Looking Outside the U.S. for Real Estate Investment
Lynn, David J
FOCUS ON GLOBAL MARKETS
THE REAL ESTATE INVESTMENT SECTOR has often been criticized for its lack of liquidity and high degree of lumpiness, transaction costs and geographic idiosyncrasies. Despite these characteristics, real estate remains one of the best risk-adjusted investments in recent years. In fact, real estate has produced solid returns-beating the U.S. domestic stock and bond markets in the last five years-is collateralized and, in the case of institutional-grade assets, typically yields a consistent income stream.
Over the past decade, a number of factors have made world markets more interesting and potentially highly profitable. These factors include deregulation, accelerating globalization, integration of financial markets, economic and political reforms, and high economic growth-especially in emerging-market countries, where growth rates typically exceed that of developed countries.
Investors who look outside the U.S. market could potentially enjoy higher returns, increased portfolio diversification, greater variety of investment vehicles and the opportunity to benefit from the growth of the global economy.
PERFORMANCE AND GLOBAL ECONOMICS CAN YIELD INCREASED RETURNS
International real estate can help boost returns by investing in international properties with prospects for better financial performance than domestic assets. For example, if U.S. investors had secured UK, Australian and Canadian office property assets between 1985 and 1995, rather than domestic assets, they would have earned significantly higher returns. During this period, the U.S. office market’s average annual return was zero, but the other markets averaged 12.4 percent, 8.1 percent and 4.5 percent, respectively. ‘
Investors also can realize potential gains though currency valuation movements. The U.S. dollar has depreciated significantly against other major world currencies since mid-2001. Though it has seen some recent improvement against the euro, the dollar remains depressed by historical standards. This dynamic has boosted the value of many U.S. companies’ real estate assets abroad.
For example, an asset that was worth $200 million to its U.S.-based owner as recently as early 2003, when the dollar traded near 1-to-1 with the euro, would translate to a value almost $240 million under current exchange rates. This increase in value occurs even without additional investment in the property.2 Of course, the downside effect from foreign currency depreciation is a non-negligible risk.
Timing of transactions and knowledge of the macroeconomic situations of countries is essential. Using financial instruments such as futures, forwards and swaps can further hedge currency exposure in the short and longer term.
Investing in international real estate may be the best way in the long run to secure higher returns because of declining rates in the U.S. This decline is caused by the flood of capital in the U.S. market, which pushes up the cost of transactions, and declining net operating incomes in many markets. Growing liquidity is behind the decline of capitalization rates-a common way to measure real estate returns-across all property types, averaging some 200 basis points from first-quarter 2002 through first-quarter 2005 (see Table 1).1
MYRIAD GLOBAL INVESTMENT VEHICLES OFFER A RANGE OF CHOICES
More and more investment vehicles and products are now gaining ground across global markets, in public as well as private sectors. These investments include new real estate investment trusts and REIT-like vehicles, the global expansion of the commercial mortgage-backed securities market, and a growing number of private investment products such as funds and individual deal investments. With an ever-increasing array of products and strategies from which to choose, an investor is more likely to find a better fit for his particular return/risk tolerance (see Table 2).
There are an increasing number of sophisticated financial products beyond the domain of equity investments. Public debt investing, predominantly in the form of CMBS, has emerged as a strong global trend. Liquidity, as well as the ability to securitize large income streams and tranche loans into various risk profiles, has made this asset class increasingly attractive. CMBS and other investment products may have the potential to grow faster than the U.S. market because of country-specific factors.
The Japanese CMBS market emerged as a result of the steep decline in real estate prices during the 1990s. Financial institutions stressed increased securitization to repair balance sheets. Japan as well as mature markets of Australia and Europe also should see CMBS grow much faster than the U.S. market. In fact, CMBS issuance in 2006 far outpaced the previous year’s volume (see Table 3).
Another key trend in the industry is the rapid expansion of global real estate investment options in terms of quantity and variety of nonlisted private investment vehicles. In addition to nonlisted property investment vehicles in U.S., there is a large number of established vehicles with various strategies, specialized sectors and return targets (i.e. core, value-add, opportunity, etc.) available to investors. According to INREV, the European Association for Investors in Nonlisted Real Estate Vehicles, the gross asset value, or GVA, of nonlisted real estate funds has grown from approximately euro140 billion in 1995 to more than euro320 billion in 2006 (see Table 4). This represents an increase of more than 200 percent in just over a decade. The number of real estate vehicles also grew substantially. A similar trend exists in Asia.
As a result of the global growth-in quantity and diversity-of real estate investment vehicles and public and private markets, we have seen beneficial byproducts of increased transparency, credibility and liquidity, which in turn is attracting more real estate investment capital.
