A Small World

IT'S SORT OF A XENOPHOBE'S WORST NIGHTMARE: YOU CAN'T KEEP foreign investors out of any domestic real estate market, anywhere on the globe. An international commercial real estate community has truly developed in the past decade; though ironically, property markets remain characteristically local in nature. * As real estate investors scour the globe for yield and value, the outlooks shared by industry leaders on both sides of the Atlantic have become remarkably similar. They all understand, for example, no one can hide from the consequences of global financial crises. A case in point, cited over and over: the 1998 Russian bond default and ruble free-fall, which led to interest-rate spikes around the world and the evaporation of funding for real estate debt transactions. * Real estate investors realize global capital markets tend to make their trends the other guy's too. One such current trend is too much capital chasing product. Investors' perspectives, however, vary somewhat depending on which side of the Atlantic they sit. Those sitting on the Old World side look to policy-makers in the United States to put the brakes, however lightly, on this phenomenon.

"I'm trying to will America on, to put up her interest rates and flush out the dumb money in real estate," says Robert WoIstenholme, director of Resolution Property pic, London. He's been having some minor success with the Federal Reserve's recent hikes in the federal funds rate target.

Resolution Property manages European real estate funds for British and international investors, and has begun raising up to 300 million for a new fund. "We've ended up almost entirely with investors outside the United Kingdom," says Wolstenholme. Thus precipitating this insight: "New York is similar to London. There is a crush of capital, and both are lousy occupier markets. Southern England is a lot like Silicon Valley, with a tech overhang of space in occupier hands. So the strategy is universal: You've got to get in at the right price.

"It's the same in the U.K., Europe and the States: You must diversify in real estate investing to survive the frothy amount of institutional cash looking to find a home," Wolstenholme says. "Institutions have a great herd mentality, in search of low risk, income and long leases. And, voil, prices are bid up."

Much like NATO members during the Cold War, members of this "Atlantic Alliance" in commercial real estate are on the same page when discussing strategy and shifting fundamentals.

Echoing across the pond is talk of normalcy returning to real estate after more than a decade of crash-and-burn episodes and phoenix-like revivals (courtesy of historically low interest and cap rates). In this more stable climate, property has been emerging as a "legitimate" and favored asset class for institutional investors. "Repricing" has become a favored term in the context that real estate will continue to successfully compete with equities and bonds in institutional portfolios.

"I've never seen so much capital ever in property markets," says Michael Strong, European chairman of CB Richard Ellis, London. "But what we are actually witnessing is real estate being re-evaluated as an asset and returning to its normal returns and valuations. It had been held back for a while by dramatic moves in the cycle."

Jeffrey Hudson, chief executive officer of George Elkins Mortgage Banking Co., Los Angeles, points out: "Commercial real estate in the past three years has been the most attractive of the three investment classes that include equities and bonds. It was more stable and had higher returns. That's why so much money has been available. Now equities are becoming more attractive, but not because real estate is falling out of favor as interest rates move up. I think real estate over the next year will occupy a position between stocks and bonds for investors."

Hudson adds, "As interest rates rise, we won't see any more 8 percent cash-on-cash returns with 5 percent cap rates-as we know cap rates fell in concert with interest rates. What we will see and are seeing is repricing and adjustments in cap rates and cash-on-cash returns. Until some sort of stability and upward course is set with the stock market [and that is not a given], real estate will still attract lots of capital, which will drive values-been there, done that. In fact, we could see even more capital in the next year if bonds sell off."

Investors slowly are copping a new attitude, Hudson says. "Their thoughts are shifting from ? want to double my money in three years' to ?? [percent] to 12 percent IRRs [internal rates of return] annually over the next 10 years look pretty good compared to equities and bonds/Real estate is back to a true position of legitimacy as a stable and long-term investment. That also means that more smart kids coming out of business schools will choose real estate as a career rather than Wall Street. That's good for our industry."

The big American commercial real estate players with global reach concur. "In general, the attraction of real estate holds on for the foreseeable future," says Thomas MacManus, president of North American operations for GMAC Commercial Holding Corporation (GMACCH), Horsham, Pennsylvania.

He adds, "Though spreads will widen, that will not disrupt real estate markets; rather, borrowers will just pay more. The tight investment spreads of the past couple of years are not the historical norm." GMACCH originated $26.5 billion in mortgages in 2003, including $1.8 billion in Europe.

