OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM 277 EAST TOWN STREET, COLUMBUS, OH PERS (7377)

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1 MEMORANDUM DATE: January 5, 2006 OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM 277 EAST TOWN STREET, COLUMBUS, OH PERS (7377) TO: CC: FROM: OPERS Retirement Board Members Laurie Hacking Executive Director Jenny Hom, Director Investments Greg Uebele, Senior Investment Officer External Management Bradley Sturm, Real Estate Manager RE: Private Real Estate Strategy Review Purpose As outlined in monthly Real Estate Program Review Updates since June, staff, working closely with The Townsend Group (TTG), has performed a comprehensive review and revision to the real estate strategy. This memo provides an overview of these activities and the resulting private market real estate strategy as outlined in the 2006 Investment Plan. The real estate strategy is ultimately governed by the Real Estate Policy, which for convenience, is provided as Attachment A. Background OPERS began investing in commercial real estate in late In the early 1990s, OPERS adopted an opportunistic investment strategy, which led to fairly consistent long-term outperformance. OPERS strategy was to exploit weaknesses in the real estate capital markets by overweighting investments in out-of-favor property types that lacked capital. In addition, OPERS took advantage of the then nascent and out-of-favor public REIT market by over or underweighting REITs relative to private directly held investments. The gains in OPERS REIT investments during this time provided a substantial amount of the past outperformance generated by the overall real estate portfolio. OPERS also exploited pricing inefficiencies by investing along the entire capital structure, taking advantage of risk/reward imbalances between equity and debt. This opportunistic investment style was combined with a control-oriented approach. Specifically, staff retained ultimate control of the individual acquisition and disposition decisions through separate account managers. Again, this model worked well when the commercial real estate market was less efficient and permitted slower execution speeds. Furthermore, OPERS had a preference for using 100% equity in acquisitions. With the explosion of cheap debt during the last few years, our cost of capital became a material disadvantage, preventing OPERS from achieving its acquisition targets during the recent bull market. This supply of capital sharply contracted the speed of execution requirements, also 1

2 curtailing our ability to close. Thus, staff s control oriented opportunistic strategy became stale and ineffective leading to under allocations and under performance. Market Review While real estate is primarily driven by local factors, aggregate transaction and capital market conditions have changed considerably in recent years. Figure 1 shows the number and market value for the National Council of Real Estate Investment Fiduciaries (NCREIF) transactions since This figure shows that the market has matured from annually averaging about $5 billion in under 200 transactions through 1996 to over $20 billion in approximately 600 transactions during the last two years. The increased level of activity has been driven by two primary factors: 1) real estate has been the highest performing asset class over the last five years leading to increased demand from institutional investors and 2) the unprecedented liquidity that greatly reduced the cost and increased the availability of capital for transactions. Figure 1. NCREIF Property Transactions NCREIF Property Sales As of 9/30/ ,000 Properties Source: NCREIF, The Townsend Group Year # of Properties Market Value The capitalization rate is the net operating income of an asset divided by the price of the asset, or the inverse of the price earnings ratio. Figure 2 shows that the increased liquidity during the last few years drove cap rates to unprecedented levels. Since prices move inversely to cap rates, pricing is at record levels. Sophisticated investors are taking advantage of this sellers market by culling their portfolios of marginal assets and exercising extreme caution in pricing acquisitions. 25,000 20,000 15,000 10,000 5,000 0 Market Value (millions) 2

