The Hartford YMCA honored Earvin “Magic” Johnson Oct. 15 for his commitment to investing in urban areas. The State of Connecticut’s pension funds, managed by Treasurer Denise Nappier, have lost $15 million to date investing in two funds managed by Johnson’s company, Canyon-Johnson, as reported by Raising Hale. Nappier’s office did not comment before deadline, but spokesman Christine Shaw responded to an email Q&A after publication.
How did you decide to invest in urban real estate? How did you decide to invest with Canyon-Johnson II? CJUF III?
The Connecticut Retirement Plans and Trust Funds (“CRPTF”) adheres to a long term asset allocation plan, which includes a 5% allocation to real estate investments. The CRPTF invests in real estate to generate a return stream of current income and capital appreciation. It also invests in real estate to diversify its portfolio against its stock and bond holdings and due to real estate’s ability to protect against inflation over the long term horizon.
The CRPTF invests in urban and rural real estate in order to meet its primary return objectives for its real estate investment strategy. Urban and rural real estate provides a unique niche investment opportunity driven by inefficiencies in these markets and barriers to entry, therefore providing untapped return potential. Of further interest to the CRPTF is that these opportunities exist here in Connecticut and offer the potential to further enhance economic development within the State.
The CRPTF has made two investment commitments as a limited partner with Canyon Johnson funds. The first investment was a $50 million commitment in the Canyon Johnson Urban Fund II (“Fund II”), a 2005 vintage year fund with $600 million in total commitments. The second investment was a $50 million commitment in the Canyon Johnson Urban Fund III (“Fund III”), a 2007 vintage year fund with $1 billion in total commitments.
These Funds represent opportunistic real estate investments that target urban retail and residential development projects. The Funds focus on inner city areas that have high concentrations of ethnically diverse and underserved communities. In employing these strategies, Canyon Johnson works closely with local governmental and other community organizations to tailor its investments to meet local needs and fully access available economic incentives.
In order to meet its investment objectives, the CRPTF follows a rigorous due diligence process to identify and select appropriate investment opportunities. The Treasurer’s decision on any investment is informed through the due diligence efforts of in-house professional investment staff and an outside consultant, and a formal recommendation by the Chief Investment Officer. The Treasurer then presents each of her investment recommendations to the Investment Advisory Council (“IAC”) for its feedback that she considers prior to entering into a contract.
The Treasurer’s decision to invest in these Funds followed full due diligence by the then outside consultant, Pension Consulting Alliance, in-house professional investment staff, and a formal recommendation by the Chief Investment Officer, and after receiving positive feedback from the Investment Advisory Council. The terms of the partnership, the investment strategy and other key documentation were reviewed during the due diligence process and served as key elements of the investment decision.
Canyon Johnson is one of the early pioneers of urban investing and has amassed a solid team of investment professionals that have worked together for over 20 years with proven depth and skill sets to navigate through the complexities of this niche market. The investment merits that supported the worthiness of this opportunity at the time of investment included a strong track record, with the first fund largely realized, an attractive investment return target, a proprietary network of deal sourcing, and a proven investment strategy.
Are you satisfied with the performance of the two Canyon-Johnson funds the state has invested in? Are you satisfied with the performance of the real estate investments as a group?
Like most real estate funds committed during the peak of the market in 2005 to 2007, investments made during this time period have struggled. Fund II, a 2005 vintage year fund, is mostly invested and still has several more years to harvest investment results. As of June 30, 2010, Fund II has a net internal rate of return of -3.95%, performance that is competitive with similar funds of that vintage. No investments in Fund II have been realized and until they are the ability to predict the final performance results with certainty is unknown.
Also, note that Fund III did not make its first investment until December 2009 and still has approximately 75% of the CRPTF’s $50 million commitment yet to be drawn and available for new investments. As a result, the unfunded commitment remains under the Treasury’s custody and is fully invested with periodic pacing studies performed to ensure that capital calls can be honored in a timely fashion.
