The Dallas Police and Fire Pension's Big Real Estate Gamble

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Things have gotten so bad, someone went and made a sticker out of it.

One of the biggest feuds Dallas has seen in years has everything except sex: art, money, power, police and the looming threat of litigation. That's why people have been hanging on every detail of the dispute between the Nasher Sculpture Center, the downtown sculpture museum built by the late developer Ray Nasher, and its neighbor, Museum Tower, a $200-million condo development whose mirrored glass is, according to the Nasher, directing damaging light, blistering heat and awkward, art-muddying shadows into the museum's garden and galleries.

Museum Tower's developers admit nothing of the kind, and the two sides have been in mediation since mid-April. Then, last month, the stickers showed up. They emerged first at Anvil Pub in Deep Ellum: a cowering stone sculpture of a man, engulfed in flames shooting from a teetering building.


Ray Nasher

"Museum Tower," the text read. "Setting the art world on fire!"

The stickers were quickly, gleefully snapped up by patrons, evidence of how this story has seeped into lives of everyday Dallasites. And as the story has spread, more attention has been focused on the owners of the tower, who previously were barely mentioned at all: the Dallas Police and Fire Pension System, which collects and invests the retirement savings of the city's 9,000 retired and active police officers and fire fighters.

In 2010, the $3 billion pension fund borrowed $160 million — the equivalent of more than 5 percent of the fund's entire portfolio — to purchase and revive the stalled development. "This is an investment in Dallas by the people that protect and serve this community," Richard Tettamant, the pension fund's administrator, said at the time.

But that bright optimism has given way to arguments over literal brightness and the question of whether the project can survive the PR nightmare of owning a building whose target demo is now its mortal enemy. In the process, some of the tower's light and heat has been turned on the fund's overall investment strategy, which is heavily focused on "alternative investments" — higher-risk plays that include private equity, natural resources and real estate.

Museum Tower, it turns out, is just one of a few shaky real estate projects the fund has invested in over the past decade, throughout which the fund has increased by millions of dollars the amount it pays in fees to advisers. It's done all of this while entrusting a whopping 70 percent of its real-estate investments to just one company, with whom the fund happens to share an office building. Meanwhile, the fund recently slashed benefits for new hires to levels unseen since the 1970s.

There will be no sticker for any of that. The dispute over Museum Tower will eventually be resolved, the sexiness of the argument dissolved into some kind of pedestrian solution — new glass, maybe, or a "skin" on the outside of the tower to cut the glare. But the police and firefighters of Dallas will still have a large chunk of their nest eggs wrapped up in property that no one else wanted, a project that's now surrounded with doubts about its future. And that project will still be one of many.

At the foot of Arizona's Tucson Mountains, 10 minutes or so from the heart of downtown Tucson, there's a hilly, steep 300 acres, densely studded with saguaros, some of them more than 150 years old. It's one of the largest remaining stretches of saguaros for miles, and it's teeming with animal life, too: mule deer, javelinas, screech owls, rattlesnakes.

The people who live nearby have long wanted to keep it that way. Pima County residents voted in 1997 and again in 2004 to have the county buy the privately owned parcel, hoping to make it part of a nearby nature preserve. But the county never found the money, and the land's owner didn't want to sell — at least not for the land's appraised value, around $4 million.

Then, in 2005, the cops and firefighters from Dallas showed up. And they came wielding a checkbook.

At the time, the Dallas Police and Fire Pension System worked like most other public-employee pension funds, and in most ways it still does. Every active-duty cop and firefighter contributes 8.5 percent of each paycheck. That money is supplemented by City Hall, which kicks in an amount equal to 27 percent of police and fire payrolls — around $108 million last year. The average retiree collects $39,000 from the fund every year.

Until relatively recently, the fund invested those contributions the way pensions traditionally have: in stocks and bonds. Almost 80 percent of its portfolio was in stocks and bonds in 2000. But around the time the pension fund showed up in Tucson, and accelerating around 2007 and 2008 as the worst of the recession hit, fund officials began leaning heavily on those "alternative investments."

Forays into alternative investments are common for public pensions these days, as cash-strapped governments and a sluggish economy make traditional investments less likely to keep fund levels steady. But Dallas' police and fire pension has dived into these riskier investments at a rate unmatched by almost any other fund, with alternative investments now making up about half of its total assets.