3 Figure 2. NCREIF Quarterly and Average Cap Rates Since 1978 Cap Rates vs Historical Average As of 9/30/ % 10% 9% 8% 7.86% 7% 6% 5.85% 5% 4% 1978Q1 1980Q3 1983Q1 1985Q3 1988Q1 1990Q3 1993Q1 1995Q3 1998Q1 2000Q3 2003Q1 2005Q3 Source: NCREIF, The Townsend Group CV CAP Rate CV CAP Rate Average Another significant factor on real estate is the vacancy rate trends. Figure 3 shows that the association between vacancy rates and cap rates, while somewhat weak, was generally directional through More recently, liquidity and supply/demand factors seem to have altered this relationship. Figure 3. NCREIF Vacancy Rates and Cap Rates NPI Vacancy vs Cap Rates 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Source: NCREIF, The Townsend Group Vacancy Cap Rate Market Outlook Unrealized gains and losses for private market real estate are based on periodic property appraisals. This appraisal process is backward looking, so appraisal values tend to lag current 3

4 market transaction values. Given the substantial decline in cap rates over the past two years, we foresee additional appreciation in the assets that constitute the NCREIF Property Index (NPI), as the appraisals catch up with current pricing. Thus, good assets in existing portfolios should experience at least one more year of above average returns. After a remarkable compression in cap rates, it is unlikely that this trend will continue for an extended period of time. Through 2006, staff expects that cap rates should generally be bound by 5.25% and 6.75%. Borrowing costs are beginning to increase and staff anticipates that at the margin, leveraged buyers should begin to be displaced by institutional investors willing to use more equity. Institutional investors, such as pension funds, appear willing to invest as long as the expected return on real estate meets or exceeds their actuarial assumption rate of return. In an attempt to achieve marginally higher expected returns, many investors are targeting assets with lower quality cash flows, as well as properties that are in secondary or tertiary markets. We believe that these investors may be mispricing operating risks, providing sellers an opportunity to dispose these assets at a premium. For 2006, staff expects that the NPI will generate above average returns, cap rate movements will be modest, capital markets for real estate investments will remain strong, and investors will move farther out on the risk curve in search of incremental return. Staff anticipates that 2006 will be another good year for disposing marginal assets, but remain a challenging year for acquiring real estate at reasonable risk/reward prices. Portfolio Review, Dispositions and Acquisitions Figure 4 shows the unaudited private market real estate assets as of September 30, The portfolio has a market value of $3.2 billion, with approximately 90% managed through separate account managers. As of September 30, 2005, the OPERS had less than a 0.1% exposure to international real estate, as OPERS first entry into this space was in Figure 4. Private Real Estate Portfolio as of September 30, 2005 (unaudited) ($millions) Apartments Industrial Office Retail Other Total Separate Accounts $888 $648 $750 $122 $486 $2,894 Commingled Funds Total $950 $683 $868 $173 $547 $3,221 Each of these separate account managers has historically provided staff with a business plan for the coming year, including planned acquisition and disposition activity. During the Fall, staff led a comprehensive hold/sell analysis of all separate account holdings resulting in a simple return expectation classification of the assets: underperform, market or outperform. Dispositions This effort indicated that we should sell 33 assets, which have a combined fair market value of approximately $930 million, as they are not expected to generate at least market returns for the foreseeable future. This information is shown in more detail on page 68 of the 2006 Investment Plan. 4

5 Figure 5. Anticipated Separate Account Dispositions through Property Type $ Millions Apartment $210 Industrial 104 Office 376 Retail 1 Other 239 Total $930 Acquisitions Staff has established a goal to achieve the 8% target private market real estate exposure by the end of Given the existing portfolio and the planned dispositions, staff projects that we will need to acquire or commit to approximately $1.1 billion of new assets through each of the next three years. Figure 6 summarizes the projected acquisitions for 2006 and more detail is provided on page 70 of the 2006 Investment Plan. Figure 6. Projected Acquisitions/Commitments for Property Type $ Millions Apartment $125 Industrial 350 Office 200 Retail 350 Other 75 Total $1,100 While the disposition and acquisition activity will not materially change our private real estate market value by year-end, the portfolio construction should be more balanced by property type with assets better positioned for outperformance. Strategy - Keys to Success Staff has identified and is embarking on the following areas as keys to success with the private market real estate program. Strategic Direction In a more efficient and capital rich market, the value added from staff approving individual transactions is marginalized. Staff s true ability to add value is at the strategic level through careful attention to portfolio construction. In moving the portfolio to the property type targets, we believe that we can add value by overweighting new investments in non-core assets, targeting geographic regions and seeking niche strategies with favorable supply and demand characteristics. In particular, during 2006 we expect to allocate approximately 60% of our acquisitions to noncore assets. Given the current rich pricing for stable core assets, we believe that OPERS will earn better risk-adjusted returns if we assume development and leasing risk leading to the creation of core assets through time. 5