Why have the state’s real estate investments lagged behind the NCREIF index (-.81 percent over seven years vs. 6.7 percent)
The CRPTF attributes its underperformance to the NCREIF to three factors: first is the incorporation of the legacy investment portfolio into a best of class real estate investment strategy; second is the comparison of the benchmark to the construction of the CRPTF portfolio; and the third factor is attributable to the tumultuous real estate markets since 2008. Each of these three factors is discussed below.
Treasurer Nappier, with the assistance of a real estate expert consultant, redeveloped the strategy for CRPTF investment in real estate assets against best practices for this asset class. The foundation of the strategy for building an illiquid private real estate portfolio is centered on the basis of diversification, which includes diversification by vintage year, geography, manager and strategy. However, the long-term implementation of the strategy has not always been the case, and during the past several years, the CRPTF has been slowly re-building its real estate portfolio as a result of its inherited legacy real estate portfolio and its desire to align the performance of the real estate portfolio with its policy objectives:
(1) During a prior administration, the real estate portfolio was virtually gutted, leaving only investments with significant impediments for sale or which were seriously impaired. It took the Nappier administration several years to address the long-term challenges left by some hasty decisions. The CRPTF was, simply put, not positioned to take advantage of one of the longest and strongest real estate booms our nation has seen.
(2) In addition to the need to address a difficult portfolio, the corrupt activities of Treasurer Nappier’s immediate predecessor warranted a hiatus from making commitments to illiquid investment vehicles at least until (a) her administration could understand the depth and breadth of damage done and (b) Nappier’s recommendations for Treasury Reform could be considered and adopted by the state legislature and implemented by her office. Therefore, the CRPTF did not re-enter the real estate investment market until 2004.
In an effort to properly implement our real estate strategy, Treasurer Nappier has taken several years to re-build the real estate portfolio, jettisoning non-performing and difficult investments and searching for core, value added and opportunistic investment products.
In addition to the issues associated with the legacy real estate portfolio, the CRPTF’s benchmark, the NCREIF index, is an unlevered, core property index. Comparatively speaking the CRPTF manages its real estate portfolio through a combination of real estate strategies of core, value add and opportunistic investments. The CRPTF implements these strategies utilizing various degrees of leverage.
Over the past seven years, the most conservative, unlevered core investments have performed the best as market participants were not properly compensated for taking on additional risk. Therefore, given the CRPTF’s use of strategies that utilize more leverage, the portfolio underperformed its unlevered benchmark.
Additionally, the CRPTF rebuilt its real estate portfolio beginning in 2004, with the subsequent vintage years representing some of the most difficult times in the real estate market since the Great Depression. Typically, the first five years of an investment – known as the “j-curve” – do not produce indicative performance results because the fund is too young. As investments are realized, actual performance results crystallize — typically during years 5 through 10 of the investment. The Great Recession has exacerbated the typical j-curve effect through the significant disruption in the real estate markets characterized by significant peak to trough declines of over 40%, lack of market transactions, inability to secure financing, high levels of unemployment and low levels of economic growth.
With that said, the real estate portfolio has a 40% percentage allocation to core assets which are beginning to rebound. The balance of the portfolio is invested in value add and opportunistic strategies, and includes nearly $500 million in unfunded commitments that are ready to be invested at the much more attractive valuations.
What is your plan for making real estate investments going forward?
The CRPTF will continue to prudently manage its real estate portfolio within the risk and return parameters prescribed by policy. To date, the CRPTF has slightly increased its core allocation by $50 million and successfully invested $200 million in the Public-Private Investment Program (“PPIP”) during 2009. The PPIP investments are on track to meet our return objectives of 15% to 18%.
During calendar year 2011, the CRPTF is scheduled to begin an asset allocation study, which will reassess the capital market outlook for all assets classes, including real estate, and develop policy weights for each of the CRPTF’s 14 plans and trusts.