Stiff competition from local players is diverting foreign capital away from hotbed markets like New York and Los Angeles. It’s also luring some offshore dollars into value-added properties.

Those are two takeaways from the Association of Foreign Investors in Real Estate (AFIRE) conference that was held earlier this week at Boston’s Four Seasons Hotel. The yearly gathering brought together hundreds of top investors and investment managers from around the world. All of the AFIRE delegates invest in U.S. commercial real estate.

San Diego and Tampa are two secondary office markets that weren’t exactly on foreign investors’ map until recently. But both cities’ office markets have seen a steady increase in foreign demand, according to AFIRE.

“We are not afraid of secondary markets [in the U.S.],” says Peter LeLoux, chairman of the board at Munich-based Oppenheim Immobilien KAG, which sponsors a large German open-end property fund. “We’ve bought commercial properties in secondary markets on the West Coast and in Tampa.”

LeLoux says that Oppenheim Immobilien has invested roughly $250 million into the U.S. property market this year. Were there more core offerings, not to mention higher yields, he says he would have invested twice that amount by now.

Foreign investors generated 13% of all U.S. investment-grade office sales during the second quarter, reports Cushman & Wakefield.

So will LeLoux buy more U.S. commercial real estate if more sellers enter the market? “We have a strong appetite for properties, so we would be in the market,” he says.

Core yield compression = Value added demand

It’s well known that the U.S. office market is booming with respect to both sales and leasing volume. But get this: The largest economy in the world is also expected to generate 45% of all global office sales this year. Janice Stanton, a senior managing director at Cushman & Wakefield, adds that a tight lid on new supply will continue to juice market fundamentals.

“New construction really isn’t that high given how well the fundamentals are shaping up,” says Stanton, who presented her data at the conference. Expect office assets in primary and secondary markets to continue turning over at a furious clip, too: Stanton claims that 40% of the Phoenix office market changed hands last year as profit takers exited the market.

When asked about a possible influx of foreign capital into secondary markets such as Phoenix, Stanton believes that the more interesting shift involves foreign capital buying value-added properties.

“The cash yields [for core properties] are very low, so that’s one big concern for foreign buyers,” says Stanton, who sees more U.S. investment managers plowing foreign capital into value-added deals.

Cap Rates By Market Size*

1/06 7/06
Secondary 7.2% 7.1%
Primary 6.8% 6.7%

*deals over $5 million in U.S.

Source: Real Capital Analytics

“Some foreign buyers also suffer from being relatively unknown in a super competitive market, which doesn’t help them win competitive bidding wars,” she adds.

AFIRE panelist Lynn Thurber, CEO at Chicago-based LaSalle Investment Management, says that most of her investors — her company manages $39.5 billion in private real estate throughout the world — prefer value-added deals over core for a very simple reason: Yield compression for core properties remains an issue.

“But the spread between core and value-added yields [for investment grade properties] isn’t getting any wider. It was about 150 basis points last year, but we’re now seeing it tighten to 50 basis points,” she says.

Red Flags On Chinese Property

Ian Hawksworth, managing director at UK-based Capital & Counties, offered AFIRE delegates a sobering appraisal of the Chinese property markets. Emulating late night talk show host David Letterman, Hawksworth delivered a “Top 10” List for investors eying Red China’s high risk/high return property market:

No. 1: Don’t follow the crowd.
No. 2: Don’t think that you can quickly dip in and out of the Chinese property market.
No. 3: A proper evaluation of the risks [involved in Chinese property investing] isn’t possible.
No. 4: China will be the most important property market in 30 years, so developers need to establish a long-term business there.
No. 5: Do not fool yourself that China is different than most real estate markets.
No. 6: Decide what your cycle [hold period] is before you enter the market.
No. 7: Plan for a collapse in the market.
No. 8: Don’t try to fool the Asian consumer.
No. 9: Don’t be too keen to get the deal done.

No. 10:

Try to listen to your local partners and adapt to their style.

“There are billions [of various currencies] heading east, destined for China,” says the well-traveled Hawksworth, who has endured several Asian coups and secret police interrogations over the past few decades.

Capital & Counties owns a $1.08 billion portfolio of commercial properties in both the UK and US. The company is owned by FTSE 100 (London stock exchange) listed firm Liberty International, which predominately owns retail centers in the UK.