St. Louis Post-Dispatch

12/18/2008

California's giant pension fund takes giant hit on real estate

By Michael Corkery, Craig Karmin, Rhonda L. Rundle and Joann S. Lublin THE WALL STREET JOURNAL

At the height of the property bubble, California's giant pension fund, known as Calpers, made a fateful decision: It aggressively poured money into real estate. As a result, today it's one of the biggest owners of undeveloped residential land in America.

Partly because of these investments, California Public Employees'

Retirement System is struggling to avoid one of its worst annual declines since its 1932 inception. Calpers has lost almost a quarter of its assets since July 1.

The problems come at a time of uncertainty for the nation's largest public pension fund.

Calpers is now warning California's cities, towns and schools that they may have to cough up more money to cover the retirement and other benefits the fund provides for 1.6 million state workers.

Calpers has said in recent weeks that it expects to report paper losses of 103 percent on its housing investments in the fiscal year that ended June 30. That's because Calpers invested not only its own money, but billions of dollars of borrowed money that must be repaid even if the investment fails.

In the latest wrinkle: To generate sorely needed cash, a troubled Calpers venture known as LandSource recently started the process of selling land in the worst property market in a generation. Calpers potentially could lose nearly $1 billion on LandSource, a $2.5 billion deal completed early last year.

With $239 billion in assets as of June, Calpers' portfolio was bigger than the government-run funds of Russia, South Korea, Dubai and Chile combined. In recent years, Calpers became much more aggressive than other pension funds in making nontraditional investments -- real estate, foreign stocks, even forest land.

Unless Calpers' returns bounce back by June, the fund expects that the rates it charges governments to participate in the pension could rise starting in 2010.

Calpers points out that its commercial properties, including a chunk of Time Warner Center in New York, haven't been nearly as hard hit as residential investments, which are valued at about $6 billion.

Together, residential and commercial holdings total about one-tenth of the fund's overall $182.6 billion portfolio. Its real estate portfolio fell 14.4 percent for the 12 months ended in September.

Calpers stresses that it is a long-term investor and can earn back the declines in the future, just as it erased declines suffered in the dot-com bust a few years ago.

"No one in the marketplace knew how swiftly the housing market would fall, not the Federal Reserve, not the Treasury," said Ted Eliopoulos, head of Calpers' real estate portfolio.

The fund also has added "checks and balances" on property-investment decisions, Eliopoulos said.

The details of Calpers' housing deals, and the identities of some of the house builders it invested with, are only starting to come to light. That's because investments often were made through ventures with names such as "Hearthstone Path of Growth Fund," and Calpers doesn't detail many of their holdings.

Calpers says its investments were done with "customary oversight"

and were "appropriate for the asset class and typical of the industry."

In recent years Calpers invested in:

-- Three large parcels near Phoenix, one of the nation's hardest-hit property markets. Last month, Calpers in effect walked away from one of the three, after having invested $140 million.

-- A massive block of land with room for about 8,000 units near the small town of Mountain House, Calif., the nation's most "underwater"

housing market by one measure. As of June 30, Calpers valued the investment at negative $305 million.

-- About 10,000 acres near Jacksonville, Fla. The plan was to sell timber from the property, as well as residential lots. But as real estate collapses, it could take five years before the venture can start selling lots.

Just one particularly bad year for investments can have serious consequences for California governments in the retirement system.

Calpers recently estimated that if its declines for the current fiscal year are greater than 20 percent, it would trigger an increase of 2 percent to 5 percent of an employer's payroll.

Currently, the average employer-contribution rate for public agencies, including cities and counties, is 13 percent of payroll, Calpers said, which is already on the high side for state pension funds, according to industry analysts. A 5 percent increase in California's rate would be the largest increase to hit public employers since the dot-com bust.

Rate increases aren't a certainty, Calpers says, as the fund still could earn back its declines.

Real estate losses aren't the primary reason Calpers is taking a hit. Its stock portfolio is down 41 percent this fiscal year.

But Calpers has targeted less money in bonds, and about double the allocation to private-equity investments and real estate deals, than the average public pension fund, according to Calpers documents and an industry survey.

Calpers got more aggressive in real estate amid the tech-stock selloff of 2000-02. Its board decided to increase its investments in real estate and private equity, shifting some money out of safer but lower-yielding holdings such as bonds.

Robert Carlson, a former Calpers board member who left the board earlier this year, said publicly at that time, "We believe taking no risk is the biggest risk you can take."

Land purchases are among the riskiest real estate investments. Not only can property values swing wildly, but unlike, say, a stock, land can take months or years to sell. Amplifying risk, many of Calpers' land investments used borrowed money.

Investing borrowed money acts as a lever: In a rising market, it lifts overall returns because you're profiting not only on your own capital, but the borrowed money, too. But in a falling market, that leverage amplifies losses.

To help it identify promising real estate investments, Calpers turned to a small circle of partners it had previously done deals with since 1992, albeit on a much smaller scale.

"The early investments had worked very well," said Barry Gross, president of Developers Research, an Irvine, Calif., advisory firm that had consulted on several earlier and smaller Calpers land investments. "Calpers said, if we can do it with 300 houses, let's do it with 3,000."

Michael McCook, then head of Calpers' real estate investments, proposed boosting returns by investing more borrowed money. "I told them it would help in the good times, and it would hurt in the bad times," McCook recalled telling the board in 2002.

Investing borrowed money is common in land-buying partnerships.

McCook said he felt Calpers would be at a disadvantage when vying for a piece of these deals if it was unwilling to boost returns in a similar way.

Calpers already had used borrowed money in commercial-property deals. Between 2001 and 2002, it raised the amount permitted to an average 50 percent from 25 percent.

In residential-property deals, traditionally Calpers hadn't used much borrowed money. But in 2005, the trustees sanctioned use of borrowed money in residential deals at an average rate of 60 percent.

Because the average rate applies to Calpers' entire housing portfolio, some individual deals used as much as 80 percent borrowed money, McCook said. Calpers says other public pension funds have invested borrowed money at the same level.

The increased use of borrowed money corresponded with the peaking property market. In 2004 and 2005, housing prices were jumping as much as 30 percent a year.

Until last year, Calpers' strategy worked. Through its housing partners, the fund pursued big, complex deals with large builders.

Returns on housing investments were an impressive 16 percent average annually from 2004 through 2006.

In a typical deal, Calpers would provide the funding to its partners, who would team up with a builder to buy land. Most of the equity would come from Calpers, while the builder would put down 10 percent to 15 percent, in exchange for the right to eventually buy the land.

Builders like to do this because it lets them essentially control land without having it weigh down their balance sheets. And Calpers hoped for big returns by selling that land to the builders in a booming market.

As the property market soured, deals that once looked smart revealed a dark side, because Calpers agreed to terms that exposed it to more risk in bad times.

For instance, Calpers guaranteed $1.7 billion in debt across several deals. Typically, house builders are the guarantors -- that is, they're on the hook in the event of a default.

By being guarantor, Calpers used its rock-solid reputation to obtain lower borrowing costs. But today, as projects struggle, the guarantees mean Calpers is pouring additional cash into projects from which it might otherwise walk away.

Calpers is setting up a new computer database to more closely track "balance and diversification" in the real estate portfolio. It also is proposing to reduce the maximum amount of borrowed money that can be used in housing deals, and to cut back on loan guarantees.