That includes investments in private equity, like the $130 million the fund poured into a company called Huff Energy, which backs oil and gas companies, and $66 million with Pharos Partners, which helped fund the website WebMD. These investments now make up 17 percent of the fund's portfolio, more than twice the national average for public pensions.

But the fund's been especially busy snapping up real estate, which by 2007 made up a full third of its portfolio. That has since dropped to 24 percent, and trustees recently voted to reduce that number to 15 percent. But for now, real-estate holdings still outweigh any other category of investments for the pension fund. And they still include Painted Hills.

Pima County officials had just begun negotiating with the landowner again when the pension fund showed up. It was partnering with a developer, Las Vegas-based Land Baron, that wanted to build 300 luxury homes on the land residents wanted so badly to preserve. And the fund offered a price the landowner apparently couldn't refuse: $27 million, almost seven times its appraised value.

The roadblocks didn't take long to emerge.

Environmentalists, led by the Tucson Mountains Association, were outraged by Land Baron's proposal. And while the developer eventually agreed to build fewer homes, there were still "residual issues," says Edwin Verburg, vice president of the Tucson Mountains Association.

"Some of the buildings obstruct wildlife corridors," he says. "Some of them are too close to ridges, 150 feet from a ridge or so when 300 feet is the rule."

More pressing was the lack of water. Land Baron needed the city of Tucson to annex land from the county and provide it with water service. But the Tucson city council, wary of urban sprawl and environmental impact, voted them down.

So off the pension fund went to court. Along with Land Baron, it sued the city for $45 million in damages. The case was dismissed in Superior Court, then rejected by the Arizona Court of Appeals. So the developers tried approaching a friendly member of the Arizona Legislature, asking him to write a measure that would force the city to extend water service. That bill failed, though it has some chance of being revived next session.

After years of legal wrangling, the city and the developers have recently discussed doing a land swap, with the pension fund trading its prized parcel for something nearer downtown — something with water. Fund officials won't comment on the swap, nor will they say how much they've spent in legal fees on Painted Hills or other projects. They pay about $600,000 a year total to their outside firm, Strasburger Price, internal documents show.

Meanwhile, Painted Hills sits empty.

"I believe they didn't do full due diligence on this plan," Verburg says.

It was around the same time that the fund set its sights on another enticing parcel, this time in California's wine country. Working with a California developer named Bill Criswell, the fund spent more than $35 million on 2,650 acres of land for a development it dubbed Lake Luciana, which it envisioned as a championship golf course and 17 luxury homes in rural Napa Valley. The deal also included Aetna Springs, an older golf course and social club about 10 minutes away that the fund planned to redo.

But while Aetna Springs went ahead as planned, the Napa County Planning Commission turned down the plan proposed for Lake Luciana by Criswell's firm, Criswell Radovan. The land, it turned out, was located in an agricultural preserve whose use was tightly regulated. The developers appealed to the Napa County Board of Supervisors, who also voted against it.

The problem, once again, was water. "They were going to use up 100 million gallons of water a year with the golf course," Supervisor Brad Wagenknecht says. "It's a dry area of our county and you're going to use 100 million gallons of water? What's the agriculture going to do?"

Criswell's firm sued Napa County in both state and federal court, alleging that the permitting process was biased and unfair, and that Aetna Springs couldn't be as successful without Lake Luciana.

"It struck me as odd they wanted to build another golf course less than a mile away," Wagenknecht says. "To me, this was the property that was begging for the loving care that they were going to put into Lake Luciana."

After three years in court, both suits were dismissed last month. The hundreds of acres the developers planned for Lake Luciana are still undeveloped, and still owned by the pension fund.

The Napa project isn't exactly something for Bill Criswell to bold on his résumé. But its struggles didn't seem to bother the pension fund. After buying a $32-million stake in the Museum Tower project in 2007, that project stalled too, sitting idle for more than three years. But instead of folding its hand and licking its $30-million wound, the pension fund went all in, announcing in 2010 that it would finance the entire project. And it named Criswell the lead developer on the project.

Before the fund bought Museum Tower, the project had to be approved by its board of trustees. The fund is overseen by a 12-member board: eight current and retired police and firefighters, who are elected by the membership, and four city council members, appointed by the rest of the council.

