Second-tier markets

Attracting Global Investors

Priced out of big cities, international funds seek new opportunities in secondary markets.

U .S. markets always have attracted foreign investors, and this trend is expected to continue through year-end. Foreign investors accounted for more than $5.5 billion in real estate in 2003, slightly down from nearly $6 billion in 2002. This drop in spending is not due to decreased interest, but reflects foreign investors' difficulty in finding prime investment opportunities in first-tier markets, such as New York and Washington, D.C. As a result, many foreign investors are rethinking their strategies and turning to secondary markets to find high-performing assets.

Looking Beyond Big Cities

Although foreign investors have plenty of capital to invest, it has not been easy for many of them to build U.S. portfolios. U.S. investors targeting top properties often beat out foreign investors because of their ability to respond quickly to opportunities, their knowledge of the real estate markets, and their willingness to accept more risk.

Washington, D.C., New York, Los Angeles, San Francisco, and Chicago attract the majority of large foreign investors; however, many small foreign funds are shut out of these markets, prompting them to look beyond traditional big-city markets. To find the deals they're seeking, many are visiting second-tier U.S. markets, trying to understand what makes these cities tick. Today more activity and due diligence is occurring in San Diego, Atlanta, Denver, South Florida,and the Texas markets, to name a few.

Foreign investors primarily are interested in properties that qualify as top local assets and meet their usual investment criteria ? attractive high-quality buildings, credit tenants on long-term leases, and limited rollover exposure. For example, a Hamburg, Germany-based open-end fund operator recently purchased a $64 million office tower in downtown Seattle ? new territory for international investors familiar only with the top U.S. cities. The competition and high prices will continue to drive many foreign investors to similar markets with the hopes of picking up such opportunities.

Top Foreign Investors

German funds are the largest, most notable group of foreign investors currently active in U.S. commercial real estate. Recent legislative changes have increased the amount of capital Germans can invest outside of the European Union, and, as a result, more first-time German funds are entering the U.S. market. Many of these investors need to diversify their portfolios and believe that they can find opportunities to meet their goals in U.S. markets.

German funds generally seek secure investments that offer stable cash flows and are leased to credit tenants with minimal rollover. However, as many markets heat up, such properties are becoming more difficult to obtain at the prices that attract foreign investors.

Australian investors have been the second most active group, acquiring more than $2.5 billion of U.S. commercial real estate in 2003. Limited domestic real estate investment options, coupled with the Australian government's compulsory superannuation program, which requires employers to contribute 9 percent of employees' wages to a retirement fund, have fueled a U.S. investment wave. Direct investors in U.S. commercial markets include the $500 billion Australian pension funds, which seek stable, annuity-style returns over time and are administered by external fund management organizations.

Most private Australian investors have been successful by entering into joint ventures with U.S. operating companies. This strategy has proven a good fit for both parties because it allows the Australians to deploy their monies in a more-efficient manner and offers their American partners a different source of capital and property management fees.

British and Israeli investors have made a smaller splash in the U.S. commercial real estate scene. British investors are interested in U.S. properties due to the currency play: With the dollar still cheap compared to the British pound, investors feel they are getting more for their money. In Israel, the government recently relaxed restrictions that now permit Israeli funds to invest up to 20 percent of their assets overseas compared to 5 percent previously. Therefore, many are seeking value-added opportunities, particularly in the New York market.

Looking Ahead

As prices skyrocket, yields drop, and competition increases in many of the world's major real estate markets, more foreign investors will seek opportunities in the United States. Though office properties traditionally have been their top choices, more foreign investors are educating themselves about other asset classes, particularly retail and industrial.

Another trend to watch this year is foreign investors' tendency to be more creative in how they pursue investments. Many small international funds will have to step outside of their comfort zones to compete for properties by forming joint ventures with U.S. partners, pursuing property recapitalizations, and looking at secondary market opportunities. These strategies may create the momentum foreign investors need to succeed in U.S. commercial real estate markets.

William J. Bannon III

William J. Bannon III is a global investment liaison between Grubb & Ellis and Knight Frank LLP in London. Contact him at william.bannon@knightfrank.com.   Why Invest in the United States? A large investment pool, politically stable government, strong economy, and property owner rights entice many foreign investors to U.S. commercial real estate markets. However, the following factors also influence their decisions. Solid Returns. One of the most fundamental reasons why foreign investors choose the United States is the ability to achieve stable returns on their invested capital. Commercial real estate\'s internal rate of return has ranged from 6 percent to 9 percent in recent years, which investors are unable to match in other countries. Investment Security. The invested capital\'s safety and the security of its returns are very important to foreign investors. The United States generally provides a safe, secure environment that other countries may lack due to governmental influences, government instability, and currency fluctuations, among other reasons. Residency and Citizenship. Some investors are attracted by the eventual possibility of gaining U.S. citizenship or permanent legal residence. Clearly, invested funds are not U.S. citizenship criteria; however, many foreign investors, individually and through controlled entities, choose to invest in the United States with the idea that future citizenship may be on the horizon. The desire to place capital and financial interests close to family interests both directly and indirectly affects their decisions. Diversification. The ability to diversify investments also brings foreign capital to the United States. Many investors\' diversification strategies involve geographic relocation to increase the capital\'s safety and stability and to mitigate risk. Therefore, diversifying funds from one country to another often is beneficial. Owners\' Rights. In some countries non-citizens cannot invest in real estate or certain property types. However, in the United States, most individuals can purchase real estate with few limitations. Investors must follow income and property disposition reporting requirements, but the ownership limitations for foreign interests are almost nonexistent. Quality of Investments. With its abundance of high-quality, investment-grade projects, the United States provides an opportunity to be on the leading edge of investments. Many foreign investors favor the quality and size of U.S. investments over comparable properties in other countries. In addition, the ability to more quickly market and dispose of assets within the mobile and active U.S. marketplace is extremely attractive, especially when foreign investors contemplate the need for exit strategies. Hedge for the Future. Hedging investments for future considerations is important to many inbound international investors, particularly those who face rising prices in their own countries. Compared with the United States, many countries have increasingly high inflation rates, such as in parts of South America within the last decade, that discourage potential foreign investment in U.S. properties. Movement of Funds. Notwithstanding some foreign investment reporting requirements, the ability to move funds in and out of the United States with ease is very appealing to foreign investors. It is difficult to move invested funds out of some countries, which inhibits foreign investors from placing monies there. The United States provides the flexibility these investors are seeking. Technology Considerations. Technology, including e-mail and the Internet, affects the speed and ease of making real estate investments. The trend toward developing and using such technologies in U.S. investment activities offers foreign investors another advantage over other less technology-oriented countries. For example, the ability to move funds electronically allows investors to act more quickly when responding to U.S. market opportunities. ? by Mark L. Levine, CCIM, CIPS, CRE, professor and director of the University of Denver\'s Burns School of Real Estate and Construction Management in Denver. Contact him at 303.871.2142 or mllevine@ccim.net.

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