6 We also believe that a geographic focus will increase returns. For the office and multifamily property type, we intend to target areas where the job formation rate is expected to be above the national average. For the retail property type, we will target areas where household formation and household incomes are stable or growing. For the industrial property type, we will target locations that are critical to the domestic and global distribution of goods. We will remain alert to niche strategies including hospitality, senior housing, storage and singlefamily home development, that may develop favorable supply and demand characteristics. Specialized managers would likely be engaged for any niche strategy. Separate Accounts and Commingled Funds Value can be added to the portfolio through optimizing the use of separate account managers and commingled funds. The ratio of separate account managers to commingled funds in the marketplace is diminishing because many separate account managers are migrating to commingled fund structures that provide a better business model and competitive advantages in the market place. These commingled funds generally have a higher cost component, but they can still provide added value through operational experience or by exploiting niche strategies. Staff has assessed our use of separate and commingled managers and anticipates greater use of commingled funds for broad market domestic and international exposures. The number of separate account managers will be pared back and those that we continue to use will have increased discretion with a sharpened market focus. Staff envisions that by the end of 2008, approximately 65% of the portfolio will be invested through separate account managers and 35% of the portfolio will be invested in commingled funds. We intend to have a majority of the real estate equity invested through the separate account relationships because separate accounts provide OPERS with more flexibility and a lower cost structure than we can achieve through commingled funds. Staff can tailor the mandates with each separate account manager to create portfolio compositions by property type, leverage, core/non-core and other policy parameters and achieve performance objectives. Best In Class Managers As we continue to build the private market real estate exposure, it is essential that we engage best in class managers. Staff has worked closely with TTG in evaluating our existing manger line-up and potential new manager selections. Figure 7 shows the separate account managers that have been confirmed for continued relationships. Of the four property types, we do not currently have a dedicated separate account manager for new apartment acquisitions. Separate account managers will have expanded discretion and will invest in core and non-core assets consistent with revised, explicit manager guidelines. Figure 7. Confirmed Separate Account Managers Manager Bristol Group Great Point Investors LaSalle Investment Management Sarofim Realty Advisors Property Types Industrial Office, Industrial Office, Retail Office, Retail 6

7 Discipline The Real Estate Policy controls the program parameters and the Investment Plan outlines our strategy. While maintaining an awareness of the evolving market and participating in new opportunities, we must maintain the risk/return discipline for the program to be a success. We have established a course of action based on our market knowledge and we must now execute with diligence. Next Steps Staff looks forward to presenting this private market real estate strategy and welcomes comments and suggestions from the Investment Committee. 7

8 Ohio Public Employees Retirement System Real Estate Policy October 2005 Attachment A

9 TABLE OF CONTENTS I. SCOPE... 1 II. PURPOSE... 1 III. INVESTMENT PHILOSOPHY... 1 IV. ALLOCATION... 1 V. INVESTABLE INSTRUMENTS AND RESTRICTED INVESTMENTS... 2 A. PRIVATE MARKETS Investment Types Investment Structures Derivatives... 2 B. PUBLIC MARKETS Investment Types Derivatives... 3 VI. PERFORMANCE OBJECTIVES... 3 A. PRIVATE MARKETS... 3 B. PUBLIC MARKETS... 3 C. DEFINED BENEFIT FUND... 3 VII. RISK MANAGEMENT... 3 A. PRIVATE MARKETS Property Type Risk Life Cycle Risk Liquidity Geographic Exposure Single Investment Risk Manager Risk Leverage Currency Risk Valuations Vertical Integration Lease Maturities... 6 B. PUBLIC MARKETS Liquidity Portfolio Composition Single Security Risk... 7 VIII. ROLES AND RESPONSIBILITIES... 7 A. BOARD OF TRUSTEES... 7 B. INVESTMENT STAFF... 7 C. INVESTMENT ADVISORS... 8 IX. MONITORING AND REPORTING... 8 A. QUARTERLY... 8 Attachment A

