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Attachment 1, Page 1 of 32

2013-2014 ANNUAL REAL ESTATE UPDATE


California Public Employees Retirement System

November 2014

Attachment 1, Page 2 of 32

Agenda Items

Section

Tab

Real Estate Update

Appendix

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 3 of 32

Section 1: Real Estate Update

CalPERS 2013-2014 Annual Real Estate Update

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PCA Real Estate


CalPERS Board Consultant dedicated real estate team:

Christy Fields, Co-lead, Managing Director, PCA Board Member:


Ms. Fields rejoined PCA in 2007 as Managing Director of Real Estate Consulting Services. Ms.
Fields has extensive experience in structuring and analyzing real estate transactions,
developing investment strategy, analyzing manager fees and performance, evaluating
manager reporting practices, and supervising and negotiating workouts.

David Glickman, Co-lead, Managing Director:


Mr. Glickman joined PCA in 2009. He has more than 40 years of global institutional investing
experience, with an emphasis on commercial real estate debt and equity for pension and
retirement system clients. In 1999 he founded Ambassador Capital Management, Inc., a
registered investment advisor, specializing in publicly traded real estaterelated securities.

Dillon Lorda, Principal:


Mr. Lorda joined PCA in 2008 and covers real assets. He has been working for CalPERS on
behalf of PCA since the Global Financial Crisis. Mr. Lorda has been actively involved in real
assets inclusive of real estate acquisitions, development, and consulting as well as
agricultural commodities trading.

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 5 of 32

Real Estate Portfolio


CalPERS Real Estate Portfolio:

Portfolio metrics continue to move towards strategic targets:

New capital deployed through separate accounts

Better alignment and reduced investment-management fees

Focus on reducing risk associated with leverage

Facing challenging market factors:

Tepid economic growth

Increased demand from large institutions and spread investors

Pricing of stabilized assets often below targeted long-term net return of 7% for
real estate

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 6 of 32

Real Estate Strategic Plan


The 2011 Strategic Plan addressed the embedded risks.

Staff and PCA collaborated to develop a five-year Strategic Plan consistent with the role of
real estate in CalPERS overall Asset Allocation Model:

Reduce correlation to public and private equities

Emphasize income (versus capital gains) for majority of return

Produce stable, distributable cash yields

Strategic Plan remains relevant and prudent:

Strong strategic portfolio performance

Greater control of portfolio

Consistent with CalPERS Investment Beliefs

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 7 of 32

Market Dynamics

CalPERS faces a challenging and highly competitive investment market:

Sovereign wealth funds, high net worth, and other large direct investors

Persistent low interest rates fueling demand for income-producing assets

Capital flows putting upward pressure on pricing

Pockets of distress still exist but are less widespread

Returns generated over the last three years unlikely to be sustained:

Absolute performance will likely slow over the medium term

CalPERS core properties should continue to perform well relative to the


benchmark

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 8 of 32

Property Market Challenges

Many assets appear fully valued, nevertheless, by some relative measures (e.g., spread
over treasuries), real estate is reasonably priced.
Core Market Dynamics (not unlike 2004):

Stabilized assets in gateway cities appear to be fully priced

Cap rates at historic lows

Low economic growth

Occupancy and rent growth recovery lag pricing

International Markets:

Developed markets (e.g., Europe) opportunities not part of Strategic Plan

Developing markets continue to have slowing growth outlooks and additional


political uncertainty

Legal issues

Social and demographic changes

Exchange rates

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 9 of 32

Implementation Challenges
Implementation challenges include:

Maintaining focus and diligence on implementation of Strategic Plan

Desire to put more capital to work

Core separate account managers report that it is difficult to invest and generate
returns in excess of hurdle rates

Reinvestment risk

Availability and allocation of human and other resources

Assessing risk and investing in emerging markets without adequate resources

CalPERS 2013-2014 Annual Real Estate Update

Attachment 1, Page 10 of 32

Implementation Options

In light of the difficulties that have existed, and that continue to exist, for the System in
reaching its target allocations, PCA has observed that Staff have been questioning
whether real estate investment criteria should be relative or absolute. PCA believes that
this matter warrants study within the context of the entire portfolio.

