Foreign real estate investors are returning to the U.S. with gusto just months after frothy prices in major markets turned them into aggressive sellers and wary buyers. But in a search for higher yields this time around, foreign real estate funds are taking bigger risks.

Not only are they increasingly investing in smaller markets like Chattanooga, Tenn., and San Antonio, Texas, but they're also developing new projects and buying underperforming properties for turnaround plays.

Foreign investors poured $163 billion into U.S. commercial real estate in the first half of 2007, a 37% increase over the first half of 2006, according to real estate services provider Jones Lang LaSalle.

Nowhere is the shift more pronounced than among German funds, historically the largest source of foreign capital in U.S. commercial real estate. In 2006, the funds sold more than $11 billion in assets in the U.S. and bought only $2.8 billion. In the first half of 2007, German investors spent $2.26 billion — nearly as much as they spent in all of 2006 — even though they still remained net sellers by $1.4 billion.

The increased appetite for risk runs counter to a standard foreign capital real estate strategy over the past two decades. Primarily focused on paying reliable dividends to shareholders, German and other European investors largely acquired only stable or “core” downtown office buildings in only a handful of tr,ès top-tier, 24-hour markets such as New York, Washington, D.C., and Boston.

But times have changed. “Yields in the top-tier markets are too tight for foreign investors, and they're realizing they can buy other products in other markets,” says Steve Collins, managing director for international capital markets at Jones Lang LaSalle. “It's now acceptable to go to Richmond, [Va.], Nashville or other cities where they haven't invested before.”

Opportunistic Jamestown

Case in point: Atlanta-based Jamestown, which raises German capital for U.S. real estate investment, acquired 999 Peachtree Street in Atlanta's Midtown submarket for $127 million earlier this year. The 620,000 sq. ft. office building posted a 12% vacancy rate at the time of purchase, and another imminent tenant departure will push vacancy to around 27%.

In addition to filling the building and making physical improvements, Jamestown plans to add 20,000 sq. ft. of retail space to the 28-story structure. To attract tenants, Jamestown intends to leverage its central location in Atlanta's burgeoning “Midtown Mile,” an urban shopping destination generally along Peachtree that is being modeled after Chicago's Magnificent Mile. It also has hired Jones Lang LaSalle to lease and manage the building.

Among other projects, Jamestown is spending $10 million to remake the Warehouse Row outlet mall in downtown Chattanooga, Tenn., into an upscale urban shopping center. The company last year paid $13 million for the 259,000 sq. ft. property, originally built in the early 1900s, and plans to bring in new retailers, rebuild interior spaces and make general capital improvements.

Jamestown is financing those projects and several others with its $650 million Jamestown Co-Invest IV fund, which is hunting for turnaround projects and development opportunities mainly in the Southeast. It's the company's first opportunistic pool, after more than two decades of raising and managing core funds.

“This is a big departure from what we've been doing — we've moved from the most conservative strategy to the most risky,” says Jeffrey Ackemann, a managing director at Jamestown. “We just think being on the risk side of the spectrum pays you better.”

How much better? Jamestown Co-Invest IV is shooting for internal rates of return in the high teens over seven years. Its core funds generally aim for annual yields of around 8%.

Strategic expansion

Other investors employing similar strategies include Wereldhave, a publicly traded Dutch real estate investor, and HGA Capital, a German closed-end fund manager. In late June, for example, Wereldhave acquired its first property ever on the West Coast, paying $210 million for the 380,000 sq. ft. Broadway 655 office tower in downtown San Diego.

Wereldhave also has begun to develop a $180 million mixed-use project in San Antonio, Texas, and a 600-unit apartment complex in suburban Dallas.

HGA Capital, meanwhile, purchased nine apartment complexes in the Houston area and two in Gaithersburg, Md., in December for $160 million. Company officials say they have been focusing less on investing in office properties in markets such as New York and more on investing in apartments in regions with growing economies and populations.

New pitfalls

Still, the funds face bigger risks as they move to smaller markets and unleash new strategies. Opportunistic projects have a greater chance of failing to generate enough cash flow to justify acquisitions, for example.

What's more, fewer property buyers shop in smaller markets, which can jeopardize even the best-laid exit strategies, says Michael McMenomy, global head of investor services for CB Richard Ellis Investors, a Los Angeles-based real estate investment firm that manages roughly $30 billion.

“You want to be pretty cautious about going into secondary markets during this period of a cycle,” says McMenomy, referring to the run-up in property prices during the past several years, a trend that appears to be peaking. “Investors tend to have more of a comfort with major markets where there's greater liquidity.”

Still, German retail investors have clearly displayed a hankering for more risk in exchange for better returns. Jamestown principals anticipated raising only about $200 million or so in Co-Invest IV, but investors surpassed those expectations by $400 million. The average shareholder put in less than $50,000.

“All capital — not just foreign capital — is moving out of [major] markets searching for yield,” says Ackemann, whose firm sold some $5 billion worth of New York and Boston office buildings, or interests in the buildings, in the last 18 months. “Foreign capital is looking for opportunities in different markets.”

