Time to take on the world
Real estate investment is now closely tied to the capital markets, as the growth in global capital flows has propelled this asset class into the international arena. Institutional investors the world over are closely examining the prospect of real estate investment on a global basis. The issue is complex, as standard cross-border investment issues are compounded by the local nature of the real estate industry. Profitable tactical opportunities are available for international real estate investors equipped to tackle a global strategy rewards, both in nominal and risk-adjusted terms, for expanding the investment horizon beyond national borders is compelling.
Real estate is an especially interesting cross-border investment at present, since global real estate investment strategies remain in their infancy relative to global equity investing. There are good reasons for this, among which are:
q real estate’s highly intensive management requirements;
q property market information and analysis, which is spotty and often driven by marketing requirements; and
q poor initial results in previous forays into cross-border property investing.
In each case, the problem is often magnified because of the limited local knowledge of the in-bound investment fund and its management. Whereas investment in equities requires monitoring of performance reports – which can be done at the home office – property investment requires on-site asset management. But if these hurdles can be surmounted, the potential rewards are significant – and should be enhanced for the early adopters of a truly global perspective.
In the recent past, cross-border property investors have tended to follow one of two courses when securing assets abroad:
q Build-your-own network. This has been the traditional approach of many major public property companies and institutional investors. While a wholly owned network brings control and access to local markets, the tangible and intangible costs of establishing the network are significant. There is a risk that the existence of a network representing large sunk costs may be a disincentive to trade out of a market or sell individual assets at an opportune time in the property cycle.
q A series of affiliations with local market experts. The goal is to align the interests of various different local experts with those of the investor through financial participation in investment performance. In addition to bringing local market expertise to the cross-border investor, this strategy may also bring the unwanted added complexity of managing a series of different joint ventures, partnerships and other relationships.
In fact, to be cost-effective, a real estate investor following the traditional pattern of direct, asset-by-asset investment would have to commit to a large enough investment in a foreign country to support a locally knowledgeable asset management infrastructure. Such a commitment would allow for appropriate oversight of specific assets, as well a growing familiarity with local market conditions. The latter is especially needed as a corrective to the uneven quality of information publicly available on local markets. And, with appropriate local asset management infrastructure, property oversight, and information analysis, the likelihood of sub-par performance would be diminished.
The principal concern with implementing cross-border real estate investment strategies is the perceived level of risk associated with investing in foreign markets. The principal cross-border risk factors that cause concern – other than traditional market and property level factors, can be broken down into three categories:
q Political risk – concerns that a foreign society will implement unanticipated policies or initiate events that will be detrimental to investment performance;
q Currency risk – this risk is applicable to all cross-border investment, and can be managed through hedging strategies which result in higher return requirements on cross-border deals; and
q Tax risk – where cross-border investing can create myriad additional tax issues for tax-exempt institutions. These can be mitigated by artfully structuring individual transactions, but cannot be entirely eliminated.
Risk reduction, necessary to any cross-border strategy, is primarily achieved through local knowledge. Accessing locally based real estate exerts whose interests are aligned with those of the investor mitigates the tyrannies and uncertainties of distance. Unfortunately, this level of commitment assumes a massive investment in each of a number of markets, and makes it impractical (if not impossible) for many institutional investors to pursue a dedicated cross-border strategy. However, there are – particularly in the well-developed US property markets – significant alternatives. The US markets have, over the past decade, developed a complex series of alternatives that make indirect investing in American property available to institutions from around the world. The alternatives available include:
q The real estate investment trust market. Following some technical changes in the structure of real estate investment trusts (REITs) in 1992, the market saw an explosion of initial public offerings of equity real estate companies. The current market capitalisation of the REIT market in the US is approximately $150bn, after rebounding in 2000 from a dismal performance in 1999. Although there are over 100 REITs, the market for each property type is dominated by a few large national or regional companies with individually high market capitalisation and large enough stock floatations to allow liquidity in the shares. US pension funds are large holders of stock in many of these top-tier REITs, attracted by a combination of relatively liquid property investments, transparent management reporting requirements, and high returns. In addition, with many REITs selling at a discount to the net asset value of the underlying property portfolios, the potential for further upside in share prices remains bright.
q The commercial mortgage-backed securities market. The commercial mortgage-backed securities (CMBS) market developed in the US in the aftermath of the banking crisis of the early 1990s. The market is now quite mature, having levelled out at approximately $50bn–55bn in new offerings each year. The market for investment-grade CMBS is very liquid, with an active secondary market and transparent pricing. The structure of the securities themselves, however, differs from the norm for European CMBS in that in theUS single asset issues are the exception, and virtually all CMBS offerings are portfolios of commercial loans. These portfolios are generally quite diverse, with representation from all major property types and all regions of the US. Creditworthiness of individual mortgages varies widely, and so these securities are highly structured to achieve acceptable credit ratings for the different tranches offered.
q Investment in third-party managed funds. Because of the size and variety of the US pension investment market, funds run by independent managers attract capital from numerous individual pension funds that share common investment goals. These funds vary from core investment vehicles to high-yield opportunistic property investment schemes. They have in common an arrangement that effectively separates the allocation of capital – the responsibility of the investment manager – from the cost of maintaining the network – the responsibility of the service provider. As the service provider is not dependent upon the investor’s capital, it will remain in a market whether or not an individual investor remains committed to it. This facilitates the investor’s ability to sell out of and then re-enter a given market without concern for dismantling or rebuilding an infrastructure. It also allows the investor to secure assets in a number of markets simultaneously, thus increasing diversification and reducing risk.
The real estate industry is in a period of major evolution to meet the global needs of real estate users and investors. Real estate is increasingly viewed as an asset-based industry that competes in global capital markets as opposed to a separate asset class operating under unique rules and financial regimes. Cross-border investment strategies are the culmination of this evolution.
The key to success is overcoming the global/local tension that distinguishes real estate. The capital markets are global, but the property markets are local. The investor’s goal is to access both markets to reduce risk while preserving flexibility. One of the most important tools available to the sophisticated cross-border investor is the ability to invest in property markets indirectly, thereby avoiding the costs of establishing multiple local networks. Currently, this section of the property investor’s toolbox is most fully developed in the United States, where a slowing but still powerful economy may make property pricing attractive in the coming months.
Arthur Margon is a principal in Lend Lease Real Estate Investments, based in New York