Both approaches have merits and challenges

Absolute return investment criteria (the current model)


Makes it harder to invest during certain points in the cycle and under certain
market conditions, such as a low interest rate environment
May improve absolute performance of the real estate portfolio

Relative return investment criteria


Provides more flexibility to invest during all points in the cycle, presuming that
Staff determines stabilized real estate to be attractively priced relative to
other asset class options
Might result in lower absolute returns within the real estate portfolio

Without broader portfolio analysis, PCA endorses the System staying with existing
underwriting criteria.
CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 11 of 32

Continued Monitoring
Several areas merit diligent oversight:

Portfolio management of emerging markets exposure

Progress towards long-term strategic targets (i.e., Base versus Domestic Tactical;
orderly disposition of Legacy portfolio assets)

Staffs compensation program

Reliance on outside resources; internalize whenever possible

Resources to manage portfolio, particularly for resource-intensive programs


including emerging markets, emerging managers, RCP and ESG initiatives.

CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 12 of 32

Conclusion

Continued progress on 2011 Strategic Plan objectives, portfolio management


initiatives, and Real Estate Unit operational efficiency

Portfolio generating positive performance, with significant market tailwinds and


favorable leverage compared to the Benchmark

Returns are unlikely to continue same pace over medium term

Market conditions are challenging

Pricing is acting as a governor on acquisition pacing

Reaching target allocation should be a deliberate process

CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 13 of 32

Section 2: Appendix

CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 14 of 32

Capital Flows
U.S. Transaction Volume

U.S. CRE Buyer Profile 1H 2014

$461

$363

$ billion USD

Institutional and
Equity Funds
21%

$316

$314
$266
$213

$89

$105

$130

$205
$154

Cross-Border
42%

Publicly Listed
REITs
18%

$128
$63

Private
10%
User/other
6%

Unknown
3%

U.S. commercial transaction volumes have picked up but are still below peak levels. The competition to CalPERS
investment managers includes diverse international investors who view U.S. commercial properties in gateway cities
as relatively attractive safe havens.

Sources: Real Estate Capital Analytics, Deutsche Asset & Wealth Management
CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 15 of 32

Competing Investors
Cumulative number of SWFs

1990

1976

1854

Abu Dhabi
Investment
Authority
established

Norway's
Government
Pension
Fund
Global ("the
oil fund")
established

June 2014
The total
number of
sovereign
wealth funds
worldwide
reaches 75
with assets
of US$6.6
trillion

Origin

Fund

Norway
UAE
Saudi Arabia
China
China
Kuwait
China
Singapore
China
Singapore
Qatar
Australia
UAE
UAE
Russia
Russia
Kazakhstan
Algeria
South Korea
UAE
Kazakhstan
Libya
UAE
Iran
USA
Malaysia
Brunei

Government Pension Fund Global


Abu Dhabi Investment Authority
SAMA Foreign Holdings
China Investment Corporation
SAFE Investment Company
Kuwait Investment Authority
Hong Kong Monetary Authority Investment Portfolio
Government of Singapore Investment Corporation
National Social Security Fund
Temasek Holdings
Qatar Investment Authority
Australian Future Fund
Mubadala Development Company
Abu Dhabi Investment Council
National Welfare Fund
Russia Reserve Fund
Kazakhstan JSC
Revenue Regulation Fund
Korea Investment Corporation
Investment Corporation of Dubai
Kazakhstan National Fund
Libyan Investment Authority
International Petroleum Investment Company
National Development Fund of Iran
Alaska Permanent Fund
Khazanah Nasional
Brunei Investment Agency

1854
1952
1953
1956
1958
1974
1976
1980
1981
1983
1984
1985
1990
1993
1994
1997
1998
1999
2000
2001
2002
2003
2005
2006
2007
2008
2011
2012
2013
2014

Texas
Permanent
School fund
established

The SWFs with assets of US$40 billion+

Source: Sovereign Wealth Fund Institute (as of June 2014)

Provided By: IPD


CalPERS 2013-2014 Annual Real Estate Update

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Value (US$billions)
878
773
738
575
568
410
327
320
181
173
170
90
90
90
88
86
78
77
72
70
68
66
65
59
52
41
40

Attachment 1, Page 16 of 32

Real Estate Cap Rates

Cap Rate

Core Real Estate Current Value Cap Rates


10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%

301 bps

Core Cap Rate

LT Average Cap Rate

10 Year Treasury Rate

Core Cap Rate Spread over 10-Year Treasury Interest Rate


5.0%

Cap Rate Spread

Current cap rates are nearing


historic lows, which implies that
real estate is expensive.