10 Revisions History Action Date Approved Policy Established December 2002 Policy Revised June 17, 2003 Policy Revised October 18, 2005 Attachment A

11 I. SCOPE This policy applies to the private market Real Estate assets within the Ohio Public Employees Ret irement System ( OPERS ) Defined Benefit Fund and the public market Real Estate assets within the OPERS Defined Benefit Fund and OPERS Health Care Fund. This policy does not govern the public Real Estate securities exposure within the U.S. Equity Policy. II. PURPOSE This policy provides the broad strategic framework for managing the private and public market assets within the Real Estate asset allocation for the OPERS Defined Benefit Fund and Health Care Fund. III. INVESTMENT PHILOSOPHY The role of the Real Est ate program within the OPERS Defined Benefit Fund and Health Care Fund is to: Provide a total return that is competitive on a risk -adjusted basis with the returns provided by other approved asset classes. Provide a diversification benefit through less th approved asset classes. an perfect correlation with other Provide a potential hedge against inflation. Provide sufficient liquidity for the Health Care Fund through investments in public Real Estate securities. The private market Real Estate portfolio u ses active management strategies with external managers. The public market Real Estate portfolio may engage in active and passive management strategies through internal and external managers. IV. ALLOCATION OPERS controls allocation risk at the Fund level as shown in Table 1. The Defined Benefit Fund asset allocation establishes a 9% target for Real Estate, consisting of 8% (+/ - 3.5%) to private market Real Estate investments and 1% (+/ %) to public market Real Estate investments. The Health Care Fu nd asset allocation establishes a 5% (+/ - 3%) allocation target for Real Estate, consisting wholly of public market Real Estate investments. Attachment A 1

12 Table 1. Target Allocations and Ranges Private Markets Public Markets Total Fund Target Range Target Range Target Range Defined Benefit 8% +/-3.5% 1% +/- 0.50% 9% +/- 4% Health Care 0% +/- 0% 5% +/- 3% 5% +/- 3% I. INVESTABLE INSTRUMENTS AND RESTRICTED INVESTMENTS Private Markets 1. Investment Types This policy authorizes investments in all forms of private market Real Estate. Non-equity oriented investment types will not exceed 25% of the private market Real Estate portfolio. The Real Estate program will not invest in vehicles where the primary objective is investing in whole loans. Investment guidelines establish the security type limitations at the manager or portfolio level. 2. Investment Structures This policy authorizes the use of all types of investment structures including: Separate Accounts Co-investments Joint ventures Open and closed-end funds Partnerships Limited liability companies Private Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs) 3. Derivatives The use of derivatives shall be consistent with the OPERS Derivatives Policy. Public Markets 1. Investment Types This policy authorizes the holding of all forms of Public Market Real Estate securities including: Common stock Exchange-trade funds American Depositary Receipts Warrants Initial Public Offerings Preferred securities Cash and cash equivalents as necessary Attachment A 2

