The Role of Foreign Investors in US Commercial Real Estate
By Adam Gower Ph.D.
How and why investors from other countries choose to invest in the US should be of interest to every American commercial real estate investor. It is no secret that foreign individuals and companies often compete for the very same deals many of us are on the hunt for; just ask commercial real estate brokers or investors in NYC, the SF Bay Area, and Seattle, among other places.
We often focus on the role that domestic players fulfill in the CRE markets. Today, I’m going to look at something a little different- the role that foreign investors fill within the commercial real estate markets in the United States, and how US-based investors can take advantage of opportunities created by this influx of overseas cash. I’m also going to look down the road at how these opportunities may change in the future. Let’s get into it.
The Role of Foreign Investors in Commercial Real Estate
Why is there international interest in US CRE?
Foreign Investors in CRE Now
What countries invest in U.S. commercial real estate?
What areas do they invest in?
Foreign Investment Market Impact
The Future of Foreign Commercial Real Estate Investors
Like any disparate group of people, international investors have many different motivations for deploying capital in US commercial real estate.
The United States is a political and economic safe haven
Instability in their home country is a primary driver behind the influx of foreign CRE capital into US markets. The unsteady political and economic situations in many countries leads those with the means to seek out opportunities elsewhere as a way to hedge against a whole host of issues related to instability, from government seizure of assets, to losses caused by political upheaval, overbearing taxation regimes, and all of the other ways that those with means can suffer economically from a problematic social system.
Investors know that when they deploy capital in the US, their assets will not be seized without cause, and they will benefit from the stability that has long been the hallmark of the American economic system.
The United States offers excellent returns compared to many foreign property markets
Overseas investors often have a different definition of what constitutes a “good” return, especially when you take into account the possible returns they might see in their home countries. Put another way, their hurdles are lower than those a traditional US investor would seek. They don’t have to get maximum return from a deal. When they engage in development or look out for existing cash flow deals they are not necessarily looking for the highest yields. They are looking for a good yield, but many times they are not looking for the same yields that domestic investors are set on.
This is one of the reasons you see many foreign groups outbid domestic investors; their yield requirements are lower, and so they can afford to pay more. For example, take a hypothetical development deal. A US group might be seeking a 20% internal rate of return (IRR), while a foreign group might be happy with a 12% IRR. Similarly, for a cash flowing deal, domestic investors could be looking for a 6 or 7% cash return, while overseas investors would settle for something in the range of 4% - a material difference.
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Moving to the United States
Another driver of CRE interest in the United States is the fact that deploying large amounts of capital in the country, including through CRE investments, opens up a shortcut towards legal residency and/or citizenship. The EB-5 Immigrant Investor Program allows investors who acquire or buy shares in certain US assets with a value between $900k and $1.8 million to get on the fast track for citizenship. That said, many foreign investors are institutional or high net worth individuals who already have their visas set up or for whom immigration to the US is not a concern.
Working with local partners
In many cases, foreign investors also like to pair up with a US partner to both reduce their sweat equity and to help get the lay of the land. This takes the form of teaming up through a JV development partnership. Working with foreign investors, local sponsors can afford to pay higher prices for real estate assets than if they were working with US investors.
Their promotes also can be higher because, as mentioned earlier, foreign investors typically don’t need the same returns U.S. investors require. Local sponsors can make out quite well in this scenario because although deal level projected profits may be lower as a result of paying higher prices for assets, their promotes are larger and the returns they have to pay the foreign investors lower, so overall the two balance out and the local sponsor can get into deals they may not otherwise have been able to compete on.
Adding to the economic attractions of working with foreign investors, relative to US institutions and private equity shops, they also tend to be very hands off. Typically, you can see anywhere from 9-13 hours in time difference between sponsor and their investors which, from a strictly practical perspective, makes it harder for overseas investors to be hands on. As a sponsor, this is why you’ll find that working with overseas investors, they take great care that, when they do partner with US companies, they place very high emphasis on teams with a good track record.
