Separate Account Real Estate Investments: What Do I Need to Know and What is My Role?

The NAPPA Report

Separate account real estate refers to the direct ownership by a public pension plan in income producing real property, and in some cases, the property where the public pension plan has its headquarters building and related operations. Many public pension plans choose to use direct investment in real estate as part of their overall real asset investment strategy. Depending on the size of the public pension plan and its specific investment objectives, it is common for public pension plans to have an asset allocation of 5 to 10% of total assets to real estate as part of its overall investment portfolio. In some cases an investment allocation to real estate also includes "real assets" such as timber, farmlands and even infrastructure investments. While some public pension plans have an exposure to real estate only through alternative investment vehicles, others either combine investment in real estate through both separate accounts and alternative investment vehicles and still other public pension plans only invest in real estate through a separate account. The following outlines the basics of separate account real estate transactions and what a public pension plan's general counsel or in-house counsel needs to know about these transactions.

Why separate accounts?

Separate account real estate provides more direct exposure to the real asset class so that public pension plans can receive more of the upside potential. In addition, overall operational costs may be reduced if the public pension plan owns its headquarters building rather than leasing space. In some states, public pension plans may also obtain property tax exemptions for the building in which they operate. Most significantly, public pension plans will receive direct income from tenants located on the property. Finally, unlike other alternative investments, a complete loss of principal is very rare, so long as the property remains insured at all times.

Many public pension plan investors prefer to invest in real estate through a developed separate account real estate investment program rather than through commingled real estate investment funds in order to retain control over the investment decisions. Typically, to maintain control, the public pension plan would require its board of directors to approve each real estate asset acquisition or disposition. This is a significant difference from a commingled fund investment because a general partner of a real estate limited partnership or other commingled entity is not required to seek approval from the limited partner investors for the acquisition of a real estate asset or the implementation of an investment strategy since the general partner would be unable to quickly implement the investment.

Common investments within the separate account real estate classification include offce, multi family residential, retail and industrial properties. In order to ensure full diversification, public pension plans are advised to spread investments across property types, location and property size/value. Within the real property or real asset investment allocation, public pension funds have very different approaches to the use of separate accounts. Again, the average public pension plan has an allocation of between 5 to 10% of overall assets towards real estate, although some advisors (such as J.P. Morgan, in a 2012 white paper) are predicting increases to up to 25%, in large measure due to reduced returns from equities and bonds and increased pressure to meet return assumptions of 7 to 8%. So long as a separate account portfolio is large enough to attain diversification, such a portfolio could constitute a significant portion of the real estate/asset allocation. Some funds are able to achieve reasonable diversification with a portfolio as small as $100 to $200 million, although this depends heavily on the ability of an advisor to find available properties that otherwise meet risk and return objectives. With the overall trend toward increasing real estate allocations, however, many public pension plans should consider whether separate account may work for them.

How does separate account investment work?

Most public pension plans hire a separate account real estate advisor to investigate opportunities and to coordinate the purchase and operations of direct real estate investments. Public pension plan investors have the option of selecting a non-discretionary account or a discretionary account for purposes of their real estate investments. With a nondiscretionary separate account the investor will engage a real estate advisor to assist with acquisition, asset management, and disposition of real estate investments on behalf of the public pension plan. The non-discretionary option allows the public pension to retain control of what actions the real estate advisor takes without prior approval of the board. The advisor may not have the authority to purchase or dispose of a real estate asset or make investment decisions without the prior approval of the board. Because a non-discretionary option tends to be a time consuming process that requires hands-on participation from the board, most public pension plans today select a discretionary separate account program. In a discretionary account, the board will establish certain investment guidelines but otherwise delegates responsibility for making all investment decisions to the real estate advisor. Another option for some public pension plans who want to blend the investment decision-making responsibilities is the quasi-discretionary account or "discretion in a box." This approach allows many decisions to be made by the advisor in accordance with a predetermined investment strategy agreed to by the public pension plan and the advisor while at the same time requiring board approval for major investment decisions (such as acquisitions or dispositions, significant capital expenditures, or change in the investment strategy). This approach allows some level of control but fewer decisions are subject to review and approval by the board.

Public pension plans are well advised to work with their overall plan advisor to make sure that the selected investment strategy complies with the public pension plan's risk and return assumptions. Public pension plans will frequently divide separate accounts into three different overall strategies: 1) core, 2) value-added and 3) opportunistic. Core is generally a stabilized property that is close to fully leased and is intended to provide steady rental income and an overall increase in value over time. Value-added investments frequently involved a repositioning of an existing asset, either because it is under leased, or a group of tenants is about to leave the property upon lease expiration. Investors will frequently complete a repositioning and then sell the property. Opportunistic can be a higher risk version of value-add or may be a brand new development project. In general, public pension plans may be open to any of these three investment strategies, but a larger allocation to core is the most common for our public pension plan clients.

Once an individual property has been identified by an advisor for potential acquisition, the parties will negotiate and enter into a contract more commonly referred to as a "Purchase and Sale Agreement." A key initial question for most public pension plans is whether to set up a new entity for the purpose of holding title to the asset, such as the 501(c)(25) title holding corporation, named for the section of the Internal Revenue Code that authorizes these income-tax exempt entities. Additionally, public pension plans should consider what level of control they wish to have on the corporate functions of any title holding entities. The benefit of using a separate entity is that it potentially protects the parent plan from liability associated with the property, whether it be due to personal injuries or environmental contamination. In addition, 501(c) (25) entities that are created under an umbrella 501(c)(25) are permitted to consolidate tax returns, which can reduce administrative expense for public pension plans that own multiple properties. Some public pension plans also prefer a stronger level of control within the corporate entity that holds title, such as by retaining all seats on a board of directors, holding all offcer positions or requiring that certain actions outside the ordinary course of business obtain approval of offcers or directors installed by the public pension plan.

