Foreign investment in U.S. commercial real estate continues to grow by leaps and bounds, but fierce competition has boosted the price of admission and led to more creative ways to finance— from joint venture partnerships to preferred equity deals.
In 2004, foreign investors plowed $13 billion into U.S. real estate, an increase of more than 60% over 2003, reports Real Capital Analytics. The flood of capital shows no signs of retreating anytime soon. In February, for example, Macquarie CountryWide Trust of Australia and Regency Centers, a Florida-based REIT, announced the $2.7 billion purchase of 101 grocery-anchored shopping centers from CalPERS/First Washington.
The deal, which gives Macquarie a 65% ownership interest in those 101 properties, makes the joint venture partnership one of the largest owners of grocery-anchored shopping centers in the U.S.
With prices rising and cap rates falling, the Aussies are helping to offset any pullback by German investment funds, some of which are curtailing their investment in the U.S. because they are hamstrung by strict rules on yields and use of leverage. Even so, German investors poured nearly $5 billion into U.S. commercial real estate in 2004, by far the largest source of foreign capital. The Australians ranked No. 2 with $3.4 billion invested (seebelow).
There is a feverish demand for properties among both domestic and foreign investors, says Jim Fetgatter, chief executive of the Association of Foreign Investors in Real Estate (AFIRE). “There is a wall of liquidity trying to find the best yields,” he says.
That capital influx shows no signs of abating anytime soon. A survey conducted for AFIRE published in January indicates that its members plan to increase their investment in real estate both globally and domestically in 2005, with slightly more than half of those total allocations (55%) targeted for U.S. real estate. Foreign investment accounts for 24% of the institutional equity invested in all income-producing properties in the U.S., estimates Fetgatter.
Investors get creative
As German investors look for new ways to invest in American commercial real estate, without running afoul of their own legal and financial structures, many are entering into preferred equity structures, which pose less risk than more traditional forms of ownership.
Last December, Jamestown, an established German syndicator with offices located in Atlanta and Cologne, Germany, recapitalized New York's General Motors building, valued at about $1.7 billion, in a preferred equity structure, explains Stephen Zoukis, a partner with Jamestown. The syndicator invested $300 million in the property, replacing short-term equity and debt financing from Vornado Realty Trust and international financier George Soros, a hedge fund investor and currency trader.
A preferred equity structure works essentially the same way as a preferred stock investment. Jamestown is not buying the building outright, but rather a stake in the property, says Brad Olsen, president of Cary, N.C.-based Atlantic Partners, an investment advisory firm specializing in European and American investments. A preferred equity structure typically includes a local operating partner and a passive investor, which in the Jamestown/GM deal would be Jamestown. The operating partner is New York-based real estate magnate Harry Macklowe.
In preferred equity deals, the preferred equity investor/partner will receive a higher return on current cash flows in the short run in exchange for a lower return at a later date, when either the rents or the value of the property increase, explains Olsen. Typically, a preferred equity structure protects the new investor from some portion of the downside risk, such as the loss of a major tenant or decreased rents. But since the operating partner assumes more risk, he stands to yield higher returns in the end, if the investment performs well.
German investors prefer to own office buildings in the corridor that runs from Washington, D.C. to Boston, the markets with predominately high barriers to entry. The problem is that American institutional investors also are bidding aggressively on those same Class-A assets, which have traditionally appealed to the German market, says Steve McCarthy, managing director of Atlanta-based WestWind Capital Partners. McCarthy represents the Kan Am Group, a collection of German investment funds based in Munich and Frankfurt.
The bidding process for these properties has become more competitive in the last year or two for a variety of reasons, says McCarthy. “Some buyers are willing to make non-refundable deposits to get an asset, or waive due diligence,” he says.
U.S. pension funds present fierce competition for foreign investors because they are particularly aggressive buyers, says McCarthy. Fund managers who need to get money out the door to meet their target allocations have no choice but to spend money.
Fund managers “are less sensitive to the initial return, which determines the price you are willing to pay.” His own clients need to be more circumspect and methodical about the way they make their acquisitions, suggests McCarthy.
Why are German investors so enamored of U.S. office buildings? Investment funds are willing to pour a lot of money into office properties, Fetgatter explains, because they are much less management-intensive than retail and residential properties.
There are two types of German funds active in the American market — open-ended funds, which are similar to American REITs, and closed-end funds, which are similar to the syndicators that were active in the U.S. in the 1970s and 1980s. German law prohibits the open-ended funds from having more than 50% leverage on a portfolio basis, says McCarthy.
While closed-end funds have no legal restrictions on how much debt they can utilize, they need to be mindful of the cost of overhead as well as syndication and sales commissions. If they fail at expense control, they won't be able to offer the 7% returns that investors require, says McCarthy.