13 Individual portfolio guidelines indicate limits on specific security types. For internally managed portfolios, all U.S. dollar denominated, short-term securities are subject to the same criteria as established in the OPERS Cash Management Policy. 1. Derivatives The use of derivatives shall be consistent with the OPERS Derivatives Policy. I. PERFORMANCE OBJECTIVES Private Markets The private market Real Estate performance is benchmarked against the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI). The private market Real Estate portfolio is measured net of manager fees (not including overhead expenses) and the NPI is unadjusted. The private market Real Estate portfolio is expected to meet or exceed the NPI over rolling five-year periods. The OPERS Investment Plan establishes the short and long-term approaches for achieving the performance objectives consistent with the requirements of this policy. Public Markets The public market Real Estate performance is benchmarked against the Dow Jones Wilshire Real Estate Securities Index (WRESI). The public market Real Estate portfolio is measured net of fees (not including overhead expenses). WRESI is not adjusted for fees. The public market Real Estate portfolio is expected to exceed the benchmark returns by 50 basis points annualized over rolling five-year periods. The OPERS Investment Plan establishes the short and long-term approaches for achieving the performance objectives consistent with the requirements of this policy. Defined Benefit Fund The Custom Real Estate Index is calculated as the weighted average of the private and public market performance objectives based on their allocations within the Defined Benefit Fund. II. RISK MANAGEMENT Private Markets For private market Real Estate investments, the following sections identify the most significant risks and the method of control. 1. Property Type Risk Table 2 shows the NPI weights, long-term OPERS target allocations and associated ranges for the benchmark sectors. At least 80% of the private market Real Estate investments will be in apartment, industrial, office and retail assets. Attachment A 3

14 Table 2. Private Market Target Sector Allocations OPERS Target Sector NPI Weights Allocation Range Apartment 20% 20% 10-30% Industrial 18% 20% 10-30% Office 37% 30% 20-40% Retail 23% 20% 10-30% Other 2% 10% 0-20% Total 100% 100% *Targets are approximations to actual NPI weights that move through time. The current NPI weights listed are from June 30, Strategic and tactical property type allocations are a function of economic, capital, and property market conditions that will be addressed in the OPERS Investment Plan. 1. Life Cycle Risk Real Estate investments can generally be classified into two life cycle risks, core and non-core, as defined in Table 3. OPERS will have at least 65% of the private market Real Estate portfolio in core properties ( core portfolio ). OPERS will endeavor to ensure that the core portfolio is 80% leased. OPERS will limit its investments in non-core life cycle properties to no more than 35% of the private market Real Estate portfolio. Table 3. Life Cycle Categories Life Cycle Leased / Occupancy Stage Core >60% Operating Non-Core <60% Development, redevelopment, repositioning 2. Liquidity Private market Real Estate investments are illiquid and may have expected holding periods of 7-10 years. Liquidity risk is managed by minimizing the possibility of forced sales that may arise from exceeding exposure limits. 3. Geographic Exposure OPERS will endeavor to ensure the private market Real Estate portfolio is well diversified by location. OPERS will attain geographic and economic diversification by investing no more than 20% of the directly held, private market Real Estate allocation into any single metropolitan statistical area (MSA) for the 20 largest MSAs in the United States, and no more than 10% of the directly-held, private market Real Estate allocation in any other single MSA. Investments outside the United States will be limited to no more than 25% of the private market Real Estate portfolio. Attachment A 4

15 1. Single Investment Risk OPERS does not want the failure of a single investment to have a material impact on the performance of the total Real Estate program. The following limitations will be applied to control single investment risk: a) OPERS will limit the amount of equity in a single direct investment to the lesser of 5% of the private market Real Estate target allocation or $300 million. Multiple buildings in geographic proximity and operating as a single property are considered a single investment. b) OPERS will limit its commitment amount to a commingled fund to the lesser of 5% of the private market Real Estate target allocation or $400 million. 2. Manager Risk Manager risk consists of two elements, the exposure to a manager and the number of managers in the private market Real Estate portfolio. To control manager exposure, the allocation to a single private market Real Estate manager is limited to 20% of the private market Real Estate portfolio. The optimum number of managers in the portfolio varies with time and is established by the OPERS Investment Plan. 3. Leverage Leverage will be limited to 40% loan to value of the aggregate private market Real Estate portfolio. Leverage will be limited to 70% loan to value for an individual, directly held investment in the private market Real Estate portfolio. 4. Currency Risk The Real Estate program accepts the currency risks consistent with the geographic constraints. Real Estate managers may or may not hedge currency risk and the Real Estate program will not implement currency hedges. 5. Valuations The real estate asset class is relatively illiquid, is not fungible and many investments have a longer term holding period. As a result, real estate lacks the trading frequency to establish values and relies on an appraisal process to periodically value investments. OPERS will utilize valuation policies consistent with industry standards for the asset class of real estate. The current industry standard for private real estate investments owned by tax-exempt investors is the NCREIF Real Estate Information Standards. All investments in the separate accounts will be independently valued not less than every three years by a qualified, third party expert (an individual or firm certified MAI or its successor equivalent) selected by the staff. The goal is to ensure at least some portion of each real estate investment manager s portfolio is independently valued each year. During interim calendar years, an internal valuation shall be performed by the investment manager for investments not scheduled for external appraisal. Attachment A 5

