Efficient. Bare-bones. Cost-conscious. These words perhaps best describe the California State Teachers' Retirement System's approach to investing in real estate in general and multifamily properties in particular. After all, portfolio manager Jim Hurley is the only full-time staff member dedicated to the $1.5 billion multifamily fund. He runs a virtual corporation, relying on a team of operators, consultants, researchers, and auditors.
Entrepreneurial, though, may be an equally good way to characterize this operation. The $116 billion California State Teachers' Retirement System (CalSTRS), a Sacramento, Calif., pension fund, relies heavily on the expertise of joint-venture partners to buy and run properties. It gives those companies latitude to buy and sell buildings.
Broadening Horizons The seeds for CalSTRS' joint-venture system, unusual among conservative pension funds, were sown in the late 1990s. After the Dow Jones hit 11,000, the management team realized the equities market had become overheated and decided to diversify its portfolio. It decided to increase its real estate allocation from 2 percent to 5 percent.
Traditionally, CalSTRS, like other institutional investors, put most of its real estate money in industrial portfolios. To help better organize its expanded real estate investments, Mike DiRé, director of real estate, divided them into four product types – multifamily, office, industrial, and retail. In 2001, the real estate team saw that the pension fund needed to be more responsive to the market and more flexible in its approach to investing in it. In multifamily, for instance, the portfolio was almost entirely class A apartments in the Sun Belt region. "We needed to align ourselves with better operators, diversify the operators we used, and give them the flexibility to execute," Hurley says.
After evaluating different structures for multifamily, two years ago CalSTRS decided on joint ventures because it could invest in a variety of properties, without having to spend a great deal on staffing.
The joint ventures CalSTRS enters into are the key to its multifamily programs. So far, it has partnered with six developers – SSR Realty Advisors in Morristown, N.J.; General Investment and Development in Boston; Waterton Associates in Chicago; Fairfield Residential LLC in San Diego; Morgan Stanley's real estate group in Boston; and Apartment Investment Management Co. (AIMCO) in Denver – to invest in everything from class A development to student housing. Two more partnerships are in the works. Instead of purchasing properties itself and using an adviser to manage them, the pension fund partners with operators that buy properties. CalSTRS typically invests 90 percent; the partner contributes 10 percent. Partners receive management fees and a bonus if properties get returns above a prespecified amount. They also can buy and sell apartments at their discretion if they fall within agreed-upon parameters.
A Partnership While the pension fund is putting a lot of faith in its partners in these ventures, it knows that it has to if it wants to continue growing. "We realized that if we grew to 100 properties, it would be difficult to manage," Hurley says. "We wanted our partners to manage it instead."
The major drawback: CalSTRS would rely heavily on its partners to make the right decisions and not play fast and loose with the money. The pension fund and the partners set up parameters for the size, geography, and percent return expected for each property. These criteria differ by partner. If a property meets the specifications, the partner needs no further approval from CalSTRS to buy it. If, however, a partner finds an attractive property outside of the specifications, a board made up of representatives from both CalSTRS and the partner must review the proposal.
Each year, representatives of the pension fund and its partners sit down in late fall and develop a strategy for which projects to hold and which ones to sell. The partners generally make the buy-sell decision. "The strategy is determined by consensus, and tactics are determined by the operator," Hurley says. "We want operators to have flexibility without bringing every decision back to us."
CalSTRS' partners applaud this strategy. "The ability to have delegated underwriting authority based on meeting certain parameters is a great attribute of this program and a real responsibility," says Jerry Brand, senior vice president at Fairfield Residential.
Stringent Requirements Since CalSTRS gives its partners a lot of latitude in making deals, it only works with companies that have a track record in the niche and region it targets, share similar goals, and have a loyal, committed group of employees. "We want to partner with leaders in the multifamily industry," Hurley says. "We like to see companies with well-compensated employees and low turnover. We want alignment of the two companies and alignment of everyone involved. So, when everyone gets up in the morning, their first job is to make money for CalSTRS and the general partner."
The personal stake in each deal motivates the partners to do more than work for a management fee. "We are looking for good deals, where we can see a return on our investment dollars," says David Schwartz, managing member of Waterton Associates. "It puts us in CalSTRS' position. When we sell a property, we are looking at how much money we will make, not the loss of management fees," which would be the case with a typical manager for a pension fund.
The pension fund makes a point of paying market rates for management fees. "Because of our size, we could push their fees lower," Hurley says. "But since we want the best operators, we want our prices to be competitive." CalSTRS gives partners a performance incentive: Returns above the low teens (depending on each agreement) on a property earn them a bonus.
Spaces and Places CalSTRS knows the region and product types it wants to focus on for each partnership. For instance, when the pension fund sought to build affordable housing with a transit emphasis in California, it targeted and eventually partnered with Fairfield, which had good experience in that niche. When it wanted to do class B apartments, a mortgage banker pointed it to Waterton, which was accomplished in that area.