That board oversees a 25-person staff whose salaries total $3.68 million, or an average of about $147,000 per person. Each trustee reportedly has a $15,000 expense account per year, and there's a $110,000 line item in the fund's budget too for "continuing education," which allows trustees to travel to various conferences and look at potential investments. (Pension fund staff cut that amount by 25 percent this year, after complaints from membership that it was excessive.)

Ann Margolin, the North Dallas city councilwoman, served on the pension's board for eight months in 2010. It was during that time that the board voted to buy Museum Tower. Margolin voted against it, as did Councilman Sheffie Kadane; Steven Shaw, a former DPD officer and the board's vice chairman at the time; and John Mays, a retired police officer who's still on the board.

"I thought as an isolated investment it was too risky," Margolin says. "They were expecting they were going to sell the units at $700 a square foot. Their prime competition was the Ritz Carlton, which wasn't even selling at that."

Margolin says it was important for her to decouple her feelings as a councilwoman from what she knew was wise as a trustee. "As a council member, you could go, 'Oh wow, that would be great for the city, a fabulous building downtown, we should do it,'" she says. "But as a pension board member, voting, I had to be clear.

"The decision to go ahead with it was very much from the management of the pension fund," she goes on. "There was a lot of desire to do it from their point of view. It certainly didn't come from the council members."

Other board members didn't return phone calls seeking comment. An atmosphere of skittishness pervades the conversation around the tower these days. "I'm not wading into this one," said one former state official, an expert in Texas pensions.

Then, though, he couldn't help himself.

"There are plenty of people who looked at that tower and said, 'Bullshit,'" he said. "What gives the police the particular confidence that it's gonna succeed?"

The pension fund's headquarters sit on a little hill on Harry Hines Boulevard, in a surprisingly hip, LEED-certified building, full of big windows and curving walls. The fund moved into the building in 2010 along with CDK Realty Advisors, a seven-person firm that has overseen some of the pension fund's real-estate investments for 15 years. Today, a whopping 70 percent — $519.8 million — of the fund's real-estate assets are with CDK. The pension fund is the firm's "primary client" says Jon Donahue, one of CDK's founders, although it claims 14 others, including other pension funds and a few "high net-worth individuals."

But for a fund that prides itself on diversifying its assets, parking 70 percent of anything with one adviser seems odd.

"Certainly that's a subjective decision," says Ed Easterling. He's the founder of Crestmont Research, a financial analysis firm, and a senior fellow at the Alternative Investment Center at SMU's Cox School of Business. "But generally diversification does reduce the concentration risk of having a significant portion of your investments concentrated with one adviser."

Then there's the matter of sharing the building. DPFP owns the first three floors, Donahue says, while CDK owns the fourth. "We condoed the office," he says. "We basically took an abandoned building and created this project."

But entering into a business venture with CDK, as well as sharing an office, seems to afford the fund less freedom to switch advisers, lest things get awkward in the elevator. (Brian Blake, the fund's chief investment strategist, wrote in an email that "the fund does not think a reduction in real estate holdings would affect our relationship.")

CDK maintains a comprehensive list of projects on its website, but it's not clear how many are owned by the pension fund. In general, answers from the fund about specific assets can be frustratingly vague. Despite repeated public-records requests, officials refused to provide a comprehensive list of its alternative investments and gains or losses to date. At a board meeting in mid-July, Tettamant, the fund's administrator, told the Observer that the fund has been "inundated" with records requests and lacks the staff to fulfill them.

His inundated staff did, however, find time to provide a list of seven "successful" investments. It included a $20-million loan made to NorthPark Center for its expansion in 2005, when the mall added a Nordstrom, the AMC movie theater and a food court. The fund invested $20 million and got a 22.9 percent return, according to the documents provided.

Among the other successes listed are the 2006 sale of the Landmark building in Dallas' West End, which brought a 27 percent return; the Fountains at Fair Oaks, a Sacramento apartment complex; and the Legends Outlets at Village West, a Kansas City retail center into which the fund invested $15.75 million back in 2005. The fund sold its share of the Kansas City property to JP Morgan in 2007, netting a 67 percent rate of return.

That last deal was orchestrated through a partnership with RED, a Kansas City-based developer that has worked with CDK and the fund over the years. And last year that partnership strengthened, when the fund bought half of RED.

According to the Kansas City Business Journal, the terms of the deal mandated that RED double the size of its real-estate portfolio within five years. But RED now seems headed in the opposite direction. That same Legends project defaulted on a $137-million refinancing of a construction loan in November 2011, and a federal judge recently appointed a receiver to oversee the property.