16 The real estate procedures to be prepared by staff shall set forth in greater detail the process, frequency and procedures to be utilized in the selection of third party appraisers and the review of the appraisals. 1. Vertical Integration Unlike most public equities and fixed income investments, real estate has the possibility of the combination of the roles of the investment manager and the operator in the form of vertically integrated real estate firms. These are firms that provide investment management services as well as property management, construction management and/or leasing services with respect to the properties it manages. OPERS acknowledges that vertical integration may offer potential benefits to the investor, such as greater control, efficiency in the decision making process, and potentially lower costs. OPERS also recognizes that the use of vertically integrated firms raises issues of potential conflicts of interest, as firms that are vertically integrated may be subject to influences on their decision making not found in firms that contract out such services to unaffiliated third parties. One potential conflict is whether the investment manager s property management or leasing personnel are the most qualified to manage a particular property in a specific market. Another potential conflict is the impact of a sale recommendation on the manager s personnel and whether that affects the investment manager s ability to fully represent OPERS interest. Other potential conflicts exist, including the lack of arms length negotiation of compensation for services. OPERS permits the use of vertically integrated firms. The goal is to capture the potential benefits offered by vertical integration while seeking to mitigate the potential conflicts of interest. The real estate procedures will address vertical integration and shall set forth specific, detailed procedures to monitor and manage potential conflicts. The procedures will also specify information that must be provided to permit adequate disclosure and allow OPERS to conduct a periodic, documented review of vertically integrated managers. These reviews will be supplemented by periodic real estate manager reviews that will be conducted by OPERS outside real estate auditor. 2. Lease Maturities A large percentage of the commercial property leases maturing during a period in which the real estate markets are under performing would subject the private real estate program to significant risk. OPERS will seek to have staggered portfolio level lease maturation dates in order to reduce volatility and mitigate concentrated leasing risk. To further reduce tenant credit risk, OPERS will seek to avoid significant concentrations of leases in a single tenant. Attachment A 6

17 Public Markets The expected tracking error (active risk) is determined by the investment staff using risk budgeting and/or other techniques and is expected to be no higher than 200 basis points per annum measured over rolling five-year periods. Staff may in the OPERS Investment Plan, define tracking error targets for specific portfolios provided the overall public market tracking error is expected to stay within 200 bps. The allowable allocation range for each portfolio type and the investment guidelines defined for each portfolio are designed to keep the public markets within its expected tracking error guidelines. Risk is managed through a combination of quantitative and qualitative constraints. The primary approach to managing risk is to control the characteristics and risk factors of the aggregate portfolio within a reasonable tolerance of the benchmark to minimize biases and unintended portfolio mismatches. The following sections identify the significant elements of risk at the individual portfolio level. Staff shall establish reasonable parameters in each portfolio s investment guidelines to control such risks. 1. Liquidity It is the objective of the public market Real Estate portfolio to be fully invested at all times in Real Estate equity and related securities. Allocation ranges will be maintained through disciplined rebalancing. A small allocation to cash or cash equivalents is permitted to provide operating liquidity. 2. Portfolio Composition The public market Real Estate investments will achieve diversification across all sectors of the benchmark. Diversification is a primary risk control element. 3. Single Security Risk Investment in any single company is limited to a percentage of the public market Real Estate portfolio s total market value at the time of purchase and is defined in the OPERS Public Real Estate Securities Investment Guidelines. I. ROLES AND RESPONSIBILITIES Board of Trustees The Board is responsible for reviewing and approving the Real Estate policy. The Board delegates investment approval authority to the Director-Investments. Investment Staff Real Estate staff is responsible for recommending the policy and managing the Real Estate program under the framework of the Board approved policy. The Investment staff is also responsible for monitoring and reporting to the Board in accordance with the requirements of the OPERS policies. The Real Estate staff will conduct all due diligence in compliance with procedures established for the Real Estate program. Attachment A 7