Once a Purchase and Sale Agreement has been executed and the public pension plan has made decisions associated with the corporate entity to hold title to the property, the public pension plan should engage in a thorough due diligence review of the status of the property to be acquired. This due diligence review generally includes review of all commercial leases, contracts, and similar agreements effecting the property, as well as the zoning, physical condition and title status of the property. The due diligence process is critical to ensure that the property meets the investments or operational needs of the public pension plan and that the public pension plan is receiving what it is paying for. If the property does meet the public pension plan's needs, then the public pension plan will complete the acquisition of the property. It typically takes about 30 to 60 days to complete the necessary due diligence and finalize the closing documentation. Most public pension plans use funds from their real asset classification to acquire properties, although some will use conventional financing, particularly for properties where the hold time is anticipated to be shorter. After closing, the public pension plan and its advisors will then operate the property by entering into new leases, negotiating lease amendments and agreements related to property management, and establishing contracts with third party service providers in connection with the operation of the property. After return objectives are met, the public plan will typically sell the property unless there is a business reason for holding on to the asset in its real estate portfolio.

What is the general counsel's role?

As a general matter, most separate account real estate transactions fall into the jurisdiction of real estate and general transactional attorneys. Public pension plans generally adopt the following three strategies for completion of the legal work associate with separate account transactions: 1) use of in-house counsel; 2) use of outside special real estate counsel; or 3) use of real estate counsel selected and controlled by separate account real estate advisors. Many in-house counsel find that even though they have the expertise necessary to complete separate account real estate transactions, their time is constrained by day to day operations of the public pension plan, such as dealing with fiduciary matters, litigation, benefits, disability disputes or other investments. Thus, most employ outside counsel either directly through the public pension plan or through investment advisors. Because of the potential for conflict of interest associated with the advisors' oversight and hiring of real estate counsel, we recommend that the public pension plan not rely on counsel retained by the advisors or even the advisors' own staff counsel but rather engage real estate counsel directly. However, many advisors have counsel with whom they have excellent relationships and who will work directly with the public pension plans, instead of the advisor which may be appropriate for many public pension plans.

However counsel is selected and retained, we believe that there are two key roles the general counsel should ensure that their outside counsel fulfill: 1) complying with all laws and regulations on the public pension plan's real asset investments; and 2) making sure that the advisor meets all obligations they may have to the public pension plan. First, with respect to compliance matters, these may include state laws and local regulations on the general operation of public pension plans, such as the Open Meetings requirements and Freedom of Information Act. As part of any overall separate account real estate strategy, general counsel should consider carefully whether their own state or local versions of these laws require disclosure to third parties of contracts necessary for the acquisition, operation and disposition of real property assets, and whether discussions of these contracts are required to be held in open session of the public pension plan's governing board. For example, California's versions of the Open Meetings Act, the Brown Act and the Bagley-Keene Open Meeting Act, have exceptions to the general requirement of Open Meetings for discussion of price or payment terms for real property negotiations. In addition, some local ordinances provide detailed rules on how and under what circumstances a public pension plan may invest in certain asset classifications. For example, one of our clients had an ordinance that only permitted the use of certain kinds of corporate entities for real estate investments, which excluded the use of limited liability companies in real estate investments. Ultimately, a lender for a proposed investment property required that the public pension plan use a Delaware limited liability company in order to receive loan funds. This required modification of the public pension plan's ordinance, as well as modification to the Investment Advisory Agreement governing the relationship between the public pension plan and its investment advisor. We recommend that general counsel review local rules in conjunction with entering into any Investment Advisory Agreement, Investment Management Agreement or Property Management Agreement with a separate account real estate advisor and/or manager, with which outside real estate counsel should assist.

General counsel should also be aware of the investment advisor's compliance with its own obligations. These obligations include compliance with the Investment Advisory Agreement, the corporate formalities of any separate entities used to hold title to real estate and general good and prudent real estate practices. As above, for example, if an Investment Advisory Agreement only permits an investment advisor to engage in core real estate transactions, general counsel should advise the governing board that a proposed investment does not comply with the terms of such Investment Advisory Agreement. If the board still wishes to move forward with such investment, modifications to the Investment Advisory Agreement should be completed. In addition, if a separate title holding entity is used, it is critical that the corporate formalities of such title holding entity are maintained. If proper formalities, such as holding separate meetings of the board of directors and segregating assets, are not followed, the entity may be subject to "piercing the corporate veil." Such doctrine is invoked when seemingly separate corporate entities are so closely aligned and operated such that the assets of one entity may be used to satisfy judgments of another. Because the purpose of using title holding entities is to prevent such consequences, corporate formalities are critical. Finally, the investment advisor should follow good and prudent real estate practices, in conformance with the investment strategy for the relevant real estate investment. The investment advisor should either know or engage local brokers who know what prevailing market conditions are within a region, what the overall leasing outlook is for a particular property class within such location, and how aggressively to market a property for sale or for lease. Real estate transactions do not always go smoothly, but knowing that an investment advisor is knowledgeable about the asset classes and local market conditions can reassure a public pension plan and its board that they are being prudent with the public pension plan's assets.

Separate account real estate transactions need not be a mystery to public pension plans and their in-house counsel. For many public pension plans, direct investment in real estate makes good sense, as the public pension plan will receive direct exposure to an asset classification. In their role as overall legal advisor to a public pension plan, in-house counsel are well advised to ensure that separate real estate account transactions comply with state and local rules governing the public pension plans and that the investment advisors retained to oversee the separate account portfolio are meeting their contractual and statutory obligations.

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