To understand how the downturn in the U.S. real estate market will affect the direction of cross-border investment in retail properties this year, take a close look at the most significant foreign acquisition to date, the sale of 730-750 N. Michigan Avenue in Chicago to Ponte Gadea S.L.
In January, the real estate company owned by Amancio Ortega, founder of the Spanish fashion chain Zara, paid $350 million for the 217,000-square-foot building. As real estate deals go, the Ponte Gadea sale is nothing to scoff at. The property, whose tenants include Tiffany & Co., Ralph Lauren and American Girl Place, serves as a prime retail destination on Chicago's Magnificent Mile and the sellers, a joint venture of Prudential PLC and JPMorgan Chase Strategic Property Fund, made a 40 percent profit on the $250 million they paid for the building just three years earlier, in December 2004.
As a result, some brokers, including Steve Collins, managing director of the international capital group with Jones Lang LaSalle, a Chicago-based real estate services firm, considers it a sign of foreigners' continued interest in U.S. retail assets.
Compare that deal to the first major acquisition of 2007, when Australian listed property trust Centro Properties Group broke numerous records with its $6.2 billion purchase of New Plan, a New York-based operator of 467 grocery-anchored shopping centers, and you will realize how much the market has changed. Mega-deals requiring billions of dollars worth of debt and equity and a healthy appetite for risk are a thing of the past. Going forward, foreign investors will concentrate on smaller, foolproof transactions involving trophy properties in core cities and class-A regional malls.
In addition, while Australian players dominated cross-border investment in 2007, in 2008 it will be West Europeans and Middle Easterners who will be on the hunt for U.S. assets.
In 2007, cross-border sales of U.S. retail properties reached a record $12 billion, according to New York-based Real Capital Analytics. The Centro deal made up a large chunk of that figure. In fact, Australian investors, who closed several large portfolio deals at the beginning of the year, accounted for 67 percent of all cross-border transactions in 2007.
This year, the volume may be down by as much as two-thirds, says Suzanne Mulvee, senior real estate economist with Property & Portfolio Research, a Boston-based independent real estate research and portfolio strategy firm.
Now, buyers dominated by West Europeans will concentrate on single-asset opportunities or small portfolio acquisitions in primary markets including New York, Boston, Washington, D.C., Chicago, Los Angeles, Seattle and San Francisco, according to Joseph French, national director of retail properties with Irvine, Calif.-based brokerage firm Sperry Van Ness.
“We have an expectation that investment flows into retail space will slow a bit, in spite of the fact that international investors are expected to increase their interest in the U.S. market overall,” says Sam Chandan, chief economist with Reis, Inc. “By and large they want to take a position that offers an exit and there is a perception right now that retail is more difficult because of consumer confidence issues and there is more retail space coming on-line this year. That's leading them to look more closely at office and multifamily.”
Just browsing
The upside is that the U.S. remains at the top of the shopping list for foreign investors interested in commercial real estate acquisitions, with 56 percent of buyers ranking it as the most stable and secure country for investment, according to the Global Snapshot survey by the Association of Foreign Investors in Real Estate (AFIRE).
What's more, the weakening U.S. dollar against the world's major currencies, rising cap rates in the retail sector and waning competition from private investors make this an opportune time to buy, says David J. Lynn, managing director of research and investment strategy with ING Clarion Real Estate, a New York City-based real estate investment manager. Besides the U.S., foreign investors also consider Germany, the United Kingdom, Australia and Japan as attractive markets for property, reports AFIRE.
But at the moment, the U.S. offers greater transparency and better yields, says French. Whereas in the United Kingdom, a core retail asset currently carries a yield of 6.25 percent to 6.5 percent, an equivalent property in the U.S. offers a yield of up to 7.5 percent. Plus, with many U.S.-based buyers facing difficulty getting financing for new acquisitions and insisting on higher cap rates, the Europeans can easily outbid local buyers due to favorable currency rates.
As of Apr. 14, the dollar was trading at $1.58 to the euro and $1.98 to the British pound, while the number of new listings in the retail market outpaced closings 4 to 1, according to Real Capital Analytics. Retail properties that would have garnered 30 bids six months ago are receiving just a dozen offers now, says Collins, who cited Jones Lang LaSalle's European clientele as poised for significant acquisitions this year. The most prominent among them: Irish, German and English, as well as some Scandinavians.