4.0%
3.0%

and cap rate spreads over


treasuries are near the longterm average spread.
Core real estate prices may be
able to withstand a moderate
increase in interest rates.

2.0%
1.0%
0.0%
Core Cap Rate Spread to Treasuries

LT Average Spread

Source: NCRIEF, www.ustreas.gov. Cap rates used in the above two tables are the trailing four quarter average of the NCREIF current value cap rate.
CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 17 of 32

Real Estate Recovery: NOI


150

Multifamily Net
Operating
Income (NOI) is
up 40% since start
of recovery.

Index Value 2008 Q1=100

140

130

120

Retail and Office


are up 10%.

110

100

Industrial is down,
but looks to be
gaining traction.

90

80

Office

Industrial

Retail

Multifamily

Source: NCREIF
CalPERS 2013-2014 Annual Real Estate Update

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Property Fundamentals: Vacancy

Attachment 1, Page 18 of 32

18
17
16
15

14.5

14
13
Vacancy Rate %

12

11.7
10.8

11
10
9
8
7
6
5

4.4

4
3
2
1
0
Office

Retail

Industrial

Multifamily

Source: AEW
CalPERS 2013-2014 Annual Real Estate Update

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Vacancy rates
have begun to
improve for all
property types,
but only
multifamily has
almost fully
recovered.
Multifamily
fundamentals
have largely
been driven by
changes in
household
formation as
opposed to
overall job
growth.

Attachment 1, Page 19 of 32

Real Estate Supply


1.40%

Multifamily
construction has
exceeded
pre-recession
levels.

Quarterly Completions/Total Stock

1.20%

1.00%

Construction in
other property
types is
beginning to
increase, but is
still very low.

0.80%

0.60%

0.40%

0.20%

0.00%

Office

Industrial

Multifamily

Retail

Source: CBRE-EA, Census, AEW


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 20 of 32

Public Real Estate: U.S.


REIT Price to NAV as of July 2014
2.5

REIT Price Premium/Discount to NAV

2.0
1.5
1.0
0.5
(0.5)
(1.0)
(1.5)
(2.0)
(2.5)

Source: AEW
CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 21 of 32

Employment

Payroll employment and the number of jobs needed to keep up with the growth in the
potential labor force, 20002014.
145,000
6.6
million
job
shortfall

Number of Jobs (thousands)

143,000
141,000
139,000
137,000
135,000

accounting for
population
growth, the U.S.
is approximately
6.6 million jobs
short of the prerecession growth
projection.
Significant new
supply of
industrial, office
and retail space
is not expected
until
employment
catches up with
population
growth.

133,000
131,000
129,000
127,000
125,000

Source: Bureau of Labor Statistics, Economic Policy Institute.


CalPERS 2013-2014 Annual Real Estate Update

The U.S. has fully


recovered all of
the jobs lost from
the 2007
recession,
however

21

Attachment 1, Page 22 of 32

U.S. Monetary Supply


4500.000

The U.S. Monetary Supply


has dramatically
increased since the
recession.

4000.000

3500.000

$ in Billions

3000.000

When will this spur


inflation in the future?

2500.000

2000.000

1500.000

1000.000

500.000

0.000

Source: Federal Reserve


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 23 of 32

U.S. Employment

Employment-to-population ratio of total population age 16 and older, 19482014


66%

Although
unemployment
figures have
begun to
improve, the U.S.
workforce is far
from its
pre-recession
levels.

Employment-to-Population Ratio

64%

62%

60%

58%

56%

54%

Source: Bureau of Labor Statistics. Shaded areas denote recessions.


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 24 of 32

U.S. Commercial Transactions

Transaction
volume within
the U.S.
commercial
market has
picked up,
almost
reaching peak
levels.

Property Sales(annualized)
1000

35,000,000,000

900
30,000,000,000

25,000,000,000

700
600

20,000,000,000

500
15,000,000,000

400
300

10,000,000,000

200
5,000,000,000
100
0

Props Sold 4Q Mov Total

MV Sold 4Q Mov Total

Source: NCREIF. Each data point represents the rolling one-year total of transaction volume.
CalPERS 2013-2014 Annual Real Estate Update

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Market Value ($)

Annual Properties Sold

800

Attachment 1, Page 25 of 32

Real Estate Recovery


Price Index
450

The NCREIF Index


value has returned
to its peak.

400

Peak-to-trough
values were down
29%.