18 Investment Advisors OPERS may engage a specialty investment advisor(s) to assist in managing the Real Estate program. Specific responsibilities will be established with the investment advisor(s) through contractual agreements. I. MONITORING AND REPORTING Quarterly Performance and compliance report prepared by staff and/or investment advisor(s). A. Annual OPERS Investment Plan submitted by staff. Attachment A 8

19 The Townsend Group INSTITUTIONAL REAL ESTATE CONSULTANTS To: Investment Committee Ohio Public Employees Retirement System From: CC: Frank L. Blaschka, Anthony D. Frammartino, The Townsend Group Greg Uebele, Senior Investment Officer - Private Equity/Real Estate Subject: Real Estate Strategy Update Date: January 3, 2006 The Townsend Group ( Townsend ), as real estate consultant to the Public Employees Retirement System of Ohio ( OPERS ), has reviewed the memorandum outlining the real estate strategic direction for 2006 for OPERS. We believe the real estate program has been placed on a firm foundation to execute the new Real Estate Policy approved by the Board in October 2005 (the Policy ), and we look forward to the opportunity to continue to provide advice and support to OPERS as it moves forward with the investment plan approved for We agree with the fundamental premises set forth in the investment strategy. The purpose of this memorandum is to highlight a number of points we believe is important to the Board s understanding of the direction of the real estate program. 1. Need for top down strategy is greater than ever. As the Staff memo indicated, OPERS was successful in the 1980s and most of the 1990s executing a bottom up, opportunistic investment strategy in real estate. While risks were taken in such an approach (e.g., a significant overweight to hospitality investments, an underweight to retail properties and a lack of traditional retail investments, larger commitments for riskier transactions that raised concentration risks), the program generally was successful in a market that was characterized as capital constrained and relatively inefficient. As the markets evolved in the late 1990s and turned in early 2000, however, the risks inherent in such an approach became apparent, particularly as the capital markets evolved and capital was no longer a scarce commodity in real estate. In effect, OPERS lost one of its competitive advantages that had served it well during the 1980s. The investment model also was becoming increasingly difficult to execute, as the increasing speed of all real estate investment activity made non-competitive any form of non-discretionary decision making process. This approach was the way that OPERS invested through its separate accounts, and the lack of deal flow in the last few years in part relates to the fact OPERS advisors were not competitive in this market without being the top bidder. Over the past four years OPERS has been implementing a top down approach to the asset class, as reflected in the Real Estate Policy and Strategy Townsend developed with the Staff and approved by the Board in 2002, and the more recent Real Estate Investment Policy developed by the Staff with Townsend input and approved by the Board in