Donahue says despite having partial ownership of the company, CDK and the pension fund "have no stake" in the property or the default. The same can't be said for another RED property, the Outlets at Legends in Sparks, Nevada. RED defaulted on a $141-million construction loan at the end of January 2012. The company is calling it a "strategic" default, and said recently it had succeeded in refinancing the property with its partners. Donahue and pension fund officials declined to say how much money the fund contributed toward the refinancing.

Closer to home, CDK and RED worked together on Akard Place, a planned $400-million, two-tower development near the Victory Park area, with 200,000 feet of retail, a luxury hotel, upscale condos and office space. The project was supposed to begin construction in 2009. In 2008, the developers claimed that the retail space was "60 percent committed," with signed lease agreements from those businesses. But Akard Place never went up.

"It's a long-term asset," Donahue says. "Ground-up development can take anywhere from three to 10 years before you pull anything out of the ground. We did just come through one of the worst recessions in history."

Yet despite the stalled project, and despite that recession, investment advisers like CDK have continued to rack up millions in fees from the pension fund — and their share keeps growing. The more risky investments, the higher the fees, so as the fund's alternatives have grown so have those fees.

Fund officials won't say specifically how much CDK has earned. But the pension fund paid around $10 million in outside management fees earlier this decade, when it had about $2 billion in assets. As assets hit $3 billion around 2005 and more or less stayed there, the fees continued to climb, reaching more than $30 million in the past two years. And in a 2011 newsletter to members, board vice chairman Steve Umlor wrote that the fund planned to dole out increased fees again, based on the performance the fund hoped its investment managers would achieve this year. He projected the fees would increase by another 5 percent in 2012, for a record $34 million.

The Texas Municipal Retirement System, which is six times larger than the Dallas Police and Fire fund, pays $9 million in fees a year.

One morning in early June, Richard Tettamant is in a sunny downstairs conference room at its headquarters, along with its investment team: Josh Mond, the pension fund's general counsel; Brian Blake, chief investment strategist; and Mike Taylor, chief financial officer. They're all arranged on one side of a long glass table, looking a little restless. They've been enduring an unusual number of interviews lately.

"We're feeling very well," Tettamant says about Museum Tower, although a mediator's gag order keeps him from elaborating. Staff has been cagey about revealing how many of the 123 units have actually sold, but Tettamant acknowledges that "sales activity declined for about one month" after news of the dispute hit The Dallas Morning News and D Magazine. Still, he insists, "I'm still confident about Museum Tower."

He's similarly confident in his other investments. The fund, Tettamant argues, has the time and ability to invest in projects that may take awhile to come to fruition. It's not uncommon for a project to get snagged in bureaucracy, he says. "A lot of these investments, the city or town might initially throw up roadblocks," he says. "But as times get tougher, they need jobs, income and taxes, and they tend to come our way."

The fund doesn't call their investments "alternatives," he says, but "real assets."

"Agriculture, timber, oil, gas, land, buildings, houses," he explains. "We invest in real assets, not some piece of paper. It's an actual object. We know what it is we're investing in."

They also know that, at least in the short term, those investments aren't performing as well as they need to. The fund's stated goal is an 8.5-percent return on its investments. But a draft of its 2011 annual report, obtained by the Observer, shows that it barely broke even last year, with just a 0.3-percent return. At the same time, its debts jumped from $55,000 to $2.04 million (not including money borrowed for investments such as Museum Tower).

And it was the fund's alternative investments — those specialized plays that cost taxpayers tens of millions in adviser fees — that spearheaded the losses. The fund's stocks and bonds fared comparatively well, outperforming the average return by 8.4 percent, according to the report. But its private equity portfolio returned just .03 percent, underperforming the public U.S. markets by a couple of points. Real estate plummeted, losing 6.4 percent, underperforming the property index by 21 percentage points. The fund's real estate investments have been underperforming for a decade, in fact, netting 7.3 percent against a national average of 8.1.

All told, the fund's average rate of return over the last decade is 4.31 percent — half of its goal, and far short of what it needs to stay on track. That's not uncommon: Public pensions across the state and country are falling short of their goals. But in the last 10 years, most have outperformed DPFP, according to Cliffwater LLC, a consultant company that studied 69 funds across the country. The average rate of return, according to Cliffwater: 5.7 percent, compared to DPFP's 4.3 percent.

