Foreign Investment

Buying American

Foreign Investors Continue to Show Interest in Many U.S. Commercial Properties and Markets.

Two years ago, it was a relatively easy decision for foreign sources to invest in U.S. real estate. The economy was chugging along in its seventh year of expansion and nearly all property types were experiencing plunging vacancy rates and soaring lease rates. At the same time, the economies of the rest of the world were weakening, many succumbing to the Asian economic crisis.

With its high-quality inventory and political and economic stability, the United States was a safe haven for real estate investment. An efficient industry with active trading, accurate investment and space market information, performance data, and advisory services readily available in major metropolitan areas helped to attract foreign investors. Property laws also are well established, understandable, and provide equal protection for both domestic and foreign investors.

As a result, the level of foreign investment in U.S. real estate increased more than 26 percent in the past two years, according to the U.S. Commerce Department's Bureau of Economic Analysis. Foreign investors now account for 12.8 percent of institutional equity real estate ownership of all property types, up from 8.7 percent in mid-1997. In addition, total investment by foreign sources reached an all-time high of $44.4 billion in 1998.

Almost one-third of these investments were made by Europeans, largely Dutch, German, and British investors. These groups accounted for 15 percent, 8 percent, and 4 percent respectively of all foreign investment. Investors from Asia and the Pacific Rim made close to another third, with Japanese investors accounting for 24 percent of all foreign investment. Canada accounted for 20 percent of all foreign investment.

Although the amount of money invested in U.S. real estate by European and Asian investors increased, both groups' shares of total foreign investments declined in the past two years due to major sales by Japanese institutions and an upsurge in Canadian activity. One exception is German investors' increase in activity. This group has gone from making up 5 percent of foreign investment to 8 percent, an increase of $1.7 billion. Another country significantly increasing its share of U.S. real estate ownership has been Canada, which grew from 10 percent in 1996 to 20 percent in 1998, an increase of $5.4 billion.

Will foreign investors continue to invest in U.S. real estate? A consensus of analysts and experts says the economy will decelerate from its recent remarkable performance, but should stay on track to provide sustained demand for real estate space and investment opportunities.

U.S. vs. Foreign Markets
In recent years, U.S. commercial real estate has become more attractive to foreign investors as returns here have surpassed those in many other countries. It is difficult to find long-term data on real estate returns in most foreign countries. One exception is the United Kingdom, which has the IPD Annual Index reporting back to 1981. Since year-end 1994, the U.S. total return has averaged 12 percent while the United Kingdom averaged 10.5 percent. In 1998, returns were 16.3 percent in the United States vs. 11.8 percent in the United Kingdom.

The difference in returns is even more striking for office properties specifically. Over the past four years, U.S. office returns averaged 14.5 percent per year, compared with 9 percent in the United Kingdom. In 1998, the annual U.S. office return was 19.7 percent compared to the United Kingdom return of 11.6 percent.

In addition, U.S. real estate is relatively inexpensive and offers higher initial yields when compared to European investment property. For example, property yields for prime European office markets offer lower yields of 5 percent (Dublin, Ireland, Frankfurt, Germany, and London's West End) to 7 percent (Brussels, Belgium) when compared to the overall U.S. central business district office yield of 8.7 percent, as reported in the Second Quarter 1999 National Real Estate Index.

Recent studies found that the office rent cycle in North America has not been in sync with the cycle on other continents. This suggests that adding another continent to a portfolio will provide diversification benefits such as improved performance and reduced risk.

It should be stressed that the capital markets debacle in fall 1998 also has had positive effects for private-equity investors. It reduced investor competition, thereby lowering acquisition prices, and prolonged healthy market fundamentals by delaying additional construction.

One attraction of the U.S. real estate industry is that it is the largest and most diverse investment property market in the world. Its recent recovery cycle has shown enormous variation by region and property type. Most markets are now at or near equilibrium, experiencing modest increases in vacancy but still seeing relatively strong lease rate growth. In 2000, rental rates are expected to continue to surpass inflation for all property types in all but a few markets across the country. Cyclical differences by property type and region offer excellent investment opportunities.