Why no disruption as interest rates rise? "Commercial real estate still looks reasonably good to investors compared to the alternatives, despite the stock market rally of the past year, because bonds have stayed about the same," MacManus says. "Strong global investor demand has not diminished. Which means we will still see a slight disconnect between valuations and performance as improving fundamentals lag investment capital."

GMACCH plans to exploit its balance sheet like an investment banker to take advantage of some contrarian plays in asset management, special servicing and specialty products as markets reprice in the coming year to 18 months. "Hospitality and health care had been out of favor, but we've seen a rebirth in demand and more capital appearing in the sectors," MacManus says. "On a risk-adjusted basis we're able to get into these sectors quickly-we know the businesses well-and ahead of the curve before the hot money appears.

"Today, we also have to be competitive where the majority of the money is flowing," MacManus adds. "Investors still are and will remain buyers of senior debt and B-pieces, and we must accommodate them. We remain confident to close transactions on our own, with our own capital, because of the strong indicators of investor interest. We take the risks ourselves, because we are highly confident that we can distribute the pieces in today's market. We like to close and then stabilize properties, which allows investors to be more comfortable with six- to ninemonth seasoning for a better investment fit. I don't foresee that changing."

Charles Lowry, chief executive officer of Prudential Real Estate, Newark, New Jersey, finds many investors who are of the view: "Don't fight the tape."

Lowry says, "Prices will continue to go up and stay up, even as interest rates gradually rise, because the recovery will lead to more lease-ups. Institutions seek current return and still believe real estate offers better returns than stocks and bonds in the near term. Given that, real estate continues to look pretty good.

"But people are chasing yields up the risk spectrum in secondary and tertiary markets, and you have to ask: Is this a bubble? Alternative investments are improving," Lowry says. "It seems that people are either more positive on real estate or resigned to the market."

As capital flows overwhelmed fundamentals during the past three years, Lowry says, investors focused on current yield and less on replacement costs and residual returns. This, of course, caused the significant price appreciation in all classes of property, and not without a caveat. "What makes real estate guys nuts is paying 50 [percent] to 60 percent over replacement costs. Better to rebuild and determine the rents," he jests.

Yet, as interest rates head north, institutional investors will still be able to buy yield. "As rates move, this will cause duress in the marketplace for leveraged buyers, and they will become less aggressive," Lowry says. n "institutions will like to see that, because buyers using leverage that institutions can't have been driving values up.

"And as rates go up, more properties will become available due to the distress on the leveraged side," Lowry adds. "I think a good job-producing recovery creates opportunities to buy vacancies. But I'm not the only one thinking that. For example, prices are already recovering in high-vacancy parts of Silicon Valley."

How long it takes for private capital to diminish in real estate markets as the Fed tightens is anybody's guess. But Lowry points out that foreign capital, especially European, will help buoy U.S. markets. "It represents less than 15 percent of real estate capital, but it creates high watermarks," he says. "It absolutely influences the markets positively. Foreign investors have completely different tax motives and return hurdles than U.S. investors." For example, German investors, who are heavily into office buildings on the East Coast, have far lower return objectives than their U.S. counterparts.

"But the reality in my business is that there was far more foreign investment in the mid-iggos than there is today," Hudson points out.

"Today it is more polarized, with international money represented more by huge funds like ING [ING Real Estate, The Hague, Netherlands] and Deutsche Hypo Deutsche Hypothekenbank, Hanover, Germany] and less by entrepreneurs. It's not the shopping-center approach it used to be. However, there is plenty of room for more global money in the states."

Speaking of global, Van Stults, managing director of Orion Capital Managers, Paris, brings an American sensibility to European property investments as he is an American working on continental deals. Orion's first European real estate fund committed 476 million euros to 30 transactions worth 1.4 billion euros.

Twelve properties already have been sold in the two and a half years of the fund's existence. Its second fund of 400 million euros opened this year. "I think investors around the world are having a much better time with fundamentals in the cycle than two years ago," Stults says. "Two years out the office markets should be bottoming with rental declines in London, Paris, Madrid and Milan.

"To be successful, you must anticipate the trends," Stults says. "It is still favorable to get in and out of properties and not hold for the long term. We're optimistic over the next year that we won't see a value bubble like we have over the past two years. Property in Europe in some ways is safer than in the U.S., on the income side. There is less rental volatility in many markets because it is harder to build. It is extremely difficult to develop a 1-million-square-foot tower in Europe, because of growth restrictions. I think a downtown office building in Atlanta is more risky than a suburban building in Paris."

