Insurance Companies Cut Direct Real Estate Assets

With the start of Prudential Insurance Company's three-year divestiture plan for its $5.6 billion real estate portfolio, life insurance companies' quiet disposition of real estate over the past several years has dramatically accelerated. Prudential, however, does not plan to leave the real estate business entirely. Instead, the company plans to trade some of its portfolio properties for real estate investment trust (REIT) stock, commercial mortgage-backed securities (CMBS), and private commingled funds. Joining Prudential in the disposition of directly owned properties are John Hancock Mutual Life Insurance, Equitable Real Estate, and the Principal Financial Group.

Shrinking life insurance company real estate ownership also has been reported by Equitable Real Estate's Investment Research Department, which tracks ownership of equity (direct ownership) and debt (mortgage instruments) real estate among the institutional real estate players (life insurance companies, savings associations, foreign investors, pension funds, REITs, commercial banks, and other sources). According to Equitable, the total value of institutionally owned real estate is estimated at $1.23 trillion. This total is split between $236.8 billion in equity and $995.5 billion in debt.

Life insurance company real estate holdings, as measured by their percentage of total institutional real estate, have decreased for both the equity and debt real estate categories. The percentage of total institutional real estate debt held by life insurance companies has decreased dramatically from 24.1 percent in 1991 to 19.9 percent by year-end 1995. Meanwhile, life insurance companies' percentage of institutional real estate equity decreased from 22.5 percent at year-end 1994 to 20.6 percent by year-end 1995. From 1994 to 1995, the rate of decline for equity ownership was much sharper than for debt ownership.

Several factors are behind the life insurance companies' sharp downturn in direct ownership of institutional real estate: strengthening values, low liquidity, management requirements, balance sheet considerations, and risk diversification.

Strengthening values. Institutionally owned real estate has experienced a significant upturn in the past several years, resulting in strong price appreciation for office, industrial, hospitality, and multifamily product categories. Given the strengthening market values, life insurance companies have had the ability to sell individual assets or a package of properties at prices that will provide an increased yield. Life insurance companies are selling properties to capitalize on these improved market conditions. Generally, life insurance company "fire sales" of the early 1990s have ended.

Low liquidity. The value of commercial real estate fluctuates widely over the course of the real estate cycle. Because real estate operates on a 15-year market cycle, owners must time purchase and sell decisions carefully to maximize a property's yield. When the real estate cycle becomes unfavorable, owners are left with the unenviable option of either selling the assets at a reduced price or waiting for a potentially extended period of time for the market to recover.

Management requirements. Even when property management functions are outsourced, the property owner must expend a great deal of time and energy monitoring each property carefully to ensure that it is properly managed and maintained. This management function increases staffing requirements of life insurance companies that own real estate, which can significantly increase the cost of owning property.

Balance sheet considerations. Because depreciation is subtracted from net operating income, the rate of return on properties held on the balance sheet is reduced. Since REITs, CMBS, and commingled funds do not represent direct ownership of the property, they are treated on an off-balance sheet basis. In addition, costly depreciation recapture taxes do not have to be paid when the security is sold. Another important factor is that risk-based capital requirements are significantly lower for investment-grade securities than for direct ownership. This frees up capital for investment that would have to be kept in low-yielding reserve accounts.

Risk diversification. By utilizing a variety of financial instruments such as REITs, commingled funds, and CMBS, an investor can diversify a portfolio's risk. Even limiting purchases to a single security category, adequate diversification can be created. Take REITs for example: risk could be diversified by purchasing several REITs with differing geographic and product category orientations. To obtain the same level of diversification through direct ownership, an investor would have to purchase properties numbering in the hundreds.

Despite the advantages of nondirect ownership, life insurance companies purchased real estate because the yields of direct ownership are potentially higher, although the yields have closed recently due to the strong performance of REITs and commingled funds. Another important factor behind the shift away from direct property ownership is the institutional real estate market's growing acceptance of real estate securities. With the total capitalization of CMBS and REITs estimated in the $165 billion range, they have reached critical mass. These changes represent a fundamental reprioritization of how life insurance companies will hold real estate assets.

Over the next several years, look for the share of the equity pie to increase for REITs and commingled funds at the expense of life insurance company direct property ownership.

However, because of the strong potential yields, life insurance companies will continue to participate in direct property ownership, but will do so at lower allocation levels than they previously have.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.