Europeans return to US real estate
After steering clear of the US from 1991–95, European pension funds are once again investing in US property. However, there has been a significant change in the participants since the British and Dutch invested heavily in US real estate in the 1980s. In particular, Dutch pension funds are now big investors in US REITs (real estate investment trusts) and German bank-sponsored funds are buying high-quality assets with long leases.
European investment in US real estate is part of a much larger boom in overall foreign direct investment (FDI) across the world and to the US in particular. FDI includes all assets that are wholly purchased, as opposed to shares in companies or partial interests. The numbers are dominated by investments in companies (such as Daimler-Benz’s purchase of Chrysler), with hard assets like real estate representing less than 5% of total inflows in 1997 and 1998.
Although corporate takeovers often include some real estate, most of the investment in US real estate is highly targeted and comes from offshore pension funds, insurance companies and other institutions.
European investors in US real estate look for stable, income-producing assets that offer two important features: capital preservation, and higher current yields than bonds. Although American real estate markets have historically been very cyclical, European investors are now attracted to the sector for the following reasons:
q Real estate, unlike the US stock market, is priced well below its last peak and thus offers good relative value in the world’s largest economy.
q The supply/demand fundamentals are strong and the major markets are showing more market discipline than the over-heated cycle of the 1980s.
q A well-established institutional property sector provides a high degree of transparency with enforceable contracts and professional management practices.
Indeed, the Jones Lang LaSalle Transparency Ranking places the US in the highest category of property market transparency. This ranking was achieved based on the ready availability of: reliable performance benchmarks, high-quality market data, reliable financials, alignment of interest among directors, managers and investors; and finally, low levels of taxes, penalties and restrictions on cross-border transactions. The other countries with the highest ranking include UK, Australia and Canada.
Over the past 12 years, there have been three distinct periods for real estate foreign direct investments (REFDI) to the US. From 1987–90, offshore investors (principally the Japanese) placed some $13.6bn in US real estate. This large level of investing contributed to overbuilding in most US markets, and fell off abruptly when prices and returns collapsed in 1991. From 1991 to 1995, net REFDI was virtually nil, as the US real estate markets were severely depressed and then in recovery.
REFDI has rebounded in recent years, although inflows have been more moderate than in the late 1980s. According to the US Bureau of Economic Analysis, net flows to real estate from outside the US have totaled $10.5bn over the past three years (1996–98). But there is little evidence that this level of investment is affecting asset prices – cap rates (also called initial yields in Europe) are significantly above the levels seen in the late 1980s. The REFDI data understates the total inflows in that it does not include indirect investments such as shares of REITs or real estate lending. The Dutch in particular have made significant investments in REITs over the past several years due to a favourable tax treaty and European banks have been among the most active lenders.
The sources of REFDI has shown dramatic changes over the past decade. Asian/Pacific countries led all investors from 1988–90, although net inflows from European Union countries were a sizeable $2.1bn over that period. Gross capital flows over that same period are estimated to be double or approximately $4.5bn. During the US real estate downturn of 1991–95, Asian countries pulled almost $1bn out of the US real estate market, while other regions showed small but positive gains. The OPEC countries were the leading offshore investors during this period; those investments should pay off nicely as the US real estate market has recovered faster and more strongly than forecast.
Over the past three years, the most active direct buyers have been from Germany (almost $2bn, net). The biggest players have been the open-ended funds (Offener Immobilienfonds) which raise capital by selling shares to the public. These shares are redeemable at any time and the value of each fund is set every 10 days. The funds are tax-transparent and dividends are open to subscription from the public. Our Frankfurt office reports that net inflows into these funds were $2.47bn in 1998 and the data for 1999 show that the inflows are likely to exceed $10bn. Not all of these funds are permitted to invest in the US, but many now have set targets to place up to 20% of their assets outside of Europe. The closed-end funds are also very active and have raised similar amounts of money to invest specifically in real estate.
European direct investment in US real estate will stay at high levels as long as US property markets do not become overbuilt. Our analysis shows substantial evidence of greater discipline by the capital markets, which reduces the chances of overbuilding. Now that the sector is providing competitive returns, its advantages of size, transparency and accessibility will continue to attract investment capital.
In the past, the typical foreign investor was attracted to large ‘trophy’ or Class A office buildings or regional malls in major US cities. Cities such as New York, Chicago and San Francisco with dense transit-oriented downtowns (like in Europe and Japan) were very popular. Today, European investors are savvier, and look far and wide for good investments and local partners. Very few are direct buyers of regional malls, but several European institutions have made strategic investments in mall companies such as Simon, Macerich or the Mills Corporation. German buyers also favour smaller, community or neighbourhood shopping centres. Larger office properties in strong suburban markets or central business districts are also targeted by both Dutch and German investors. Disappointing returns posted by REITs in the past two years have led Dutch investors to seek more joint ventures, with REITs as partners in a direct investment, as opposed to an entity-level investment. However, REITs are now trading at 15% discounts to their net asset values and are beginning to attract bargain-hunting European investors.
The rapid growth of e-commerce around the world, and particularly in the US, has also raised questions about the sustainability of the demand for ‘bricks and mortar’. Our analysis shows that the rapid growth of internet companies and e-commerce is creating far more demand for real estate than it is displacing. One of the tightest office markets in the country is in Silicon Valley, where the cost of commercial real estate has doubled in the past three years. We expect to see more European investors gravitating to the five or six strongest ‘technology markets’ in the US in the years ahead. These include Boston, San Francisco, suburban Washington DC, Seattle and Los Angeles.
Jacques Gordon is managing director and William Maher principal at LaSalle Investment Management in Chicago