The Dutch also plan to enter the game — on Apr. 18, Netherlands-based financial firms United Investment Company and SNS REAAL announced the formation of a $1 billion fund to finance the development of low-risk retail projects in the U.S., including banks and Starbucks coffee shops.
In addition to their added bargaining power, Europeans, excluding the Irish, have the advantage of lower leverage ratios than U.S. investors; they contribute 60 percent equity to their deals, Collins notes, making them less vulnerable to the turmoil in the credit markets.
“I was on the phone with a Swedish group today that wants to buy in the U.S. — they are coming over in a couple of weeks, not looking for steals, just for good quality assets,” he says. “And in the past, you could probably count active U.K. investors on one hand. This week, we met with three separate U.K. firms who decided that they now want to focus on the U.S. for investments (specifically retail).”
The catch, according to Dan Fasulo, managing director with Real Capital Analytics, is these buyers are looking for prime assets — class-A regional malls and Main Street addresses in the gateway cities of New York, Boston, Washington, D.C., Seattle, San Francisco and Los Angeles — not exactly the caliber of properties that trade hands often; especially in a down market. “In those markets where there is overwhelming confidence about the future, they have continued to buy,” says Fasulo. “If there is any pause, it's been in the secondary markets. Everyone is worried about the economic growth in the future and how it's going to affect retail properties.”
In 2008, market experts also anticipate fewer portfolio sales, Chandan says, with large financing deals harder to come by and buyers more careful about taking on second-rate properties that can be difficult to lease or sell. With the national vacancy rate rising, this year, they will evaluate each asset on its own merit. A few years ago, investors could be coerced into buying portfolios with some less-than-stellar assets because they were anxious to get the trophy property.
That is not to say foreign investors have lost their appetite for portfolios altogether. French, for example, is in negotiations with a German group that wants to buy six single-tenant fast-food restaurant assets in the United States. But 2008 portfolio deals will be smaller than in 2007, comprising about half a dozen properties and valued in the neighborhood of $100 million, French says.
If any megadeals do occur this year they are likely to involve Middle Eastern sovereign wealth funds picking up operating companies wholesale, says Collins. Several, including Qatar-based Qatar Investment Authority and Bahrain-based Arcapita Bank, have expressed interest in U.S.-based REITs. The REITs are particularly attractive right now because, as a sector, they have been trading at about 20 percent to 30 percent below their estimated value this year.
Combined, the world's existing sovereign wealth funds, state-owned funds supported by stocks, bonds and real property, have purchasing power of $3 trillion, of which approximately 10 percent is designated for investment in real estate, says David M. Jacobstein, chief advisor to the real estate group at New York-based professional services firm Deloitte and former chief operating officer of shopping center REIT Developers Diversified Realty.
“There is tremendous capital capacity and they have to invest their money somewhere and the U.S. is probably a safer place than most parts of the world,” he notes. “They used to invest in private equity funds, which in turn invested in real estate, but now for the first time they are starting to make direct investments in both real estate and real estate operating companies.”
The sovereign wealth funds might also end up taking over Centro's U.S. portfolio, one of the largest chunks of retail space likely to come on the market in 2008, says Collins. When rumors surfaced about Centro receiving several takeover bids on Apr. 3, reported suitors included U.S.-based Citadel Investment Group, Blackstone Group and Lightstone Partners and Australia-based Macquarie Group.
At a stalemate
But while foreign buyers continue to express interest in U.S. retail properties, many are waiting for the cap rates to rise before making an offer. Average cap rates for retail properties have already increased 30 basis points in the past 10 months, from 6.5 percent in June 2007 to 6.79 percent in February, according to Real Capital Analytics. And that's a conservative estimate, since the trend toward sales of high-quality assets in the past few months has skewed the numbers lower. The actual increase might be more in the 75-basis-points to 100-basis- points range, says Joseph A. Callanan, senior managing director with Los Angeles-based CB Richard Ellis Global Property Advisors. But, he adds, cap rates have room to grow another 85 basis points.
What foreign investors don't seem to realize is the jumps will probably not affect class-A properties in key markets.
“We get numerous calls from our associates in other parts of the world, particularly in the Middle East, that say the client wants to buy distressed real estate in New York City at 40 percent off,” Collins says. “That's not going to happen; there are still too many buyers keeping the pricing up.”