Though CalSTRS generally prefers to buy in Southern California, the Mid-Atlantic, south Florida, and the Pacific Northwest, the partners also invest outside of these areas. Case in point: a 700-unit property that Waterton bought in Dallas. Despite the fact that the property was in an underperforming market, CalSTRS and Waterton bought it for below-market value and spent $1 million to upgrade the amenities. Hurley expects the property, which is well located in Dallas, will benefit when that market recovers. He also thinks the capital program will improve both occupancy and rents.
CalSTRS saw a need for student housing, so it pursued a partnership in that arena. Eventually it joined up with the student housing section of AIMCO, one of the largest real estate investment trusts (REIT) in the country, which put up one-third of the money. "They had the resources and were committed to student housing," Hurley says. "They were interested in putting up more of their capital, while smaller firms don't have these resources."
As CalSTRS looks into future partnerships, demographics will play a big role. Hurley is well aware of the growing number of immigrants, echo boomers, and baby boomers hitting the market in coming years, and the fund will invest in product to meet the needs of these groups. It already is evaluating possible partners in the senior housing market and hopes to sign an agreement in the next nine to 12 months. "Over the next 20 years, [the country] will add 20 million new seniors," he says. "The senior market will be twice as big as the echo boom market. We are looking at the areas of the market that may require specialized expertise, like student and senior housing." CalSTRS already is working with Fairfield to produce housing in underserved urban areas of California. "This is very timely, given what's happening in California with housing shortages and housing affordability at record lows," Brand says. "Through this program, we have already created some affordable housing."
Adjusting to the Market Of course, other people notice these niches as well. When Hurley went to a recent National Multi Housing Council (NMHC) student housing seminar in Chicago, the number of attendees astounded him. He expected to see about 100 people, and more than twice that number showed up. He also noticed increased competition in the chase for class B properties as private investors move into that sector.
Still, Hurley knows class A is overbuilt in many markets, and he wants to meet the needs of renters priced out of this segment. To do this, he developed partnerships with Morgan Stanley and Fairfield to build affordable apartments. Hurley thinks affordable housing can give the company the same return as its class A properties while leasing up a lot quicker.
Although both partnerships develop in urban areas, the programs differ. Fairfield builds its own projects, while Morgan Stanley's mandate is to give small developers a chance to work with CalSTRS. Unlike other partners, Morgan Stanley does not develop the land. Instead, it seeks out small multifamily developers in urban centers to work with. So far, it has partnered with one regional developer to build a 250-unit affordable, senior housing project in Santa Rosa, Calif.
Competitive Balance Regardless of what happens in each of its market niches, CalSTRS looks at the big picture. It wants the ability to grow to 25,000 units by 2007. The next step is to become competitive with other capital sources, such as General Electric and Fannie Mae. To do this, Hurley thinks one move the pension fund needs to make is to upgrade internal oversight systems.
Key to achieving the upgrade is a planned Web-based reporting system to allow CalSTRS' staff, partners, auditors, and consultants to access real-time property information, such as how class A properties are performing vs. class B properties and occupancy rates across the portfolio.
In addition, the company wants to find a construction consultant to critique developments. Specifically, the consultant would look over each development from an owner's perspective, taking a long-term perspective. "We need to do some more work as far as how we handle the oversight of the development process," Hurley says. "By using outside contractors, I think we are making good progress in that direction."
The pension fund also aims to develop a track record as a place for multifamily developers to go for capital. "I think we need to continue to be responsive to the realities of the market and increase our flexibility," Hurley says. Entering into joint ventures helps. "The realities of the market are what's happening out in the field," Hurley says. "People who are best able to respond are operators with experience in that product. We need to let the operators adjust to the market."
Outside Opinions While the California State Teachers' Retirement System (CalSTRS) in Sacramento, Calif., strives to perfect its joint-venture system and increase its flexibility and responsiveness, many of its partners already like the latitude they get. "We have much more flexibility [in our relationship with CalSTRS] as to how we can invest the capital since we are really in a partnership," says Fred Lieblich, president of SSR Realty Advisors.
The pension fund's ability to let its partners act autonomously is only one thing that makes it attractive to multifamily developers and operators. Its versatility is another. "Because of CalSTRS' size, they are able to do a lot of different things," says David Schwartz, managing member of Waterton Associates. "They are big enough to do core, value-added, student, and affordable housing. They are not just stuck with core [class A apartments]."
So, while CalSTRS' joint venture system – just two years old – is not where portfolio manager Jim Hurley may want it to be, it's developing a track record. "They are already an enormous source of capital," says Jerry Brand, senior vice president at Fairfield Residential. "If we generate the proper returns, I think there is a great potential to go back to them for more capital."
CalSTRS at a Glance
- Year founded: 1913
- Location: Sacramento, Calif.
- 2003 Revenue: $156 million
- Number of Units in the Pipeline: 2,049
- Expected Units Added within Three Years: 8,000
- Geographic Coverage: Nationwide
- Revenue Streams: Contributions of various school systems to the pension fund and returns from investments.
- Number of Employees: One person devoted to multifamily. Seven devoted to real estate.