Property Segments
According to the Association of Foreign Investors of Real Estate, office buildings are the most sought-after properties by foreign investors, followed by retail, multifamily, industrial, and hospitality.

The office market is well documented with an established track record. Trophy properties in central business districts or major suburban nodes particularly are desirable investments, especially if they are in markets with physical or economic development limitations and if their tenant roster is recognizable. Many international investors find major coastal markets and those with direct air connections to Europe or Asia to be most appealing.

In general, most office markets have peaked in terms of occupancy rates and rental rate growth. In most markets, rents have risen enough to spur new construction. As supply increasingly outpaces demand, rent gains and returns will begin to level off. Over the next four years, returns are projected to average 11.5 percent annually, down from the 15.9 percent average experienced since 1995. Several markets that lagged in the recovery, primarily in downtowns, California, and the Northeast, should outperform the average.

Retail remains a popular product type among foreign investors. Shopping centers with recognizable tenant names are in demand, especially in familiar and mature markets. Many German investors particularly are drawn to upscale downtown retail environments such as San Francisco's Union Square.

Today's retail market has withstood several years of turmoil. Spurred on by a strong economy and high consumer confidence, current conditions are the best they have been in years. Returns began to rebound from their anemic levels in 1997 and have averaged 10 percent since 1996. However, due to various retailing and demographic trends, not all retail formats have performed the same. In addition, e-commerce is a significant threat to shopping centers, particularly those with retailers selling commodities.

Over the next four years, retail returns are projected to average only 8.4 percent per year, being pulled down by those shopping centers vulnerable to the Internet and the consolidation of retailers. Retail formats that have franchise value will continue to be the winners in this very competitive industry. Franchise value is attained when a center provides a uniquely attractive and convenient setting and tenant mix.

Multifamily remains a stable property sector. Although construction has accelerated, it is still well below peak levels. Vacancy rates and rental increases are steady in general, but geographic performance varies. Certain metropolitan areas still are experiencing a recovery, and particular product segments, such as lifestyle apartments that provide luxury amenities to residents who could afford to own but choose to rent, are underdeveloped in constrained markets such as California. However, these segments should outperform the average. Over the next four years, returns are projected to average 10.6 percent per year, down from the 12.4 percent average experienced since 1995.

Although industrial has been a stable performer, its appeal to foreign investors has been limited. Industrial buildings generally don't have the curb appeal of trophy office projects or retail centers. The property type is not as well documented and deal sizes tend to be relatively small. However, a large portfolio of state-of-the-art warehouses in a major port-of-entry trade market should attract the attention of international investors.

Overall, the industrial market is closely tied to the nation's economic cycle, and it staged a strong recovery in conjunction with the 1990s economic expansion. Industrial construction responds quickly to demand, and today supply and absorption generally are balanced. During the next four years, returns are projected to average 10.3 percent, down from the 14.3 percent average experienced since 1995. Profitable investments can be made in warehouse/distribution and research and development space markets where rents continue to rebound, and by developing state-of-the-art product in underserved areas.

Although cooling economic growth and expanding supply negatively will impact several segments of the hospitality market, certain hotel products and locations remain well-positioned for success. In particular, hotels with barriers to entry, either geographic or financial, still should provide attractive investment and development opportunities. Foreign investors historically have been active in acquiring trophy hotels in major metropolitan and resort areas.

The above forecasted returns are property type averages, meaning that some markets may perform above or below these averages. These select market recoveries and segment niches offer foreign investors the opportunity to achieve excellent returns.

Continued Foreign Investment
Current conditions and the projected outlook point to continued good opportunities for foreign buyers to invest in U.S. property. While the easy money has been made, opportunities remain to invest where value can be realized through specific market recoveries or niche development. The purchase of a variety of top-quality projects at attractive prices is possible for foreign investors.

Robert Zerbst and Jane H. Dorrel

Robert Zerbst is president and Jane H. Dorrel is senior director of research at CB Richard Ellis Investors LLC in Los Angeles, a wholly-owned subsidiary of CB Richard Ellis that provides real estate investment services to institutional clients representing more than $8 billion in assets worldwide. Contact them at (213) 683-4200 or or


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