly slow, and 1983 is the most recent year for which it is possible to draw a reliable estimate for all the major groups. In that year the aggregate real estate portfolio for the major institutions was estimated to have been $72 bn (see Table 1 on p 922).
In view of the size of the institutions involved, the level of investments in comparison to the UK institutional portfolio (£35 bn) is not as high as might have been expected. The explanation of this apparent shortfall lies in differing attitudes — in particular the reluctance of US institutions, especially the pension funds, to take on the direct ownership of commercial property compared with the acceptance by UK funds of property as an important part of a diversified portfolio.
While direct real estate holdings have been kept low, the American institutions do not have such reservations about mortgages. In comparison with their real estate assets, mortgage holdings are over six times greater, exceeding $500 bn in the early 1980s. Essentially these are financial assets, but the injection of such a large volume of capital has been an important stimulus to the development of all forms of property in the United States. This analysis of institutional real estate investments is, therefore, broken into two sectors — mortgages and equity holdings.
Equity holdings
Insurance companies
As well as being the largest owner, this group also has the longest-established tradition of real estate investment. For most of the period since 1950 real estate has accounted for between 3% and 4% of total life insurance assets. In addition to commercial properties, these holdings also include their own business premises as well as farm and residential investments. Commercial investments make up the bulk of the portfolio, representing around 80% of the estimated $22.7 bn of real estate holdings.
An expanding area for life company holdings of real estate has been pooled investment funds, or “separate accounts”. These are investment tools largely catering for pension funds, and can be either a mix of assets or just one. Between 1975 and 1983 real estate assets in these specialist funds increased tenfold, growing from 4% to 9.5% of total assets. The stimulus for these accounts was the Federal Government’s 1974 Employment Retirement Income Security Act (ERISA) which had a considerable impact on pension fund management.
Private pension funds
American pension funds have the same broad division as in this country, between insurance-managed and self-administered schemes. Total assets of the latter were valued at over $600 bn in 1983 compared with around $265 bn of assets with insurance companies. These are spread over a vast array of individual schemes which, according to US Department of Employment statistics, totalled 495,000 in 1978. Schemes with large corporations (10,000 + employees), although numbering only 700, accounted for 45% of participants. Asset holdings are even more concentrated and the 100 largest portfolios make up just over 40% of all private pension fund assets.
In the early 1980s real estate equity holdings totalled around $12 bn (Department of Employment figures), but indirect investment in real estate through pooled funds and special accounts is just as large. Such schemes were initiated in the early 1970s through commercial banks or insurance companies to facilitate pension fund investment in property and other equity assets.
Pooled funds for all asset groups were valued at just over $100 bn in 1983 and real estate may account for as much as one-fifth of this total. Combining pooled with direct ownership gives a total commitment by US pension funds to real estate of between $30 and $40 bn.
Direct property holdings are heavily concentrated among the pension funds of America’s corporate giants. The 200 largest funds may own as much as two-thirds of this sector’s total property assets. For very large funds the portfolio weighting of real estate is around 4%, but this drops away sharply as the size falls, until among the smallest the level is as little as 1%.
Since the late 1970s, there has been a growing acceptance by fund managers of the merits of direct management. Between 1975 and 1981 the direct real estate holdings of the funds grew by 163%, which was significantly ahead of total asset growth of 141%. This change in management philosophy was prompted by the ERISA provisions, which required funds to handle assets in a more “business-like” manner. There is a specific instruction that management should act “by diversifying the investment of the plan so as to minimise the risk of large losses, unless under the circumstances it is clearly prudent not to do so” (section 404).
Diversification became important and the heavy weight of fixed-interest securities and corporate investments, built up in earlier years, had to be reduced. Property, mortgages and new forms of security investment were given increasing attention as funds sought to comply with the government’s regulations.
Recent market conditions have not been favourable for real estate investment, and it is unlikely that there has been any major expansion of holdings over the last few years. As in the UK, the background of a long bull run on the Stock Exchanges, high real interest rates and low inflation has stimulated the flow of capital into securities and bonds. In comparison, real estate has recorded lacklustre performance, making new cash difficult to attract. Market sentiment takes a jaundiced view of real estate and it could be some time yet before any significant improvement occurs. Speculation about the possible loss of tax-haven advantages has had a detrimental effect. While principally of concern to private investors, the resulting market decline is affecting values.