Though buying property for income dominates the investment parameters of the German open-end property funds (the leading real estate investors in Europe), bond-like deals are far too expensive for smaller funds, Stults says. "Like many investors in America we have to be performance-driven," he says, "and use about 75 percent leverage in transactions. We must create value. We're betting on the tenants to improve the property's performance."

Stults sees more investors and lenders, this year and next, targeting individual properties in European markets and employing management skills to enhance returns, rather than "just buying the market." Of course the presence of buyers is critical to this strategy, and German funds were the main drivers of value last year. "We sold properties that we improved to the funds last year as did the big opportunity players, but so far this year German fund flows are down," he says.

Yet if German investors scale back some, Stults says not to worry, for European institutional demand for real estate will not diminish as British pensions and French insurance companies, among others, continue to increase their property investment allocations.

German bankers are a practical lot. They were internationalists well before globalization entered the vocabulary of leftist protestors. "Even in Germany, we're not a German bank," says Ralph Hill, board member of Aareal Bank, an international property and mortgage bank headquartered in Weisbaden, Germany.

Hill is responsible for the international side of Aareal in its three core businesses: structured property finance, consulting/services and property asset management. The bank has real estate assets under management of 27 billion euros, and international bookings represented 82 percent of Aareal's total commitments in 2003, according to the bank's financial releases. East year Aareal placed about $r billion of real estate debt in the United States.

"An inescapable trend is the internationalization of capital markets in real estate," Hill says, "both on the equity and lending sides. In the past one-and-a-half to two years, more international borrowers have looked to conduits." In December 2003, Aareal closed its second international commercial mortgagebacked securities (CMBS) deal, a 1.7 billion euro transaction comprised of 93 loans on 200 commercial properties in 14 countries. Hotel loans in the United States made up 2.95 percent of the deal's portfolio.

"As a German bank doing business in the United States, we've noticed the compression and conversion of margins between European and American real estate markets," Hill says. "This international arbitrage should balance yields in the U.S. and Europe, much like yields have compressed between current European Union countries and the new E.U. accession countries. For example, property yields in the Czech Republic were 11 percent before accession and are now around 8 percent, matching the E.U."

Capital market discipline in commercial real estate debt markets, imposed by conduits, investment bankers and institutional investors on borrowers and developers alike, has compressed margins and tightened spreads. It also has led to more efficient execution of CMBS transactions and generally benefited borrowers by pushing mortgage rates lower. These are all positive traits that have helped to mitigate the nastier edges of past real estate cycles, according to the Americans.

"But there is a countering effect in capital markets that can be a pitfall on the horizon," MacManus says. "If the markets suffer an adverse hiccup, liquidity can disappear quickly. As prices spike quickly, then portfolio lenders start to step up, which helps. Yet if there is a significant disruption similar to the Long Term Capital Management hedge fund debacle in 1998, the risk is that we lose conduit discipline. With today's tight spreads there is less of a comfort zone."

Fortunately, this discipline was imposed on a fertile marketplace, Hudson says. "Consequently, we have not seen the real breakdown in underwriting that took place in the late 19805 and early 19903 meltdowns. In the past, there was no vision as to how the loans would be taken out. Today, with strict debt service coverage ratios, property has been underwritten with a stress constant of 10. With saner underwriting, brakes will be applied with more friction as interest rates increase."

Still, Hudson says, "What concerns the industry the most is an unrelated cataclysmic event-terrorism, another ruble meltdown, significant problems in Iraq-that will shut off liquidity. Many times, the event that ruins our business is beyond our comprehension. We're globalized, so our institutions are all tied up in the debt problems in Argentina, for example."

A smaller worry is the small cadre of B-piece buyers in the CMBS market, he adds. "Wall Street loves to talk about the efficiency of CMBS executions, which is true, but what if the B-piece buyer world shrinks again, which means one large buyer exiting the market? Then our business slows down significantly."

In the old and new worlds, the optimism of the top property players trumps their justifiable worries. Hudson best summarizes the outlook: "With property fundamentals .. . improving, I don't see us on any precipice, about to stumble off. We're in the mode of grinding up and grinding down."