Foreign investors in U.S. commercial real estate are on pace this year to sell more assets than they acquire on an annual basis — something that hasn’t happened in seven years. Through the first three quarters of 2019, foreign investment in U.S. commercial real estate totaled $30 billion, compared with $60.6 billion during the same period in 2018, according to Real Capital Analytics (RCA).The New York City-based commercial property research firm tracks deals of $2.5 million and above.
To be sure, the lack of large entity and portfolio transactions driven by foreign buyers that beefed up last year’s cross-border sales volume are partly to blame. But so are a number of other factors, which have largely relegated many foreign investors to the sidelines.
Those factors include premium pricing, a prolonged period of high hedging costs, and an economic expansion that has lasted so long that it resembles the second game of a baseball double-header.
The falloff in demand has affected core office assets in major markets in particular, say commercial property experts, but cross-border buyers continue to expand into secondary markets and a broader range of properties (see sidebar).
Nevertheless, commercial property experts remain confident that foreign investors are on the cusp of once again becoming net buyers. First and foremost, they contend, the costs of hedging have declined along with interest rates.
Secondly, with the exception of some Chinese groups that are under pressure by their government to liquidate assets, most cross-border sellers have come to the end of their investment periods and are likely to recycle capital back into the U.S.
What’s more, a negative interest rate environment in Japan and some European countries, diminishing global growth prospects, and unrest in several areas — including protests in London over Brexit and in Hong Kong over China’s polices — continue to cast the U.S. as an appealing alternative.
“The view from overseas is that the U.S. economy is the strongest in the world at the moment — borrowing rates are at record lows and fundamentals in most markets remain healthy,” says Alex Foshay, vice chairman of Newmark Knight Frank in New York City, who heads its international capital markets division. “Activity in our offshore investment bidding pools is really picking up.”
The favorable opinion persists even as the U.S. confronts its own challenges, including waning business investment and manufacturing growth, a slight drop in annualized GDP to a preliminary 1.9 percent in the third quarter, and a sharp political divide between Democrats and Republicans, suggests David Bitner, head of Americas capital markets research for Cushman & Wakefield in New York City.
“We certainly have our own issues,” he says. “Yet consumer confidence remains high, business confidence remains high and unemployment is at a peacetime low. So overall, most of the drivers of the economy remain intact.”
Sales Dive
Foreign investment in U.S. commercial real estate totaled $21.3 billion during the first half of 2019, down from $33 billion in the first half of 2018, according to RCA.
The last time cross-border capital flows into the country were at that level was 2014, RCA notes. But in 2014, foreign investors were still net buyers, whereas in the first half of 2019, cross-border capital sources sold about as much as they bought.
The downward trend accelerated in the third quarter, however, as foreign capital flowing into U.S. commercial real estate plummeted to $8.7 billion from $27.6 billion a year earlier, according to CBRE’s latest U.S. Capital Markets Report.
Meanwhile, cross-border disposition volume outpaced acquisition volume by three to one in the third quarter, the brokerage noted. In one particularly large transaction, GLP, a Singapore-based global investment manager, completed its sale of 180 million square feet of logistics assets to Blackstone for $18.7 billion in September.
The massive sale contributed to the lopsided disposition volume, points out Spencer Levy, chairman of Americas research and senior economic advisor for CBRE in Baltimore.
Similarly, blockbuster deals such as Toronto-based Brookfield Asset Management’s $15 billion acquisition of mall owner General Growth Properties skewed investment volume in 2018, he adds.
Still, even excluding big 2018 transactions from a year-over-year comparison, foreign investment has dropped significantly in 2019, points out Levy. Although he doesn’t expect a quick and dramatic turnaround, Levy is confident that foreign capital will remain a vital source of liquidity.
“Foreign investment will likely be down at the end of the year, but it’s an anomaly because the greater weight of capital is going to go where there’s an opportunity to earn the best risk-adjusted yields,” says Levy. “I think the U.S. still offers that.”
South Korean investment manager Mirae Asset Global Investments is leading a consortium to purchase 15 luxury hotels from China’s Angbang Insurance group for $5.5 billion. The JW Marriott Essex House in New York City is part of the portfolio. (photo courtesy of JW Marriott)
Indeed, from 2010 through 2018, cross-border buyers accounted for an average of 10.7 percent of the U.S. commercial real estate investment volume annually, up from 6.6 percent from 2003 through 2007, says Maggie Coleman, co-head of international capital for the Americas with JLL in Chicago.
Foreign investors made up 14 percent of overall U.S. sales volume over the 12 months that ended June 30, according to RCA.
“When you look at the amount of capital that’s allocated to real estate by institutions and the amount of dry powder in closed-end funds, we think that offshore investors will continue to provide a significant flow of capital into the U.S.,” explains Coleman, who recently visited investors in Asia. “There are still a lot of investors who want to expand their real estate presence in the U.S. market.”
