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Tuesday, September 23, 2014

The effect of Desert Troon on PSPRS' investment returns

On September 3, 2014 PSPRS released this press release, Public safety pension gains for 2014 near $1 billion.  Being a press release, it is, of course, a self-serving piece, but after the last two years the PSPRS staff has the right to tout good news when it has some.  PSPRS' financial returns were covered in the September 4, 2014 post, "How did PSPRS' investment do in the fiscal year that just ended?", so there is really nothing new to discuss in regards to the press release.

What I was interested in was the document attached at the end of the press release.  The PSPRS 2014 Investment Summary ("the Summary") is a type of document that I have never before seen on the PSPRS website.  If they have released them in the past, I have not been able to find them on the website.  I suspect that this is not the type of document they would post to the website when PSPRS lost money in the prior fiscal year, but hopefully it will now be part of their regularly disclosed reports.  The Summary covers the fiscal year that ended June 30, 2014 and was produced by NEPC, LLC, an independent investment consulting firm.  The Summary breaks down all of PSPRS' investments, not just by asset class, but gives the portfolio of investments within each asset class as well.  This allows us to see what funds and firms PSPRS has invested with, how much, and the returns earned from each of them.

I was most interested to get a more detailed look into PSPRS' real estate portfolio.  In particular, I wanted to see exactly what effect the investments committed to Desert Troon had on PSPRS' overall performance.  If you go to page 50 of the PDF document, you can see a breakdown of PSPRS entire real estate portfolio.  At the end of the past fiscal year, PSPRS' total real estate portfolio had a market value of $873,820,740.  This accounts for 10.8% of PSPRS' $8,127,506,488 total market value.  The 10.8% allocation falls just about right in the middle of PSPRS' target range for real estate investments of 6-16% of the total investment portfolio.

The Desert Troon commitment to the real estate portfolio is $297,862,000.  This makes up 34% of the real estate portfolio and 3.7% of PSPRS' total investment portfolio.  The next largest real estate investment is in "Blackstone Rep IV" at $90,006,272, which makes up 10.3% of the real estate portfolio and 1.1% of the total portfolio.  The real estate portfolio is made up of 22 total separate investments with only two others valued at over $50 million.  So we can see that Desert Troon has a grossly disproportionate share of PSPRS' real estate portfolio.  Even more concerning is that Desert Troon's 3.7% of the total PSPRS investment portfolio is higher or equal to all but three other investment commitments: SSGA International Equity at 9.7% of the total portfolio, SSGA US Equity at 6.5%, and Black Rock Core Active at 3.7%.  The first two are index funds that are parts of the international and domestic equity portfolios.  The third is a bond fund that is part of the fixed income portfolio.

The total real estate portfolio had a -0.6% return for the past fiscal year.  This compares to the benchmark National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index return of 11.2%.  Real estate was the only asset class to have a negative return for the past fiscal year.  The Desert Troon commitment had a return for the past fiscal year of -16.4%.  16 of the 22 real estate investments had an annual return that surpassed the 11.2% benchmark, three had returns of 8-10%, one had no returns shown, perhaps because it was made in June 2014, and two had negative returns.  The other one that suffered a loss was "OWH Berkana Hld," which lost 24.8% and shows a market value of about $13.15 million.  If we do the math, the Desert Troon investment had an annual loss of $58.43 million, while the OWH Berkana investment had an annual loss of $4.34 million.  For perspective, the Blackstone Rep IV, the second highest real estate commitment, had a return of 32.6% and earned $22.13 million.

If we look at the three-year returns, 15 out of the 17 investments that have been held that long have a positive return, with nine meeting the benchmark.  Desert Troon is one of the two to have a negative three-year return (-3.1%), though it beat the other negative returner which had a -22.4% return.  Five-year returns show that 6 out of the12 that have been held that long show a positive return, with four meeting the benchmark.  Desert Troon is one of the six with a negative five-year return (-4.7%), though it bested three of the other six negative returners.  Desert Troon did have the dubious distinction of being the only real estate investment held for at least five years that had negative returns for one, three, and five years.  I guess they get some credit for consistency.  Even the other annual loser, OWH Berkana, managed a positive return over the three-year period.

If the total real estate portfolio of $873,820,740 had a return of -0.6%, this would equate to a loss of about $5.27 million for the fiscal year on a beginning year market value of $879,095,312.  If the Desert Troon investment had broken even, the total gain on the real estate portfolio would have been about $53.16 million.  This would have produced an annual return on the real estate portfolio of 6.05%, so the Desert Troon commitment dragged the real estate portfolio down by 6.11%.  If the Desert Troon investment had earned a modest 5% for the year, approximately $17.81 million, the real estate portfolio would have returned about 8.07%.  The total PSPRS investment beginning year portfolio value was $7,246,805,889, so the $58.43 million loss on the Desert Troon investment represents a 0.8% loss on the total PSPRS portfolio.

In summary, there appears to be an over-weighting of the real estate portfolio in Desert Troon while the portfolio itself has been consistently underperforming over the past five years.  In addition, if we go to the Desert Troon website, we can see that their properties are heavily concentrated in Arizona, though the website does not indicate what, if any, of the properties featured there have PSPRS funds invested in them.  In fairness to both Desert Troon and PSPRS, I would like to have seen 10-year and 20-year rates of return to determine if there was a long-term profitable relationship, but the current Summary is all that is available.  Regardless, it does appear that the relationship will need to change so that PSPRS can diversify its real estate portfolio and not have its returns so closely tied to a single company.

After hearing for over a year about Desert Troon, allegations that over-valuations were done to pad staff bonuses, federal investigations, and whether subpoenas should be made public, it is nice to see some actual investment numbers.  There are some who are really interested in that issue, but I am not one of them.  The valuation of real estate often appears to be more art than science when you are dealing with properties that are held for development purposes, and the valuations seems to change depending on the criteria used and who is doing the valuation.  I am more interested in how such a close relationship between PSPRS and Scottsdale-based Desert Troon developed.  I want to know why no one saw red flags with committing so much money with a single company that was so heavily dependent on the Arizona real estate market.  I am curious as to why REIT's or real estate index funds were not considered as a smarter, safer, and less costly real estate investment option.   None of this implies anything inappropriate, but rather, speaks to the need to examine the past behavior so it is not repeated.

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