Markets/Global Investing

Capital Gravitating to Hot Spots

Today, investment capital flows into commercial real estate projects and properties in virtually every corner of the globe. Direct trans-border real estate investment totaled $290 billion by midyear, 30% ahead of year-earlier levels, and is expected to reach a record $600 billion for the year, according to Jones Lang LaSalle.

So, is the competition to place funds creating bubbles of overpriced assets? Certainly, there is reason to be alert to the risk: Like heat-seeking missiles, investors tend to gravitate to the well-known hot spots, where some market observers say, there are disquieting signs of overheating. That includes some developing economies and some sectors within the U.S. market, including retail and industrial.

"Looking around the world, there are a lot of places that just make me scratch my head,” says Ross Moore, senior vice president of market and economic research at Colliers International in Boston.

Tokyo, he says, is one. The city has 12.4 million sq. ft. of office space under construction, equivalent to nearly 2% of existing inventory. By contrast, Manhattan has 5.5 million sq. ft. under construction, equal to about 1.5% of inventory. The U.S. economy is expected to grow 3.4% this year, faster than Japan’s 3%. “We follow Tokyo pretty carefully, and [that construction] makes no sense to me,” says Moore.

Still, Moore’s concern does not extend much beyond head-scratching at this point. After all, he notes, Tokyo’s office vacancy rate was 4% at midyear, down from 5% in December and 6% a year ago, according to Colliers data.

Dubai is another magnet for global capital. There, 24 million sq. ft. of office space is under construction—in a city that currently has just 14 million sq. ft. of space. But, because the oil-rich city is morphing into a global money center, demand for space is so high that companies are renting houses for office space until they can move into the new towers that are appearing on the skyline. It’s unclear how much of the space going up is pre-leased. The Dubai market has traditionally resisted preleasing, but the practice is becoming more common due to the tight, 1% office vacancy rate, according to Colliers.

Calgary, Alberta, also enjoying the oil boom, is growing its office supply by a whopping 6.6% this year with the construction of 3.3 million sq. ft. But with a 1.46% vacancy rate in the suburbs and zero vacancy downtown, the injection of new space seems sorely needed.

Gambling on growth

"The globalization of real estate investment has had the greatest impact on developing markets,” says Tony Horrell, CEO of Jones Lang LaSalle’s International Capital Group. Emerging markets lead the pack in terms of construction, largely building to future demand based on economic growth projections.

Investors have certainly been enthusiastic about the so-called BRIC economies (Brazil, Russia, India and China). As a result, Moscow has 26.9 million sq. ft. of office space under construction, Beijing has 23.58 million and Shanghai has 21.61 million sq. ft. in the pipeline.

"Look at Shanghai and Beijing,” says Moore of Colliers. “All that office space is basically sitting empty, based on the hope that the Chinese economy is going to keep growing by 10% a year. It probably will, but let’s say the economy slows down, or the U.S. stops consuming Chinese goods. You’d really feel that.”

Cap rates and volatility

Investors are not unaware of the added risks in some of these markets. In Russia, for example, investors can buy commercial property with high initial cap rates, but they are also aware that the outsized returns reflect outsized risks, both economic and political, Moore says.

Moscow’s average office cap rate of 10% contrasts with 6.5% in Warsaw, which enjoys a more stable market and prospects for an economic boost through participation in the European Union. “In St. Petersburg, the cap rate is 13%, but who knows if you’ll ever get your money back,” Moore says. “At the end of the day, it’s all about risk and return.”

However, it’s a mistake to interpret a low cap rate as an indicator of safety, says Bob White, president of Real Capital Analytics, which tracks commercial real estate investments in the United States. “Cap rates are all-encompassing,” he says. “There are so many other things baked in there.”

To complicate matters, in emerging economies such as India and China, the commercial real estate markets still lack transparency. Investors in these markets, White says, are a bit like those who picked up repossessed commercial properties from the Resolution Trust Corp. in the 1990s after the savings and loan scandals. “Over time, they were well-compensated and got great returns, but they didn’t entirely know what they were getting into,” White says. “Those conditions still hold in some of these foreign markets. It’s like the wild west out there.”

U.S. trouble spots

On the other hand, in the U.S., market transparency has helped avoid some of the extremes of past cycles. For example, San Diego showed signs of unrealistically high pricing due to intense investor competition in early 2005. Thanks to widely available market data, many investors saw the red flags and put money elsewhere, defusing the speculative bomb. “Total transaction volume for the U.S. market was up 50% in 2005, but it was flat, if not negative, in San Diego,” White says.

While it’s way to soon to sound the all-clear, there are signs that excesses in the U.S. condo market are also being unwound. “A year ago I did feel the condo market was getting out of hand,” says White. “Then around Thanksgiving, the market showed some softening, and almost immediately the lenders started slowing if not curtailing in total their lending to condo converters.”

The retail sector has shown signs of overheating but, again, investors are paying attention: In a recent survey by Real Estate Research Corp. (RERC) and Certified Commercial Investment Member (CCIM), investors ranked retail last among property sectors for potential returns.

The U.S. industrial market has also become frothy in some areas, says Craig Thomas, senior vice president and director of research at Torto Wheaton Research. “There are technological changes taking place in the distribution industry, and companies prefer larger, high-ceilinged buildings of 200,000 and 300,000 sq. ft. in important distribution areas,” he says. “It’s relegating a lot of 100,000 sq. ft. and smaller boxes to being almost obsolete now.”

On the international front, where lender discipline may have less influence on investment, the equivalent of $3 dollars is chasing every $1 worth of available real estate and pushing property values skyward. It’s difficult to determine when a market has become overpriced, but rapid value increases are a red flag. Places to monitor include Hong Kong, which is experiencing unusually high pricing of $224.53 per square foot for offices, according to Colliers, but is known for volatile swings.

"We talk about cap rates having come down in the United States, but they’ve come down much more so in other places,” says Moore of Colliers. Cap rates in Prague, for example, have fallen from 12% five years ago to 5.6% today. “That’s serious cap rate compression. Unless operating income has come way down, that implies that values have gone up dramatically.”

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