They’re relying heavily on their local partner to execute the business plan, to manage the property, etc. That’s why more than 50% of their underwriting is really underwriting their local partner because they can’t be hands on, and they can’t be big brother watching over and directing them on a daily basis.
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Citizens of most, if not all major countries have interests within the US CRE sector, but there are some nations that have particularly tight links with the development community in the United States.
The makeup of foreign investors in the CRE sector varies over time, but in the first two/three years of the Trump administration, many investors from Asia have been the prime players. In particular Japan, South Korea, and Singapore have been active replacing investors from mainland China whose investments in US real estate have waned due to geopolitical issues there. Japanese, South Korean and Singaporean investors have become very active. They want to do bigger deals, and almost any deals they see they want to figure out how to make it work. That's probably the most active group of foreign investors in the US at the beginning of 2020.
Often when Middle East capital is mentioned, Abu Dhabi, Dubai, and Kuwait, are mentioned but, while these countries do have a presence, the real money from the Middle East is coming in from Saudi Arabia. A lot of the times they're coming in privately, so to speak, more discretely, without any big announcements that they’ve made investments in certain deals. But the money's in Saudi Arabia for the Middle East. That's who all the big deals are getting done with. In fact, after Asia, Middle Eastern, and Saudi money in particular, is the biggest single foreign capital flow into US CRE.
Europe is third on the list in terms of activity in the US. There’s a lot of activity from some of the large pension funds in Europe, mainly from the Nordic region. They are typically more focused on buying or investing in A Class assets like office buildings in downtown locations or in industrial logistics facilities. They're looking for deals that don't have a lot of risks whereas Asian and Middle Eastern investors have different risk tolerance compared to Northern Europeans and are more likely to invest in and redevelopment deals.
In the commercial real estate space, foreign investors work with both debt and equity investments. Singapore, South Korea, and Japanese investors tend to prefer to invest in equity deals, though South Korean investors in particular focus heavily on debt, particularly first position and mezzanine debt. South Korean investors also like development deals where they can provide the debt. On the equity side all Asian investors will look at buying existing projects, versus ground up, and on construction deals they will invest in first mortgages and mezzanine loans on anything ranging from hotels to offices and multi-family projects.
This works to the advantage of local developers, who can sometimes get a lower rate on a mezzanine loan than they would normally find from US-based lenders. This is why many groups choose to work with South Korean money – they can get access to cheaper capital with partners that are not looking over their shoulder at every turn and micromanaging the process. The terms of these deals are also comparable to terms one would expect of a local partner/investor i.e. while interest rates are cheaper the remaining components of the financing, like 3-5 years of construction with extensions, etc., are comparable with US lenders.
Value-add is another major focus for international investors. For instance, a redevelopment deal for a Class-B building downtown that has the potential to become a Class-A building with the right refurbishing. In a similar manner to mezzanine loans, foreign investors can and will take lower returns for redevelopment or value-add projects, which works out well for them, since they are comparing it to returns back home, while local partners gain a greater degree of control and lower interest rates.
Asset Classes Preferred by Overseas Investors
For foreign investors, there’s always an interest in Class A and Class B office space value add. There’s a familiarity with these types of assets in investor home countries, and underwriting is often run on similar models, there as here. Multi-family is also an interesting asset class to them as well. Interestingly, however, some overseas investors aren’t as knowledgeable about residential rental models as they have far fewer similar developments in their own countries. Some will report that while people tend to own their own condos and maybe own a few more units that they rent out on an individual basis, owning large residential apartment buildings in their entirety for rent is less common.
Despite having less exposure in their home countries to the apartment building model, foreign investors are interested in investing in this asset class in the US, because they see and understand how it presents an alternative and lower risk asset class. As of the two/three-year period leading into 2020, there’s been a focus on investing in ground up development of multifamily and value-add multi-family. Historically, overseas investors have wanted to do Class-A stabilized multifamily project or tower developments, but more recently their preference has been for Class-B, value-add, and redevelopment deals.
What regions/cities in the US are foreign investors deploying capital in?
