Public Pensions Struggle as Real Estate Investments Underperform in Recent Years

Public pension funds have been experiencing disappointing returns due to their significant exposure to real estate. Several state pension plans, including those in Connecticut, New Jersey, Washington, and Arizona, have underperformed against their benchmarks in the latest fiscal year.

The Impact of Real Estate and Equities

The findings indicate that real estate and equities, especially U.S. stocks, have played a significant role in shaping pension returns. Pensions with larger real estate allocations tended to perform worse, while those with greater equity exposure fared better.

For example, the Arizona State Retirement System, with an 18.7 percent allocation to real estate, reported a return of only 9 percent, falling short of its benchmark return of 11.9 percent. In contrast, the Georgia Teachers Retirement System, which had a more conservative allocation, achieved a 14.5 percent return, demonstrating the benefits of a diversified investment strategy.

The Changing Landscape of Private Real Estate

The landscape of private real estate has undergone significant changes since the COVID-19 pandemic began. Previously, private real estate investments were relatively stable, with project selection being the primary driver of returns. However, the pandemic has shifted this trend, making sector allocation a critical factor in determining performance.

The Cambridge Associates Real Estate Index recorded a 4.2 percent decline for fiscal year 2024, compounding a 1.9 percent drop from the previous year.

Reassessing Real Estate Strategies

As a result of these challenges, public pension plans are reassessing their real estate strategies. Many are divesting from current managers and reevaluating their allocation sizes. The behavior of the asset class has changed significantly, and the future remains uncertain as return-to-work plans evolve.

Tacoma Employees’ Retirement System, for example, reported a return of 7.68 percent for the calendar year ending December 31, surpassing its actuarial assumed rate of 6.75 percent.

Concerns about Long-Term Funding Metrics

The underperformance of real estate investments has raised concerns about the long-term funding metrics of state pension plans. Lower asset returns relative to the discount rate used for liabilities can put pressure on a pension plan's funded status. Despite the decline in real estate valuations impacting overall returns, many pension plans remain diversified across various asset classes and have benefited from strong public equity returns in recent years.

Adjusting Investment Approaches

In response to the challenges in the real estate market, public pension plans are adjusting their investment approaches. They are shifting their portfolios towards properties with stronger fundamentals, such as industrial and multifamily assets, while reducing exposure to distressed traditional office and retail properties. This strategic pivot comes amid rising borrowing costs and ongoing pressure on valuations, although some experts believe the market may be approaching a turning point that could signal a recovery.

The Complexities Faced by Public Pension Funds

The evolving dynamics of real estate investments highlight the complexities faced by public pension funds in a post-pandemic landscape. With the asset class experiencing a prolonged downturn and negative returns recorded in every quarter from late 2022 through mid-2024, there is a pressing need for strategic adjustments. As pension plans continue to adapt, the focus will likely remain on balancing risk and return in an increasingly unpredictable market.

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