PORTFOLIO DIVERSIFICATION AND RISK REDUCTION
To benefit from diversification, investors must create a market portfolio consisting of many sectors and submarkets that exhibit low correlations. The U.S. is the largest and most diverse real estate market in the world. However, it still represents a minority share of the global investable universe of commercial real estate.
Since 1990, the U.S. share of gross domestic product relative to the world total hovered between 25 percent and 32.5 percent. In the longer term, the U.S. economy will likely command a trend share of about 30 percent.5 According to estimates,” the global real estate investment universe was US$6.2 trillion at the end of 2005 (see Table 5).
The U.S. share of investment-grade commercial real estate is estimated at $2.4 trillion, which is less than half size of the global universe. These estimates clearly indicate an ample supply of investment-grade properties across different countries with different economic conditions and even varied sector performance.
Diversifying real estate investment from domestic to international, as with other asset classes, can reduce risk by reducing volatility. Some real estate markets-Canada, for example-demonstrate less volatility in the office sector than the U.S. To put it in the language of stocks, some global real estate markets exhibit lower betas. Investors can reduce risk simply by diversifying their portfolios with the inclusions of foreign assets whose performance is likely to be minimally correlated with the performance of domestic assets. Such low correlations are attributed to differences in behavior over time stemming from different market regimes, and idiosyncratic economic characteristics.
Despite increasing global integration of economies, significant country and continent divergence still exists in real estate market property performance. Though few markets have return series for private equity real estate with an adequate history to calculate the correlations directly, one of the few exceptions is the United Kingdom. Based on roughly 30 years of data from the UK and U.S. property markets, the correlation between returns in the UK and U.S. has been about 0.40.
Given the similarities and close relationships between the UK and U.S., it seems reasonable to assume the correlation between them should be among the highest. To put it another way, real estate markets in different countries have relatively low correlations compared with those for other asset types such as stocks.
RIDING THE GLOBAL GROWTH WAVE, ESPECIALLY IN EMERGING MARKETS
Economic growth rates tend to be higher in emerging markets than in developed economies. In other words, emerging markets are in the early phase of their growth cycles. High GDP growth rates are typically composed of population, employment and investment growth-all of which drive real estate returns. Countries in Asia, South America and even several countries in the Middle East and Africa are expected to show much higher rates of growth than developed countries over the next four years (see Table 6). As a result, real estate markets in these countries are expected to experience proportionate expansion in the real estate sector (new and renovated buildings of all types), to accommodate the growing demand for larger quantity and modern assets, at a faster pace than in developed countries.
Decreasing entry barriers in many countries has facilitated investment in emerging markets. For example, as recently as the late 1990s foreign investors could not invest directly in South Korea. The same was true for Taiwan as recently as a few years ago. India liberalized its foreign direct investment laws with respect to real estate only a yearand-a-half ago. Today, more real estate markets are open than ever, and the trend toward greater openness, transparency and increasing capital flows continues.
In short, there is more room for achieving alpha in the globalized real estate investment market. Because of the unique risks of international investing, attaining superior risk-adjusted returns is not always an easy task.
1 Raymond Torto, “Benefits and Issues in Global Real Estate Investment: A Review of the Research,” Real Estate Issues, Volume 27, Numbers 3 and 4 (The Counselors of Real Estate, 2002).
2 Kenneth Rudy, The Open Window; Why 2005 Is the Year To Sell Real Estate Abroad ( Jones Lang LaSalle, 2005).
3 Water, Water Everywhere (Prudential Real Estate Investors, 2005).
4 Philip Conner and Youguo Liang, Global REITs: A New Platform of Ownership (Prudential Real Estate Investors, 2005).
5 Philip Conner and Youguo Liang, Ask Not Why International, Ask Why Not International (Prudential Real Estate Investors, 2005).
6 Lijian Chen and Thomas I. Mills, Global Real Estate Investment Going Mainstream (DBS Real Estate Research, 2004).
BY DAVID J. LYNN, PH.D., MBA, CRE
About the Author
David J. Lynn, Ph.D., MBA, CRE, is the global bead of research and investment strategy at AIG Global Real Estate Investment Corp., based in San Francisco. He has expertise in real estate investment, redevelopment, raw land use and development, and provides advisory services to clients across North and South America, Europe, Asia, the Middle East and North Africa. He earned his doctorate at the London School of Economics and Political Science and bis master’s in business administration at the Massachusetts Institute of Technology Sloan School of Management. He also holds accreditation from the American Institute of Certified Planners.
DAVID J. LYNN, PH.D., MBA, CRE, is the global head of research and investment strategy at AIG Global Real Estate Investment Corp., based in San Francisco. His practice focuses on real estate investment, redevelopment, raw land use and development, and he provides advisory services to clients across North and South America, Europe, Asia the Middle East and North Africa.
Copyright Counselors of Real Estate, The Winter 2006/2007
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