The collapse and fall of Studebaker Corp in 1963 left 10,000+ employees holding their collective breath as their poorly funded pension fund was divvied up. 4000 workers received 15% of their value, and 2900 workers received no benefit. This significant event of an underfunded pension ultimately led to the Employee Retirement Income Securities Act (ERISA) of 1974. ERISA is a federal law that establishes the minimum standards for a pension plan in the private industry.
“The most powerful force in the universe is compound interest” – Albert Einstein
Before ERISA, very few private pension plans existed and of those that did exist few were properly funded to meet their unfunded liabilities (future payouts to employees). However, since ERISA companies have been forced to comply with certain requirements of funding. In simple terms, a company can achieve those minimum requirements by contributions (cash in) or through returns (interest). As pension funds began to grow slowly in contributions through the 70s and into the 1980s, the effects of compounding interest began to make for more significant amounts of capital. Now 40+ years later the compounded interest on pension funds has grown into a very substantial amount of capital.
To try and give an example of this I will use a simple example to try and give an understanding of this concept if private pension funds as a whole contributed $1M/year and received an average of 5% return over 40 years it would be worth over $120M. That is, of course, a simple breakdown, but the fact of the matter is that Morgan Stanley estimates that pension funds worldwide hold over $20Trillion in assets. Yes, that is a T as in Trillions. Which puts the pension funds as the largest category of investors ahead of mutual funds, insurance companies, currency reserves, sovereign wealth funds (SWF), hedge funds and private equity (PE).
In the example above I used a very simple breakdown and a straight 5% return over 40 years. If I had a crystal ball and could consistently deliver 5% returns risk-free, I would likely manage the vast majority of capital in the world. But alas, I don’t have a crystal ball nor do I manage most of the capital in the world. Since there is a risk in almost every investment in the world. Pension funds have devised a way in which they can help to hedge risk and still deliver their required rate of return. I have covered this before but as a refresher, this is achieved by diversifying their investments into four main categories: Equity, Fixed Income, Cash and Alternatives.
Equity = stocks, Fixed income = bonds, Cash = $$, Alternatives = Private Equity, Real Estate, Venture Capital.
As you can see from this chart from Pensions & Investments the alternatives segment of diversification has been on a steady growth rate over the last 40 years. Pension funds are finding that alternatives are proving to consistently deliver better returns. As pension funds have been growing exponentially in capital size and paired with the substantial increase in allocations towards alternatives we have seen a fundamental shift in the real estate capital markets.
As I talked about in the previous blog, institutional investors favor core/growth markets (SF, LA, NYC, London, Paris, etc.) at nearly an 8 to 1 ratio. The risk to these institutional investors is that they are growing by the day thanks to compounding interest and with higher allocations towards alternatives, they are all chasing the same core markets. The chase of these core markets then leads to institutional investors forced into overpaying for assets. As those assets then fail to perform as expected because of the higher purchase price the subsequent downturn in the cycle ensues, this is especially exaggerated in these core markets. Or this forces the institutional investor into other non-core markets.
The take away from this blog post is that pension funds and institutional funds are slowly beginning to take over the vast majority of real estate holdings and investments in all core markets the world over. As I don’t see the amount of capital slowing down (compounding interest and more allocations) anytime in the future, I am predicting that institutional investors will begin to pivot. As they pivot, they will start engaging in value markets. Today marks a fascinating period in which technology is increasing allowing more access to information; that was limited only to local players. An example is that it is just as easy for me to look at a property down the street as it is for me to research one 1500 miles away. Combine this with the fact that I believe value markets are trading at a discount from their true value. Over the next 10-20 years, I predict the value and second tier cities will see a wave of institutional investors pour money into urban core centers and redefine and reinvent the majority of American cities. Ultimately making the real estate markets more efficient.