20 Investment Committee OPERS January 3, 2006 Page 2 October This top down approach includes defined risk management parameters and objectives to frame the risk and return profile sought by the Board, which generally had been informal, if present at all, in the pre-2002 program. Key components of the Policy include the flexibility to invest in a broad swath of the real estate markets (private and public equity, equity oriented debt and international investments, to name a few) and to take on certain types of risk (non-core risks including development, redevelopment and leasing risks, leverage) in order to provide the opportunity for out performance relative to the benchmark. In order to constrain risk to acceptable levels, however, the Policy imposes discrete limits on such risks. Furthermore, the Policy incorporates diversification parameters to ensure that the program is well diversified by property type, location and investment manager. These provide an appropriate framework to build upon this foundation to achieve the goals and objectives for real estate in the Policy. 2. Flexible use of investment vehicles to achieve objectives. The other major issue that is highlighted in the Staff memorandum and to which Townsend is a strong proponent is the inherent flexibility to use the appropriate investment vehicle for each component of the Policy. Historically, OPERS has been a separate account investor and it rarely used any form of pooled fund investment vehicle. While Townsend generally is a strong advocate of separate accounts due to their superior control features and potentially lower costs, we also recognize that other vehicles may have compelling attributes to merit their inclusion in a balanced real estate program. Separate accounts will continue to represent more than a substantial majority of the assets owned by OPERS, as identified in the Staff memorandum. Townsend participated in the evaluation of the current manager line up and we agreed with Staff on the continued future use of Bristol Group, Great Point, Sarofim and LaSalle for multiple property types. These managers have the demonstrated track records to perform consistent with the objectives set forth in the Policy. We anticipate a need to expand this list to add capacity in other property types (multifamily is the one property type where OPERS may not have the manager line up it needs to execute going forward). We also agree with the initiatives to both broaden these mandates (e.g., to permit each firm to invest in core and non-core assets) and provide greater focus (e.g., by property type and to some degree target markets). We believe these changes will improve the functionality of these vehicles. We also strongly concur with the need to grant greater discretion within a set of parameters defined by the Policy, as the current capital rich environment clearly places non-discretionary capital at a disadvantage. We are actively working with the Staff to help define investment parameters and incorporate appropriate changes in the investment management contracts to facilitate these changes. The biggest change that has occurred over the past two years in the OPERS program and is likely to continue in 2006 and beyond is the use of pooled funds (and joint ventures) to

21 Investment Committee OPERS January 3, 2006 Page 3 supplement the separate accounts. These forms of investment vehicle can serve several critical roles that we believe improve the likelihood that OPERS will accomplish its objectives for real estate consistent with the Policy. We believe that pooled funds are the best vehicle available today for international investments. We continue to believe that real estate is a global asset class and some of the best risk adjusted returns will be found offshore. The pooled funds offer superior diversification relative to separate accounts. Further, today we see too few US based firms with sufficient infrastructure overseas to execute on a competitive basis with local market participants. Further, the role of an investment fiduciary is beginning to evolve in some international markets and if successfully established, it will allow a larger US based investor such as OPERS the ability to access strong local market participants under a similar approach as how it invests in the US. Today, however, those firms are in their infancy. In addition to international investments, we are proponents of investing in higher risk assets (and strategies) through pooled funds in order to mitigate the inherent risks of such investments. As with international investments, such funds offer superior diversification, which we believe is important in these sectors when manager selection can have a huge impact on results. We particularly recommend such funds when pursuing strategies that consciously target larger assets or portfolios of assets (due to slightly better pricing due to some scarcity at the largest levels of deals); in contrast, any such investments in the separate accounts would represent high asset concentration risks that can adversely affect the program. The use of pooled funds is not limited to such higher risk strategies or niches. We see the lower risk open end core funds as a competitive way to access the beta component of real estate, even for larger investors such as OPERS. We have recommended the use of the top performing open end core funds as a supplement to the separate accounts, as these funds tend to have investment objectives similar to OPERS (essentially to match the NPI net of fees) and provide broad diversification to lower risk. We would expect to see greater commitments to the better performing funds over time to take advantage of scaled fees breaks that would lower the marginal cost of such funds and move them closer to the cost structure of separate accounts. I will be present at the January Investment Committee meeting and will be pleased to answer any questions you may have. In the interim, do not hesitate to contact me.