While Investment Activity is Up Sharply Over 2009's Historic Lows, Sovereign Wealth Funds and Other International Investors Find Few Buying Opportunities for High-Quality U.S. Property
Foreign investment in the U.S. real estate has nearly doubled in the first half of 2010 over the dismal numbers from one year ago, but overall activity remains muted by the slowly recovering economy and a lack of high-quality property available in large U.S. metro markets.
According to research released this week by Jones Lang LaSalle, the United Kingdom has emerged as the most popular destination for cross-border investment in 2010 with $7 billion invested. International transactions in the U.S. market jumped from $2.2 billion to $4.3 billion, a significant increase but not enough to prevent Germany from bumping the U.S. as the second-most popular destination for foreign real estate capital.
"The rise in cross-border transaction volume also shows a real estate return in the major markets, and an encouraging 176% increase year over year in the United States, which had the greatest fall in cross-border investment during the downturn," said Steve Collins, managing director, Americas, for JLL's International Capital Group.
While investors have started to move back into the United States with major purchases in 2010, the long predicted rush of foreign capital has yet to materialize. Some see the lack of available well-leased core and trophy assets in major U.S. metros that foreign investors covet and the bidding wars for the few Class A properties that are brought to market as being two factors dampening investor interest.
"Demand is especially robust for well-leased, core-style product in gateway markets such as New York and Washington, DC, whereas demand remains much weaker for the non-gateway cities markets," Collins said.
Commercial property by far has the lowest foreign ownership of any U.S. asset class by percentage, just 5% as of the end of 2009, compared to ownership of U.S. government securities at 49%, corporate bonds (18%) and stocks, (16%), according to data from various government and industry sources.
"It is clear that foreign investors are under exposed to commercial real estate," said Umair Shams, economist for CB Richard Ellis. "According to recent industry surveys, however, interest in U.S. commercial real estate remains healthy among foreign investors and their exposure to U.S. commercial properties should increase significantly in the next few years."
In addition to the economy and the shortage of available product, another potential hurdle for foreign investors is a 1986 provision that heavily taxes foreign investments in U.S. real estate interests. The intent of the Foreign Investment in Real Property Tax Act (FIRPTA) was to ensure that the government can tax gains recorded when a foreign entity sells U.S. property or shares in real estate companies. But critics have long sought to amend or repeal FIRPTA, maintaining that the law effectively blocks or impedes the flow of foreign capital into the U.S. An attempt to drastically overhaul the law fell short this summer.
The Real Estate Jobs and Investment Act (H.R.5901), a bill introduced by Rep. Joseph Crowley (D-N.Y.) that would raise the allowable foreign ownership of a publicly-traded REIT from 5% to 10% before proceeds are taxed under FIRPTA, passed the House by a vote of 406-11 on July 29. The bill must still be approved by the Senate and signed by the president before becoming law.
While the industry welcomes any change in the onerous tax law, the legislation applies only to investments in REITs. That makes it a limited victory for the CRE industry, which lobbied Congress to make all direct investment by foreign entities eligible for tax relief.
"It's certainly not what we hoped for. It's really just a start," said Jim Fetgatter, CEO of Washington, D.C.-based Association of Foreign Investors in Real Estate (AFIRE). "It may encourage a little foreign investment, but it's only going to impact foreign investors who are already investing in REITs, allow them to take a bigger piece of a company. But there are a lot of countries in the Middle East and Germany that do not invest in REITs. They're direct investors and the new law won't have any impact on them."
Many foreigners used to hedge their U.S. tax costs, understanding they needed slightly higher returns on U.S. investment than in other countries, Collins said. However, "the theory now is if they make the deal and it’s a nice investment and the hedge goes their way, great, otherwise, they've still made their return."
"I don't think you'll see a huge jump in foreign activity if the legislation goes through, with the exception of a few countries that have had adverse tax ramification issues, like the Netherlands, Norway, Korea," Collins said.
While the bill might have very little impact on U.S. commercial real estate, it could bring some much needed additional liquidity to the asset class, noted Shams.
"In our view, investors can find low-risk and stable assets today in U.S. commercial real estate. Irrespective of tax and regulation effects, foreign investors will be well justified in increasing their U.S. commercial real estate exposure in the upcoming years, and domestically, the market will benefit from greater liquidity as a result," Shams said.
The good news is that global commercial real estate investment nearly doubled from $76 billion in the first six months of 2009 to $132 billion for the first half of 2010, according to JLL. Cross-border investment activity, which hit a low of 31% of total volume in the first half of 2009, increased to 43% in the first half of this year, a level not seen since before the recession. That reflects general improved confidence and a resumed search for yields by investors, according to Jones Lang LaSalle.
Growing numbers of foreign investors, spooked by the European debt crisis and the weakening of the euro against the dollar, are convinced that the U.S. is the safest place to park capital, Fetgatter said. Foreign metros such as London have been inundated with foreign investment, driving down yields, and some foreign capital is beginning to look elsewhere, including the U.S.
The Fair Market Index by London-based research firm DTZ Investments, based on relative price attractiveness, gave the U.S. a rating of 89, considered "hot" while the Asia Pacific region also scored a "hot" with a rating of 67. Europe, meanwhile, received a 49 rating, considered "warm," while the United Kingdom received a "cold" rating of 38.
However, many foreign investors remain risk adverse. Finding few quality assets that meet their investment criteria, most are still opting to hover rather than swoop.
"We won't be returning to 2007 levels, but I would expect the second half of 2010 to be a bit better than the first half," said AFIRE's Fetgatter. "Had the U.S. economy not taken the pause it did during the summer, along with all the talk about a double dip recession, I think we would have seen more activity, even among U.S. domestic investors."