For the second half of the 1980s, the scenario indicates that pension fund holdings of real estate are unlikely to change from the levels recorded in the early 1980s. Funds at the top of the heirarchy will continue to hold around 4% of their portfolios in real estate with perhaps direct ownership achieving a more equitable position with pooled property funds than applied previously. This is likely to be the only major change in investment for pension funds in the immediate future.
Public-sector pension funds
Around 19m employees are covered by various government employee pension schemes. The combined assets of the 500 to 600 schemes in operation totalled $425 bn in 1983 with state and local government accounting for 70%. Around 100 of these government funds held total assets of $500m or greater and for the top half-dozen state and city schemes, between $10 and $20 bn.
The portfolio distribution of the government schemes is characterised by its low risk pattern with a markedly higher level of investment in fixed interest securities than is the case for insurance companies and private sector pension schemes. Government securities and corporate bonds represented 64% of government pension scheme assets, while for insurance companies and private schemes the level is between 40% and 50%. Real estate holdings are almost negligible among the public sector funds with combined direct and pooled holdings comprising as little as 1% of total assets. In total, government pension schemes held property worth $3 to $4 bn in 1983.
REITs
Real Estate Investment Trusts have become an established medium in the United States for collective real estate investment. The industry dates back to the early 1960s when the first trusts were registered, though the last 20 years have seen a rather chequered history. REITs were actively involved in mortgage lending during the early 1970s with debt rising to up to 70% of assets. Heavy over-lending, particularly on construction mortgages, precipitated a liquidity crisis.
After 1974 construction and other loans were reduced and equity assets expanded. Fixed assets have grown steadily, until by the end of the 1970s direct real estate holdings approached 50% of total assets. The last few years have seen a strong revival in the health of the sector, led by the establishment of a number of specialist funds. The development activity of the sector has grown rapidly since the late 1970s as renewed investor confidence ensured a steady cash flow. Asset growth during the 1980s has accelerated rising from $7 bn in 1983 to $16 bn at the end of 1985. Mortgages continue to play a major role and account for just over half of the total assets, while property owned by REITs had a book value of $6 bn in 1985.
Commercial banks
Commercial banks (national and state) form the largest financial sector in the United States with total assets exceeding $2,000 bn in 1983. This compares with $1,700 bn for the pension and insurance sectors together. Among the commercial banking sector’s mammoth portfolio is $5 bn of real estate (other than bank premises) which is proportionately about 0.25% of assets.
Commercial banks are not real estate investors as such, and this significant pool of assets has been largely acquired indirectly as the by-product of other banking business. REITs sought short-term lending from the banks during the expansion of lending in the early 1970s, and from these and other property-related lending the banks have acquired — in a passive manner — a real estate portfolio. The most important role played by banks, with respect to institutional real estate holdings, is that of management of pooled asset funds. The banks were among the early initiators of managed funds and still play a major role in investment management.
Mortgages
Although primarily financial assets, mortgages secured on real estate represent an important link between investors and the general real estate market. The availability of mortgage loans has, to a limited extent, been property-led, with investors releasing funds when and where opportunities arose in the real estate market. A clear example of this was the apartment building boom in the 1960s. Mortgages represent a vehicle for involvement in real estate development while still allowing the institution to keep distant from the management and marketing responsibilities of direct development. The availability of capital from mortgages has been an influential regulator of real estate’s cyclical performance. This has been particularly apparent over the last two years; the US has been undergoing a major development boom and the motor for this has been a burgeoning mortgage market.
The size of mortgage holdings eclipses that for real estate equity with total outstanding debts of around $2,000 bn in late 1985. Approximately one-fifth of such loans are linked to commercial real estate development; the vast remainder being residential mortgages. As can be seen in Table 2, the structure of commercial property mortgage holdings is significantly different from that for the residential sector. Savings associations and mortgage pools are almost exclusively concerned with residential lending, while the commercial banks and insurance companies, in combination, hold two-thirds of long-term commercial mortgages. Construction loans are only a small part of the non-residential market and although usually financed through banking sources over recent years, the savings and loans group has become actively involved.