In the past most interest has been focused on gateway cities, places like San Francisco, or New York; think dense urban areas with high immigrant populations and/or proximity to ports and national borders. These days, with the flattening of the world and the digitization of the real estate space, secondary markets like Austin, TX, Charleston, SC, Denver, CO, and other growing but not yet peaking areas are seeing waves of foreign CRE capital.
Other Investment Sectors that are a Focus of International Investors
Of course, real estate is not the only sector of the economy in which foreign investors choose to deploy capital. Businesses as varied as restaurants, hotels, retail outfits, and pretty much anything you can think of outside of critical national defense industries, are filled with foreign capital – after all, we live in a globalized economy. Despite the wide variety of options that investors into the United States have, most large-scale investors carry at least some, and often a great deal of their portfolio allocation in commercial real estate assets.
The question is not whether foreign investors have an impact on the American CRE scene, it is how much impact do they have. Let’s take a look at four of the most significant factors influencing the commercial real estate markets in the United States.
Increased Acquisition Costs/Price Inflation
First and foremost, the influx of foreign cash has had an inflationary impact on certain asset classes. Multi-family and office buildings are good examples of this. Competition from domestic investors alone is heavy, so you introduce foreign money into the equation and it takes things into overdrive. There is also increased competition/acquisition costs in industrial logistics, where foreign investors are trying to jump on the bandwagon from the “Amazon Effect,” that includes warehouses, trucking facilities, and other places that help move goods from point A to Point B to the consumer.
Volatility is another effect of foreign capital in the US CRE market. For example, during the 1980s Japanese investors were dumping huge amounts of cash into the United States property markets, causing price inflation. When Japan experienced the beginning of their “lost decades” of stagnant growth, they pulled that money out, creating downward pressure on pricing and consequently bringing volatility to the market. A similar phenomenon happened with Chinese investment where years of uninterrupted Chinese cash that had been coming in suddenly stopped due domestic regulations and even reversed with Chinese investors being forced to divest of assets at huge losses in order to repatriate capital.
Foreign Investment is a Boon to the US Economy
That said, foreign dollars flowing into the US economy is almost always a good thing for the economy as a whole. There is a reason the government created programs like the EB-5 investor visa. Created in 1990 as a way to shore up the economy during the early years of the first Bush administration, dollars spent by foreign investors encourage economic development through the creation of planning, construction and management jobs, as well as create ongoing business concerns that pay taxes into local, state, and federal coffers. This can be particularly beneficial in areas with slow or negative economic growth, which brings us to the next point.
Providing Capital to Underserved Areas
When foreign investors increase acquisition costs in Tier-1 cities, like San Francisco and NYC, it becomes less desirable for investors to work in those cities. This particularly applies to domestic investors with a need for higher returns. Even though they may be unable to turn a profit in Tier-1 cities, they are still in the CRE game and need to find a way to grow their capital and generate business. This has led to many traditionally overlooked areas seeing more investment dollars, places like Tampa, Pittsburgh, and Charlotte amongst other Tier 2 and, increasingly, Tier 3 cities.
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In the five years through 2025, we are likely to see a continuation of present trends or even growth in international investor presence particularly from the countries noted earlier in this article, barring some sort of major international incident or geopolitical shift. A not insubstantial driver of demand, as we mentioned earlier, will continue to be from foreign investors.
Whether they are in South Korea, Singapore, or Japan, these institutional investors have a need to hedge their currency versus the US Dollar. Hedging costs relative to their currency are heading down, and many expect those costs to continue to decline in the coming years. As demand from these large investors is more focused on wealth preservation and playing defensively, it should lead to a situation where foreign CRE capital continues to flow in at relatively stable levels for the foreseeable future.
Despite challenges and setbacks, particularly those caused by the trade war with China, the US CRE market remains as a bastion of strength. Investors around the world flock to American commercial real estate assets due to their growth potential, relative stability, and, in some cases, the personal benefits one may acquire as a result of ownership of American CRE assets, namely the ability to live and work in the United States. These characteristics, alongside global economic woes, should lead to a continuation of, or even growth in the total amount of foreign capital invested in the US commercial real estate market.
Copyright 2019 - ADAM GOWER PH.D. - All Rights Reserved