Pension Funds and Real Estate

We are already aware that pension funds control a significant amount of investment funds across the world. The total amount of money controlled by pension funds runs into trillions of dollars. However, historically pension funds have shied away from investing in real estate.

Pension funds are generally invested in asset classes such as equity or debt. Real estate forms a very small portion of their overall portfolio and is considered to be an alternate asset. This has been rapidly changing in the recent past because of the red-hot real estate market, particularly in North America.

Pension funds have now started directly or indirectly acquiring all kinds of properties. These properties include single-family homes, multifamily homes, commercial and even retail real estate.

In this article, we will have a closer look at how pension funds typically invest in real estate and why they have now started in real estate in large amounts.

How Do Pension Funds Invest in Real Estate?

Pension funds have multiple ways of having exposure to real estate investments. The three most prominent ways are mentioned below:

1. Pension funds directly purchase real estate from the market. They compete with individual homeowners as well as professional investors in order to purchase these properties. They then either rent out these properties on their own or enlist the services of a real estate management company

2. Pension funds can also invest in funds that are specially created for real estate investments. Such funds are called real estate investment trusts. They have been created with the purpose to allow investors like pension funds to indirectly invest in real estate. When pension funds invest in REITs, they do not directly own real estate but instead own shares in a fund that then invests in real estate.

3. Pension funds also invest in real estate by buying commercial-backed mortgage securities from the market. In many developed economies, there is a very large pool of mortgage-backed securities which is actively traded in the market.

Hence, pension funds have various ways in which they can invest in real estate. Each has its own advantages and disadvantages.

Why Do Pension Funds Invest in Real Estate?

One of the main reasons that pension funds invest in real estate is diversification. The rate at which real estate prices rise has a very low correlation with the rate at which other asset classes grow.

Hence, the addition of real estate to an undiversified portfolio helps in increasing the diversification of such portfolios. Also, real estate values tend to be very stable.

Empirically, these values have never seen a significant downfall for an extended period of time. This is because a large percentage of household wealth is locked up in real estate investments.

Hence, if the housing market witnesses a downfall, it ends up creating political turmoil. The end result is that the government and the central bank are forced to prop up the real estate market. This is the reason that many pension funds perceive real estate investments as being a safe bet.

Advantages of Investing in Real Estate

There are several advantages that accrue to pension funds once they invest in real estate. Some of these advantages are listed below:

1. Low-Interest Rates: Firstly, the interest rates are at a historical low point. This means that individuals are able to borrow money more cheaply. It also means that individuals are investing heavily in the real estate market since that is where the majority of the household wealth of an average family is. The result is that real estate prices have risen sharply. This is true for most markets of North America which have seen an unprecedented rise in real estate prices after the pandemic.

2. Increasing Cash Flows: Another benefit of investing in real estate is that investors are able to obtain incremental cash flows. Since rental rates have been growing at a consistent pace every year, investment in real estate has become very attractive for pension funds.

   Most pension funds do not invest in real estate for capital investments. Instead, they invest in real estate to take advantage of incremental cash flows.

Disadvantages of Investing in Real Estate

Pension funds have traditionally shied away from making real estate investments. This is because real estate investments have several disadvantages as well.

1. Difficult to Manage: Real estate investments require active participation from investors. This is because finding tenants and managing properties is not an easy task. Since this is not the core competence of a pension fund, they find it tedious and complicated. Pension funds are more comfortable managing paper assets as compared to real assets.

2. Higher Taxation: When it comes to real estate investments, pension funds are at a disadvantage as compared to individual investors.

   Individual investors get tax breaks for making real estate investments whereas pension funds do not get any such tax breaks. Also, if pension funds invest via the real estate investment trust route, then too, they are taxed at a higher rate as compared to other investments.

3. Difficult to Liquidate: Real estate is not a liquid asset class. The price discovery and liquidation of real estate can be a very tedious and time-consuming process. Also, the transaction costs associated with real estate are prohibitive.

   Pension funds are forced to take the services of intermediaries which can add to the transaction costs and also makes the process more complicated for pension funds.

Hence, it can be said that even though traditionally pension funds have tried to steer clear of real estate investments, they are now keen to enter the sector. This is largely because of the macroeconomic factors which have made investing in real estate a compelling proposition.