All of which has hurt the fund's overall position. In 2010, the plan was 80 percent funded — meaning it had 80 percent of the money needed to pay out all the retirement benefits for its members. It would take 21 years to make up the difference, the fund's actuaries figured. Now the plan is 73.9 percent funded, a 30-year gap. As of January 1, 2012, according to the draft report, the plan's total unfunded liability was $1.9 billion, an increase of $304.8 million from 2010.

State regulators say that's all within reason. For the plan to become dangerously underfunded, things would have to go terribly wrong very quickly, says Chris Hanson, executive director of the Texas Pension Review Board. "Those types of cataclysmic events rarely happen," Hanson says.

But for DPFP, funding worries have already made an impact on members. In 2010, the fund quietly cut the benefits of all new members, to a level Tettamant described as what a retiree would have received in the 1970s. For instance: Prior to the cut, a firefighter who made $60,000 a year would collect about $45,000 a year when she retired. Under the new system, the same retiree would get about $30,000.

And even with that cut, taxpayers may have to pony up more. According to a May report from Buck Consultants, the plan's actuaries, the city will have to increase its contribution — from 27 percent of police and fire payrolls to 33 percent — to keep the plan from becoming underfunded.

Tettamant insists that no one project, and no one year's worth of returns, can make the fund second-guess its strategy. "Anything less than five years is just noise," he says. But experts say that missing that 8.5-percent mark is meaningful, even if it's just for a year or two.

"It's more than just a benchmark on the wall," says Ed Easterling, the researcher at SMU's business school. It "is the number that they use to determine their actuarial assets and their funding status." Even if the fund did manage to hit 8.5 percent each year into the future, it would still only have 73 percent of the money it needs for the next 30 years.

The question, then, is whether promising an 8.5-percent return in the first place is responsible.

"They may recognize that a traditional portfolio of stocks and bonds in today's environment going forward over the next several decades has very little chance of achieving an 8.5-percent return," Easterling says. "It will probably be more like half of that."

Easterling says funds could be more secure, and have less need for risky investments, if they moved to lower, more realistic return expectations. But that could create panic.

"It just wouldn't be acceptable to revise to a more realistic number that shows that the plan is 30 or 40 or 50 percent funded. It would create a fiscal crisis. It would lead to a combination of benefit cuts and additional funding, which makes taxpayers and beneficiaries upset."

Also, he says, more risk doesn't always mean more rewards. In fact, it may mean the opposite.

"The reality is the higher the risk, the lower the probability of achieving the return."

Back in the pension fund's conference room, the investment team isn't concerned about a few key things: They certainly don't envision the plan going bust, and they don't foresee asking the city to put in more money. "The contributions have not changed since 1984, and we don't see any need to change them in the foreseeable future," Tettamant says. "We have been steady and static on the contributions." He doesn't mention that police and fire payroll contributions will need to increase slightly, according to the fund's own actuaries.

The fund administrators are also noticeably frustrated by the amount of negative media attention they're receiving. In March, Tettamant sent an email to the fund's lawyer and city staffers complaining that the Nasher had decided to "attack Museum Tower in the press." Just before this interview, they were listening to a radio interview with D Magazine editor Tim Rogers, who wrote the cover story on Museum Tower. Rogers claimed that discussions between the Nasher and Museum Tower had gotten much more civil since the news went public.

"He'd like to think that," says Barbara Shaw, the fund's communications director. She smiles, a little frostily.

"I'm still confident about Museum Tower," Tettamant says, that day in June. As he is about alternative investments as a whole: Although the board voted recently to reduce the fund's real estate and private equity allocations to 15 percent each, it'll still have 50 percent of their assets in alternative investments, including infrastructure and natural resources.

In fact, if they can reverse those odds laid out by Easterling, they may yet surprise their critics. The same Cliffwater analysis that found such disappointing returns found that plans with a high percentage of alternative investments tended to do better than others. The real variable, the consultants cautioned, was selecting good assets and finding competent managers to oversee them.

Tettamant and his team seem certain — truly, unshakably certain, in a way that does not feel forced by the presence of a journalist's tape recorder — that they'll be one of the alternative investment success stories. Just wait and see, they say.

"I think we've done a good job," Tettamant says. "I think we've watched over our ship."

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