Hedging Relief Arrives
Commercial property observers cite the high cost of hedging as the No. 1 culprit for the slowdown in foreign investment. Many offshore investors are required to hedge their property investments to protect against losses caused by changes in currency values between the time they buy and sell the asset.
To insure against detrimental currency swings, they typically buy a hedging contract based on expected cash flow or residual value.
The cost of the contract directly diminishes yield, however, and is generally tied to interest rate differences between countries. The Federal Reserve’s decision to substantially increase the federal funds rate in 2017 and 2018 eventually helped drive up the 10-Year Treasury yield to 3.2 percent late last year from 1.3 percent midway through 2016.
Over the same period, other central banks across the globe stood pat or even relaxed rates. Consequently, hedging costs over several quarters climbed to 250 basis points a year ago from the more historical and acceptable range of 80 to 90 basis points, explains Foshay.
As the 10-Year Treasury yield dropped below 2 percent amid the Fed’s recent rate-cutting activity, hedging costs fell and were around 120 basis points in November. The costs are expected to return to more historical norms in early 2020, adds Foshay.
To avoid hedging costs, some South Korean investors over the past several months reverted to providing debt to U.S. property owners, according to observers. But now those investors are looking to buy.
In September, for example, private real estate investment firm L&L Holding Company teamed up with Samsung and Korea Investment & Securities, a financial services provider, to purchase the 1.1 million-square-foot 195 Broadway office building in New York City.
L&L Holding owns 5 percent of the property with JPMorgan Asset Management, and the $800 million deal will transfer the balance of the interest to the new ownership group.
Additionally, South Korean investment manager Mirae Asset Global Investments is leading a consortium to purchase 15 luxury hotels from China’s Angbang Insurance Group for $5.5 billion. The portfolio includes the JW Marriott Essex House in New York City, the Westin St. Francis in San Francisco and the Four Seasons in Jackson Hole, Wyoming.
“We’ve seen significant changes in the market compared to where we were at this time last year,” says Richard Stevenson, managing director of global cross-border investment for Savills in New York City. “Singapore and South Korea investors have huge ambitions and vast amounts of capital to place here, and the changes should open markets where they haven’t been as active recently.”
Core Pullback
Despite the muted investment activity, the Northeast still drew $23.6 billion in foreign capital over the 12 months that ended June 30, the most of any U.S. region, according to RCA. Cross-border buyers sunk $12.3 billion into Manhattan and $4 billion into Boston.
Among other deals, Gazit Horizons, a division of Israeli-based real estate investor Gazit Globe, in April paid $81 million for the 62,000-square-foot Marketplace Center, a retail and office property adjacent to Faneuil Hall Marketplace in Boston. That acquisition followed its $51 million purchase of a 43,000-square-foot mixed-use property in Boston’s Back Bay district in January.
Still, the foreign capital investment downtrend has been most pronounced in the core office segment in markets like New York City and Boston, in many cases the preferred asset class and locations of large
cross-border investors.
In addition to high hedging costs, peak pricing, end-of-cycle concerns and the possibility of cap rate expansion amid rising interest rates have made investors hesitant to purchase such properties, note observers.
The lack of core office product for sale in the markets also has been a drag on transaction activity. One reason for the shortage stems from the fact that some owners are choosing to refinance properties rather than sell them, says Michael Campbell, CEO of the Carlton Group, a New York City-based real estate investment bank that pairs foreign equity with U.S. sponsors.
“Everything is still expensive and sellers really aren’t adjusting their prices to what current market values are,” declares Campbell, who is working with South Korean and Singaporean investors on four deals, including multifamily and speculative office construction.
Obstacles Giving Way
With the cost of hedging in retreat, those owners may yet prove prescient. Paying 250 basis points to hedge the purchase of an asset with a 5 percent cap rate slashed the yield by half, experts explain.
Lower hedging costs make those cap rates much more attractive, especially when compared with cap rates of 2 percent to 3 percent for similar properties in countries that have very low or negative interest rates, says Foshay.
What’s more, the decline in interest rates should alleviate fears that cap rates will increase, explains Levy. In fact, with interest rates once again declining, he predicts that cap rates for core U.S. properties will see an additional tick downward.
The end of high hedging costs and the decreased likelihood of cap rate expansion leaves concerns over the cycle’s end as one of the last remaining impediments to more cross-border investment in core assets.
At the end of the day, however, large offshore investors have abundant cash to place, and they can buy only so many properties in their home countries, states Campbell.
“In most cases foreign capital wants to buy and hold it for a long time or build and hold it for a long time,” he adds. “That will help them get over the issues with the cycle. Because if the cycle ends, they’re still going to be the property owner when it comes back.”
— By Joe Gose. This article first appeared in the November-December issue of Northeast Real Estate Business magazine.