Deep market requirement

Moreover, German and other European funds have become more focused on buying in the U.S. after forays into other global markets became less appealing. Driven out of the states by initial yields of around 6% — and as low as 4% in New York — over the last couple of years, German and other European funds sought better returns in places like Eastern Europe and Asia, says Joseph Callanan, senior managing director of CB Richard Ellis' Global Property Advisors division.

But those markets simply lacked the same depth of quality office assets that exists in the U.S. The deluge of capital quickly compressed yields in such foreign markets to around 5% or 6%, which is beyond the reasonable risk/reward equation for the locations.

As a result, fund managers returned to the U.S. and have begun analyzing rent and job growth more intently as part of their due diligence on markets. Ultimately, the funds have billions of dollars of capital to place and are trying to justify paying higher prices for assets in the U.S.

“They know they need to be more aggressive than they have been in the past,” Callanan says. He and other experts say the credit crunch should benefit foreign investors in U.S. real estate — even in the pricey major markets (see sidebar).

Joining forces

In addition to direct commercial real estate investment, German and other European funds are increasingly funneling capital into U.S. opportunity funds and partnering with local developers in the States to increase capital placements.

Germany's HCI Capital, for example, last year raised $100 million in its HCI Real Estate Growth USA I fund of funds. The company, a diversified closed-end fund manager that oversees 36 closed-end real estate funds, then fed that cash into the Blackstone Group, AEW Capital Management, CB Richard Ellis Investors and Capmark Financial Group, among others. The goal: to capture short-term appreciation from value-add strategies.

This year, HCI says it plans to launch a global opportunity fund. It also intends to establish the HCI Real Estate Finance Fund, which essentially will make mezzanine loans to U.S. property investors.

Meanwhile, in June this year, German investor SEB Asset Management paid $200 million to acquire an 85% stake in nine neighborhood shopping centers owned by Kimco Realty Corp., a New Hyde Park, N.Y.-based retail real estate investment trust. Kimco retained a 15% interest and will continue managing the assets.

The properties, located in the Baltimore, Richmond and Philadelphia areas, offer diversification for SEB's Global Property Fund, a mutual fund launched in 2006, Choy-Soon Chua, an SEB managing director, says in a statement.

The acquisition continues a strategy of partnering with U.S. operators and developers, which reduces the risk of investing solely in a project, Chua adds. In 2005, SEB's Target Return Fund began working with Gainesville, Fla.-based developer Paradigm Properties to invest in student housing projects, the only German fund to focus on the product, according to SEB. Since then, SEB has placed about $44 million in four student housing assets in Florida.

“For many overseas investors, the opportunity to invest in a domestic platform where there's an operating capability and a potential for growth is very attractive,” says Callanan of CB Richard Ellis Investors. “I think we'll see a lot of those deals over the next couple of years.”

Joe Gose is a Kansas City-based writer.

Credit crunch gives foreign investors an edge

Agitation over the subprime residential mortgage debacle bled into the commercial real estate debt markets this summer, effectively strangling liquidity. But that ultimately could level the playing field and mean more opportunities for German and other European real estate funds, which are returning to U.S. markets after high prices cooled their investment activity over the last couple of years.

Many of the foreign money pools typically use between 50% and 70% of debt to finance their acquisitions, which is a lot less than private equity buyers, ambitious and busy investors who in some cases have used upwards of 95% in debt.

The conservative approach is one reason that foreign capital funds all but became net sellers last year — particularly in major markets. The funds simply couldn't compete with highly leveraged buyers when bidding for properties, experts say.

But now the credit crunch makes German and European funds more competitive, says Gary Koster, Americas leader for Ernst & Young's Real Estate Fund Services. A dried-up debt market means more expensive debt, which makes it tougher for highly leveraged buyers to finance acquisitions.

“The good news is that there's going to be less buyers in the market,” Koster says. “It's going to create a better buying opportunity with greater pure yield if you have fresh powder.”

In fact, international investors have closed 46 transactions valued at $5.27 billion in New York this year compared with 28 deals for all of last year, according to Real Capital Analytics, a New York-based research firm that tracks real estate deals of more than $5 million.

Late this summer, for example, Risanamento, an Italian publicly traded real estate investment firm that owns nearly $7 billion in global property, acquired 660 Madison Avenue in New York for $375 million. Risanamento financed the deal with $275 million in debt provided by Deutsche Bank, which amounted to about 73% of the cost.

The deal illustrates foreign capital's willingness to get more aggressive on pricing than in the past, too. Typically, European and German funds were looking for initial yields of at least 6% or so. Alexio Pasquazzo, finance manager for Risanamento, says that the company bought 660 Madison at a yield of 3.6%.

But Pasquazzo notes that tenants were paying rents significantly below market. He anticipates that the yield will climb to 6% as leases are renewed at higher rates over the next three years.

“For Risanamento, this will be a long-term investment,” Pasquazzo says. “Therefore, we maintain a long-term view on the building and its relevant market.”
Joe Gose