Real estate as an asset class has finally come of age. It has bounded back from the recession of the early 1990s -- when the U.S. real estate industry was acutely distressed and overleveraged -- to a point where institutional investors are learning double-digit returns are increasingly hard to find. Equally important, the commercial real estate market is being securitized through the phenomenal growth of real estate investment trusts and commercial mortgage-backed securities.
Just five years ago, the market capitalization of the biggest REIT, Simon Property Group, was $3.5 billion; today's largest, Starwood Hotels and Resorts, is six times that size with an estimated total market capitalization of about $20 billion. The second biggest REIT is not far behind: Simon DeBartolo Group will be close to $18 billion after closing on its recently announced acquisition of the CPI mall portfolio. The REIT industry is starting along a path of consolidation, as the larger players seek increasing amounts of capital to fund bigger real estate portfolios. Local developers will find it harder to compete with REITs and, if interest rates turn upward, they could be severely squeezed.
The implications of this consolidation phase for institutional investors are enormous. It is quite possible that by 2005 the largest REITs will have reached the size of the nation's biggest banks. As major public companies, closely monitored by Wall Street and benchmarked against their peers, these REITs will have to place a premium on growth and the quality of assets. There is only one problem: A mix of high-quality assets and high returns may no longer be available in the United States.
GOING GLOBAL
Sensitive to this dilemma, major REITs already are exploring opportunities overseas. Security Capital Industrial made a major splash in Europe by buying Frigoscandia AB, which owns 90 distribution centers in eight European countries, for $395 million. Toronto-based TrizecHahn (not a REIT, but a real estate operating company) spent $150 million to buy Advanta Management AG from German industrialist Dieter Bock. And the acquisition of Arcadian International, a hotel developer and operator based in England, by Patriot American Hospitality closed in early April.
The so-called opportunity funds -- more aggressive funds based in the United States -- are scouring eastern and central Europe in search of those double-digit returns formerly available on their own doorstep. AIG, Apollo Advisors, GE Capital, CS First Boston, Morgan Stanley and Pioneer, are just some of the names looking for real estate investments in Russia, Poland and other former Soviet bloc countries.
ONE JUMP AHEAD
The reality is that returns as high as 25% to 30% have been available recently on direct, commercial real estate investments abroad, and specifically in the regions mentioned above. Further, these returns are based on a credit risk similar to what investors might expect in the United States or western Europe, because tenants for commercial buildings -- on a 10-, 12- or even 15-year lease -- can be found among multinational companies looking to expand their businesses.
But, to take advantage of these potential returns, institutional investors need to be one jump ahead of the REITs and opportunity funds, which in any event are not "pure plays" on the high-yield countries because they also hold domestic U.S. real estate in their portfolios. Like many investment trends, the moment to seize the opportunity is often past before investors realize the opportunity is there.
Here are just some of the practical guidelines investors should follow:
* Invest alongside multilateral lenders. If investors bring equity to the table, they should expect it to be leveraged in the form of debt provided by top-class institutions such as the World Bank, the European Bank for Reconstruction and Development or the Overseas Private Investment Corp. Typically, debt will cover between 50% and 70% of project costs.
* Find a development fund sponsor with experience in finding or creating real estate and managing it. The sponsor should ideally have a real estate operation already up and running in the country or region but, at the very least, experience in managing other asset classes there is essential.
* Check that the sponsor is in good standing with the multinational companies that the fund needs to lease its real estate. A sponsor that gives multinationals operating in eastern Europe the office space they really need -- a good location with room to expand, for example, and Western-style amenities, such as professional management and air-conditioning -- will end up with long-term, high-quality leases. Further, those who know their locale can offer these tenants a rent well below the current market rate and still make a substantial profit after construction costs.
* Recognize that a real estate investment of this kind is highly illiquid. With an expected life of between five and 10 years, the typical overseas real estate fund is far from being a tradable security.
* Look for the exit. A viable fund should be able to point to a number of exit strategies, including a sale to U.S.-based REITs or insurance companies. Another alternative might be the sale or disposal of individual properties, both to international and emerging local pension funds, as well as "user sales " to tenants. Finally, it is not impossible that foreign markets will develop their own, publicly traded REITs and REOCs that would either purchase the development fund's holdings or provide an opportunity to list the fund on a public exchange.
OTHER PARTS OF EUROPE
For investors who want to put this diversification theory into practice, eastern and central Europe are attractive right now for several reasons. First, returns have been much higher recently than those available in the United States (about 10%) and in western Europe (7% to 9%). While Asia might appeal to bargain hunters over the long term, most countries in this region have a vast oversupply of commercial real estate. As for China, which is equal to Russia in potential, the country is not yet far enough down the capitalist road to offer appropriate risk-adjusted returns.
Second, countries like Poland and Russia have obtained a significant commitment from western multinationals to help develop their economies. This commitment implies a physical presence that in turn boosts demand for Western-style buildings. However, it's not widely realized that until the middle of this decade, new building construction in eastern Europe was still subject to the restrictive regulations that prevailed before the fall of the planned economies. Consequently, the supply of high-quality buildings remains very limited.
THE CYCLE
Real estate returns in these countries certainly reflect political risk. However, a development fund manager with a strong local presence and local contacts can help mitigate this risk. Also, institutions can draw some comfort from the fact they are effectively co-investing with multilateral agencies that have a better understanding of the political risk than almost anybody.
In their international equity investments, plan sponsors traditionally have moved through a cycle of strategies, beginning with a core EAFE mandate, progressing to a regional product and then to emerging markets. As comfort levels rise with each step, so does the sponsor's risk profile. Right now, international private equity is one of the fastest growing asset classes.
The odds are that real estate will follow the same pattern. Plan sponsors have largely recovered from the depression that wracked the U.S. real estate industry, and are comfortable with its public market status. But to catch the next phase of the cycle -- the globalization of real estate -- sponsors will have to get ahead of the REITs and seize the opportunities that exist today in the markets of central and eastern Europe.