Nearly all the institutions have been in an expansionist mood over the last two to three years, and mortgage debt has risen sharply. Commercial real estate loans have played a major part in this expansion and the sector’s share of debt has risen from 17% in 1980 to 20% in 1985. Even the life insurance companies, who recorded one of the more modest rises in lending, have substantially altered the balance of their mortgage debt. This has been part of a long-term adjustment that has occurred over most of the last decade. In 1985, non-residential loans by the insurance companies accounted for 73% of their mortgage portfolio, compared with just 45% in 1973.
Banks and savings institutions have recorded the largest increases in lending primarily as a result of the large inflow of deposits through IRA accounts (independent retirement accounts). This is a special tax-incentive scheme to encourage independent provision for retirement and has tended to favour small investor institutions known as “thrifts”. This sector has been the major beneficiary of the IRA programme with receipts from IRAs estimated to have added $15 bn annually.
Such rapid growth has put a strain on the management resources of what are primarily local savings offices (estimated to number around 3,000) and an over-exposure to high-risk ventures, such as construction and property development, has threatened the liquidity of many. Up to one-fifth of thrifts could be in difficulty and the Congressional Banking Committees are now investigating the financial health of the sector.
Conclusions
From the property perspective, the major point to draw from this analysis is the extent of the difference in investment policies between US and UK institutions. There are many similarities between American and British institutions; both have common investment objectives and liabilities and deal in two of the world’s most developed capital markets. But whereas the UK institutions have incorporated commercial property within their portfolio structure, the American funds have not given real estate anywhere near the same degree of emphasis.
Since the early 1970s UK institutions have embarked on a significant expansion of direct property holdings and for many of the major funds this asset group now accounts for between 10% and 20% of the total portfolio. In contrast, the holdings of US pension funds and life insurance companies have been static, and the portfolio weighting only one-third to one-quarter of those pertaining in this country. There are certain differences between the two countries in respect of real estate assets, most importantly lease periods, but the explanation would appear to lie not in the nature of property but rather in the character of the broader capital market. The chief factors appear to be:
Scale and sophistication
The capacity of Wall Street and the other American stock exchanges to absorb large volumes of investment money cannot be underestimated; in 1984 total transactions on the exchange reached $1,020 bn. The vastness of the capital market has spawned an industry of managed funds and investment advisers who specialise in package investments. Guaranteed investment contracts, index funds and securitised mortgages are examples of by-products of the American market. Given this wide choice of investment, American fund managers have been able to diversify their portfolio well beyond the traditional three-legged stool of equities, gilts and property known in the UK.
Fund managers of large and small institutions in the US have demonstrated a strong preference for managed packages resulting in less direct market dealing than is the norm for their UK counterparts. Assets requiring a more direct and specialist management style, such as commercial buildings, are at a disadvantage in the US capital market because they run counter to the American sentiment for low risk and simplified investment management.
Performance payments
Reliance on special investment schemes has led to more frequent monitoring and performance related payments to ensure effective results. Inevitably this favours assets that can achieve high short-term returns, at the expense of long-term investments. While it may be an over-simplification to suggest that funds lack a balanced strategy, the highly competitive nature of the industry does not foster the patience for long-term, steady growth assets such as real estate.
Claw back
The scale of this practice in America is substantial and nearly $10 bn of pension fund reserves are estimated to have been withdrawn by parent companies over the last five years. Companies are sensitive to the size of their pension reserves and keep a close check on the level. This is either because such capital could be deployed for commercial reasons or directors fear the attraction an over-funded scheme has to “corporate raiders”. This can affect all asset groups although real estate’s low liquidity may be a liability to those investors for whom a fast turnaround in assets is necessary.
Real estate industry’s image
America’s free markets are prone to exploitation and unscrupulous practices are not unknown. Among the major capital markets, real estate is regarded as one of the less secure. Not only is there a very poor reputation for integrity, but real estate also suffers from an image of short-term cycles of “boom or bust”. Investor confidence is, therefore, not as high as it could be and this added risk has resulted in many funds maintaining an indirect rather than a direct involvement in real estate.
Where does this leave property as an investment vehicle for US institutions? In the short term no major changes can be expected, as poor market conditions are dampening any enthusiasm there may have been for increasing real asset portfolios. Even in more favourable circumstances the factors outlined above represent a formidable constraint on buying patterns. There are indications of a trend towards direct management as the favoured real estate investment medium, rather than the pooled property funds favoured to date, but these are changes at the margin. For a long while yet, US institutions in comparison with their British counterparts, will continue to be under-represented in real estate.
