Real Estate Asset Allocation and the Decisionmaking Framework Used by Pension Fund Managers
Worzala, Elaine M, Bajtelsmit, Vickie L, Journal of Real Estate Portfolio Management
Executive Summary. This study summarizes a survey that examined the decisionmaking process used by large defined benefit pension plans in their real-estate-only portfolios. Most researchers have concluded that a welldiversified portfolio should contain at least 10%-20% real estate. But it is well documented that pension plans typically hold less than 4%, on average, in equity real estate. The survey results provide some evidence to partially explain the divergence of theory from practice, as the decisionmaking process differs substantially from that recommended by theory. Furthermore, the decisionmaking process for equity real estate investment differs by size and type of fund, making generalizations across funds inappropriate. Furthermore, reported allocations may actually be incomparable across pension funds, since managers disagree about the classification of REIT shares (i.e., if they are real estate or common stock).
Although the academic community has often been criticized for producing research that has little practical application, theoretical developments in finance in general, and investments in particular, have had a strong impact on practice over the last twenty-five years. Aggarwal (1993) suggests that it is important for academics to continue to develop theories and concepts independently of what is being done in practice, but that an ongoing dialogue with practicing professionals is necessary to fully understand areas of practice that continue to rely on qualitative judgment and subjective assessment. This study adds to the body of knowledge of managerial behavior by reporting the results of a survey sent to real estate managers at pension funds. Although factual data on pension funds, such as dollars under management and asset allocation percentages, are regularly collected by government entities and private companies, little is known about the actual decisionmaking process used to make asset allocations, both for the mixed-asset portfolio and for the allocations within the real-estate-only portfolio. Since equity real estate is an asset class that is generally believed not to fit many of the assumptions of portfolio theory, the results of this survey provide some valuable insights into the current thinking of major institutional investors.
Total pension dollars invested in real estate have increased from $15 billion in 1983 to $29 billion in 1993 and represent one of the largest sources of investment dollars for commercial, office and retail projects.l The Employee Retirement Income Security Act of 1974 (ERISA) holds investment managers to a high standard of conduct in their decisionmaking. However, fiduciary liability rules do not require that managers use the latest in theoretical investment techniques, only that methods used for asset allocation must be justifiable under a prudent expert standard (see ERISA, Section 404a).
The next two sections briefly review the relevant literature and other recent surveys of pension plan investors. The research methodology is then described in section four and results of the survey are detailed in the fifth section. Finally, the main findings are summarized.
APPLICATION OF THEORETICAL MODELS TO REAL ESTATE INVESTING
In recent years, there have been several studies examining the role of real estate in institutional investment portfolios.2 Bajtelsmit and Worzala (1995) show that large pension funds have less than 4% of their assets in equity real estate currently, which is inconsistent with the "optimal" allocations derived from mixed-asset allocation studies. Using historical data, these studies have generally concluded that institutional portfolios should have a minimum of 10%-20% of their total assets invested in real estate. Despite strong arguments favoring the use of modern portfolio theory (MPT) in the management of large pension plan portfolios, the evidence in the real estate literature is that the industry has been slow to adopt modern methods of portfolio allocation (Webb, 1984; Louargand, 1992). …