Direct or indirect? Perhaps not as lofty a question as Hamlet’s “To be or not to be?” but decision makers at US pension plans, endowments and foundations face serious choices in making real estate allocations between indirect investment vehicles and traditional direct investments. A few members of the Pension Real Estate Association share their thoughts on the choices plan sponsors make regarding these real estate investments. 
First, some definitions. Direct real estate typically involves the outright purchase of properties or investments through various funds or with joint venture partners. Indirect real estate investment, according to Thomas Dobrowski, managing director, Real Estate and Alternative Investments at General Motors Asset Management, can involve two categories. “It can include investments in a commingled vehicle, where there are other investors and a manager or general partner of a fund is responsible for making the investment decisions for that fund. A good example is an opportunity fund that has multiple investors but none of those investors has a direct responsibility for the investments held by that fund. The other category is, of course, investment in publicly traded real estate securities. They can be either REITs real estate investment_trusts or certain other publicly traded companies, like some of the hotel companies that are REOCs [real estate operating_companies].” 
Control is the major factor distinguishing direct versus indirect investments, according to the PREA members interviewed. In the case of commingled funds, “We don’t have either the fiduciary responsibility for making investments with regards to particular assets, nor do we have any operating responsibility for those assets,” says Dobrowski.  
Because there are thousands of pension funds in the US that may consider real estate investments, it is difficult to get a complete picture of the total allocation into indirect investments by plan sponsors. However, a PREA survey released earlier this year of a sample group of our members with $1.1trn in assets showed $12.1bn in commingled fund investments and nearly $8.5bn in REIT and REOC holdings.  
So why invest in REITs? Martin Cohen, President of Cohen & Steers Capital Management, turns the question around. “I have always asked the question ‘Why wouldn’t a pension plan invest in REITs?’ There are a few reasons. The first is better value. Typically, even if REITs are trading at around asset value, your cash flow yield and your dividend distributions are probably higher than what you can get in the private market. Second is liquidity. This works in two ways. Liquidity is important because you need to have real market pricing and you want to alter your investment without having to pay a lot of fees and expenses. The expense of buying and selling properties is substantial. The third element is the professional management of REITs.”
Ken Rosen, CEO of the Rosen Consulting Group and Professor of Real Estate and Urban Economics at the University of California, Berkeley, is also bullish on REITs. “Plan sponsors want to have a portion of their assets, about 20 to 25%, in indirect real estate. The reasons are lower costs than with direct real estate and they offer a quick way to get allocations out. It is a diversity factor while investing with excellent companies.”  
Mary Beth Shanahan, assistant investment officer of real estate with the $50bn Ohio Public Employees Retirement System has been a player in the REIT market. “We really like REITs. They add value to the portfolio. Typically the REIT market is not totally correlated to the direct market, so there is diversification in investing in REITs. We are also able to gain access to other property types such as regional malls.” OPERS has been investing in REITs since 1990 and currently invests 10 to 15% of their real estate allocation into REITs. The total real estate portfolio amounted to $4.6bn at year-end 2002.  
Although REITs have proved to be a popular play for investors looking for real estate exposure, they are considered to be core strategy investments and thus not an option for those seeking more value-added or opportunistic investments. The PREA survey revealed that one-third of all private real estate equity holdings by our members were in value-added or opportunistic investments.  
“Our indirect real estate exposure is principally limited to opportunistic-type investments,” said Dobrowski, whose General Motors equity real estate portfolio amounts to $6.5bn, the largest real estate investment among US corporate plan investors. “These are investments that have a higher rate of return. It use to be in the area of 20% or above, but now it is a bit more moderate. These are leveraged returns. They have a shorter holding period. These types of transactions involve a certain amount of expertise, access to deals and financial engineering, which all contribute to the success of that kind of investment portfolio.” 
Investments in REITs are relatively new for plan sponsors. According to Cohen: “Pension plans were not very active in REITs until the mid 1990s. There were three reasons. One is they did not want real estate anyway. They had had such a horrible experience with real estate in the early 1990s that they just did not want to go to their investment committee with real estate investments. Second, they did not know REITs and they did not believe that REITs were really real estate, and third, the REIT market was small up until the mid-1990s. It wasn’t a rich universe from which to choose. Each of those three things has reversed over the past seven or eight years. One, people want real estate again. Two, the size of the REIT market is substantial and diverse. Three, people understand REITs more. They are an accepted asset class now.”    
General Motors was one of the first to get involved in real estate investments. “The first real estate investments that the General Motors pension trust made were in the early 1970s,” said Dobrowski. “We first became involved in direct investments in the mid-1980s. Over time, we expanded our activities to include opportunistic investments in the late 1980s and early 1990s, and we started our REIT portfolio in 1991.”  
REITs have shone as a real estate play. “REITs have outperformed direct real estate investments by 2 to 3% (NCREIF versus Wilshire REIT Index) over the past 10 to15 years, but one has to be very careful comparing the two,” according to Rosen. “REITs have the advantage of leverage, and direct investments are more static. It is difficult to make an apples-to-apples comparison. In the long run the two should perform about the same.” Shanahan agreed that direct comparisons are difficult but believes that REITs have performed favourably versus direct investments. 
Although REITs have been a successful play for institutional investors, direct investment in real estate will continue to capture the lion’s share of property allocations for the major funds. “We do both,” said Shanahan. “Each method has a purpose in the portfolio. What we like about direct investment is the control – we make the investment decision.” In addition, Shanahan notes, “Clearly the REIT market is not big enough to accommodate all the real estate investments being made.” In addition, the large amount of funds that US plan sponsors place into real estate may make direct investments more attractive. According to Dobrowski, “We are a very large real estate investor. We have sufficient size so that we can afford to take a much more active approach to our real estate.”
Jack Nowakowski is director of research at the Pension Real Estate Association, based in Hartford CT

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