350

NCREIF Index Value

300
250
200
150
100
50
0

Source: NCREIF
CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 26 of 32

U.S. Housing Market


70.0
69.0
68.0

% of U.S. Home Ownership

67.0

Homeownership
in the U.S. has
dropped below its
long term historic
average of 65.4%.

66.0
65.0
64.0
63.0
62.0
61.0
60.0
59.0

Percent of Homeownership

Long-term Average

Source: U.S. Census Bureau


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 27 of 32

U.S. Housing Market


210.0
200.0

-2.4%
CAGR

Case-Schiller Home Price Index Value

190.0
180.0
170.0
160.0

11.8%
CAGR

The Case-Schiller
Home Price Index
Value has risen
27.5% since its
trough in 2012.

Case-Shiller
Home Price
Index

150.0
140.0
130.0
120.0

3.8% CAGR

110.0
100.0

Source: S&P/Case-Shiller, AEW


CalPERS 2013-2014 Annual Real Estate Update

Housing finally
began to recover
in 2012.

27

Attachment 1, Page 28 of 32

U.S. Household Formation

After the lull in


household
formations
between 2008
and 2010, a spurt
of household
formations
occurred in 2011.

4,000
3,500

Thousands of Households

3,000
2,500
2,000

Formation of
rental households
remains high. At
some point, the
market might see
a tipping point
where renters turn
into buyers.

1,500
1,000
500
0
-500
-1,000

Change in Total Households

Change in Rental Households

Source: S&P/Case-Shiller, AEW


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 29 of 32

Emerging Markets GDP Growth


10

7.6

8.3

7.4

7
5.9

GDP Growth (%)

5.7

3.8

6.2

3.6

4.1

3.1

2.8
2

4.8

4.3

4.1

5.9
5

4.8

2.6

1.7 1.8

-2

-4

-1.9

EM GDP Growth

Global GDP Growth

Source: IHS Global Insight , Morgan Stanley


CalPERS 2013-2014 Annual Real Estate Update

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5.3

3.4

3.7

3.9

5.7

3.9

5.5

3.7

Future estimates
predict that the gap
between global
GDP growth and
emerging markets
GDP growth is
closing.

Attachment 1, Page 30 of 32

Asia-Pacific: GDP Growth


20.00%

Asia is expected to
continue its overall
growth, although the
growth of China and
Japans economies
are slowing.

Annual % GDP Growth

15.00%

10.00%

5.00%

0.00%

-5.00%

-10.00%
China

India

Australia

Japan

Source: International Monetary Fund: World Economic Outlook. As of April 2013


CalPERS 2013-2014 Annual Real Estate Update

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Attachment 1, Page 31 of 32

Emerging Market Office

Office Acquisition Cap Rates and Unleveraged Development IRRs


18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
Russia

Poland

India

China*

Brazil

*Office Acquisition numbers represent Office/Retail

Office Acquisition Cap Rate

Office Development Unleveraged IRR

Source: Hines
CalPERS 2013-2014 Annual Real Estate Update

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Mexico

Attachment 1, Page 32 of 32
DISCLOSURES: This document is provided for informational purposes only. It does not constitute an offer of securities of any of the issuers that may be described herein. Information contained herein may have
been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified. The past performance information
contained in this report is not necessarily indicative of future results and there is no assurance that the investment in question will achieve comparable results or that the Firm will be able to implement its
investment strategy or achieve its investment objectives. The actual realized value of currently unrealized investments (if any) will depend on a variety of factors, including future operating results, the value of
the assets and market conditions at the time of disposition, any related transaction costs and the timing and manner of sale, all of which may differ from the assumptions and circumstances on which any
current unrealized valuations are based.
Neither PCA nor PCAs officers, employees or agents, make any representation or warranty, express or implied, in relation to the accuracy or completeness of the information contained in this document or
any oral information provided in connection herewith, or any data subsequently generated herefrom, and accept no responsibility, obligation or liability (whether direct or indirect, in contract, tort or
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Supplement for real estate and private equity partnerships:


While PCA has reviewed the terms of the Fund referred to in this document and other accompanying financial information on predecessor partnerships, this document does not constitute a formal legal
review of the partnership terms and other legal documents pertaining to the Fund. PCA recommends that its clients retain separate legal and tax counsel to review the legal and tax aspects and risks of
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and transferring shares of the Fund. In making an investment decision, you must rely on your own examination of the Fund and the terms of the offering.

CalPERS 2013-2014 Annual Real Estate Update

32