Many German investors also are attracted to the U.S. commercial property markets for tax reasons. “If Germans invest in U.S. real estate, they pay taxes in the U.S., but don't pay taxes in Germany,” says Fetgatter. The advantage is that they start at the bottom of the American graduated tax system.
Australians full speed ahead
While German investors are looking for creative ways to own real estate at the right price and stave off the competition, Australians are less concerned about price, but are flocking to America where they can get higher yields than in Australia, according to Fetgatter.
The volume of Australian commercial real estate investment, which is predominately in the office and retail sectors, is fueled by an Australian law, passed about 10 years ago, requiring employers to place 9% of their employees salaries into Australian superannuation funds, which are akin to American 401(k) funds, except they are not voluntary. As a result, Australia today has the fourth largest volume of pension funds under management in the world.
A lot of the money in superannuation funds is invested in listed property trusts in Australia, which are similar to American REITs. Because the listed property trusts have already purchased a considerable amount of commercial real estate in Australia, they are now moving capital offshore in an attempt to diversify their holdings.
The U.S. is the first port of call for Australian real estate capital, says Mark Baillie, head of real estate for North America and Europe for Macquarie Real Estate. “On a relative basis, America is an easier place to invest than other jurisdictions,” he says. The transparency of American corporate governance and the cultural affinity Aussies have for America make investment in the U.S. a natural, says Baillie.
Macquarie CountryWide Trust and its joint venture partners have $8 billion in assets under management in North America, says Baillie. Those holdings include retail, office, leisure and industrial properties in the U.S. Macquarie is continually seeking out local partners for their asset management skills and access to capital.
One of the giants in the mall industry is The Westfield Group, another Australian listed property trust, which has interests in 126 shopping centers in four countries — the U.S., Australia, New Zealand as well as the U.K.
Middle East is a player
The Middle East ranks fourth, just behind Canada, in terms of foreign investment in the U.S., according to Real Capital Analytics. Middle Easterners plowed nearly $1.2 billion into U.S. real estate in 2004, up from just over $1 billion in 2003. But that total may be understated, according to industry sources. Much of the capital that originates in the Middle East funnels through investment groups in the UK before the capital is employed in the U.S., according to Washington, D.C.-based Bill Prutting Jr., first vice president at CB Richard Ellis' Investment Properties Group.
Middle Eastern investors are more constrained than both their European or Australian counterparts, at least if they invest in an Islamic fund, explains Fetgatter. They can't, for example, invest in a business which involves the sale of liquor, or any other business activities which conflict with Islamic law. “They like industrial, because it is fairly easy to invest in this sector and comply with Islamic law,” he says.
Arcapita Inc., based in Bahrain but with U.S. offices in Atlanta, ensures that its investment practices comply with Islamic law.
Arcapita, formerly known as First Islamic Investment Bank in Bahrain (and whose American subsidiary was previously known as Crescent Capital Investments), has joint ventures with Denver-based ProLogis, an industrial REIT, and Denver-based Archstone-Smith, an apartment REIT. “We're among the larger capital partners with ProLogis,'” confirms Laine Kenan, director of Arcapita.
Arcapita cannot invest in an office building that has a financial institution as a tenant, because a business that earns interest is considered usurious, and usury is against Islamic law, says Kenan. “That is why we can't invest in the Bank of America Tower in Atlanta.”
Although Arcapita holds a banking license in Bahrain, “we are not a lending institution,” emphasizes Kenan. In America, says Kenan, Arcapita adheres to the traditional Islamic prohibition against usury by reconstituting loans into leases, then making lease payments to pay off what would otherwise be interest-bearing debt.
Foreign investors' concerns about currency risk vary, depending on whether they are buying with euros or dollars. While the euro is strong against the dollar (1 euro was worth $1.29 U.S. as of April 18), that doesn't necessarily mean that European investors enjoy an overwhelming advantage. That's because earnings from U.S. properties, which are calculated in dollars, are lower than they would be if they were calculated in euros, explains Bill Pollert, president of New York-based Capital Lease Funding.
However, not all Europeans buy real estate using euros. “Typically, high-net German investors keep part of their personal portfolio in dollar-based assets,” says McCarthy.
Americans tend to focus on currency fluctuations, says Fetgatter, because the dollar is so low compared to the euro. For an individual investor, the value of the dollar is important, but for a large fund with a longer-term investment horizon, it doesn't make much difference, he says.
“The real issue for European investors is what the dollar will be worth when converting back into euros,” says Fetgatter. If, for example, European investors are convinced that the dollar has hit bottom in relation to the euro, that's the time to invest so that when the value of the dollar increases, the value of their investments will increase.
Currency issues are not the main driver for foreign investors, however. The main attraction to American commercial real estate — regardless of high prices, low cap rates and steep competition — is that the U.S. remains a stable market.
Hortense Leon is a Miami-based writer