Overview

Rising from the nadir of activity in 2009, foreign acquisitions of US commercial real estate have been widely touted as one of the keys to the sector’s investment recovery. On Capitol Hill, recognition of foreign capital’s appetite for US assets has fueled legislative efforts to rescind the 1980 Foreign Investment in Real Property Tax Act (FIRPTA). These efforts, which have enjoyed broad industry support, met with their first major victory on July 30, when the House of Representatives passed FIRPTA reform legislation by an overwhelming majority of 401 to 11 (for an analysis of FIRPTA reform, see Dr. Chandan's "FIRPTA Reform in Context"). Increasing foreign investment in US real estate stands out against a cyclical decline in global cross-border capital flows. But the current momentum is supported by investors’ favorable assessments of the risk-reward tradeoff in acquiring well-located and high quality US assets.

Shifting Global Investment Opportunity

While foreign investment will undoubtedly rise in the event of meaningful FIRPTA reform, the promise of tax code changes does not explain the tailwinds already supporting foreign buyers’ attention to the US marketplace. Rising US investment contrasts with global cross-border flows that have declined dramatically from 2007/08 to 2009/10, as investors have adopted more risk-averse strategies and retreated from the global stage. In Western Europe, cross-border transaction activity has fallen from almost 60% of volume to just over 35% during this period. In Latin America, cross-border activity has fallen even more dramatically, from over two-thirds of volume to a little more than 10%. In fact, the United States and the United Kingdom are the only major countries that have experienced a rise in property acquisitions by cross-border investors over this period.

Rising foreign investment in US assets reflects a shift in the order of global investment opportunities. An early surge in investment activity across Asia Pacific markets – including China, Hong Kong, Taiwan, and Singapore – in the fourth quarter of 2009, and in Western Europe in late 2009 and early 2010, coincided with large drops in acquisition yields and higher prices in both regions. As of the second quarter, average commercial cap rate spreads over sovereign debt rates were just 153 basis points in Hong Kong. In Germany and the United Kingdom, spreads were just under 350 basis points. At the top of the range, US spreads climbed to 526 basis points in the second quarter, to their highest levels of the cycle.

Foreign Investor Share of US Activity Grows

The combination of sharply lower US property prices and a wide differential in spreads has attracted foreign investors seeking high quality assets in liquid markets at expected rates of return that, on the global stage, are proving attractive. The growth of foreign investment in 2010 demonstrates that these investors have succeeded in identifying a very favorable balance of risk and return. This balance has tipped even further in favor of US investment opportunities as sovereign debt crises and financial instability have rocked Continental Europe.

Foreign acquisitions of US real estate increased from $1.5 billion in the first quarter to $2.5 billion in the second quarter. Through the end of July, foreign investors have acquired $4.3 billion of US commercial properties, representing just under 10% of all investment activity year-to-date. Acquisitions through the end of June, up 210% year-over-year, already exceed last year's grand total of $3.9 billion by nearly 12%.

Driving Liquidity Improvements in Gateway Metros

Taking advantage of prices that remain near their cyclical lows, foreign investors have focused their attention on markets that historically have commanded the strongest interest for cross-border investment. While foreign buyers have grown their share of national transaction volume to approximately 10% in 2010, up from less than 7.5% in 2009, the increase in market share in those historic target markets – including Boston, Washington, DC, Los Angeles, Manhattan and San Francisco – has been much larger. Through June, foreign buyers have accounted for nearly one in every five acquisition investment volume in these favored metros.

Reflecting a long-standing bias in favor of prominent office properties within their target markets, foreign buyers have played a leading role in driving liquidity to that sector, often crowding out domestic investors. Year-to-date, office acquisitions have accounted for 61% of foreign acquisition investment volume. And so while accounting for nearly 20% of acquisition dollars across all property types in the nation’s “gateway” markets, foreign buyers have accounted for nearly one-third of office transaction volume in these same locations, making a disproportionate contribution to liquidity and price discovery for high quality assets in this sector. In contrast with the office sector, acquisitions of industrial properties have withered over the last 18 months and represent just 2% of foreign investment volume in 2010.

Canadian Investors Lead the Pack

Through July, nearly one-half of all cross-border investment in the US has come from its nearest neighbors: $1.7 billion from Canada and $192.0 million from Mexico. Brookfield Asset Management, Brookfield Properties, and RioCan REIT, companies investing heavily in US office and retail properties, accounted for the majority of Canadian buyer acquisitions. Mexican billionaire Carlos Slim’s acquisition of 417 Fifth Avenue in Manhattan for $140.0 million was the largest Mexican investment in the US (see “Selected Repeat Sales,” August 5.)

Former investor heavyweights such as Australia and the Middle East have been minor players so far in 2010. The presence of China among the top ten investing nations could portend major inflows from this country in the near- to medium-term. This week’s deal drilldown describes a Chinese investor’s acquisition of a West Coast hotel property. The purchase of the LA Marriott is noteworthy in that it represents a rare direct acquisition by a Chinese investor and is one of a few troubled acquisitions made by non-US buyers so far this cycle.

Of the countries that have exported capital to the US so far this year, over half have spent more than $100.0 million. The remaining countries are represented by sporadic deal activity, such as Malaysian investor IBG Corp.’s $77.4 million April acquisition of two W hotels in Manhattan. In 2005, German investors were second only to Australian buyers atop the list of foreign investors. While they have been largely on the US sidelines over the last 18 months, stalwart global institutions such as the German Open-Ended Funds (GOEFs), described in a special feature this week, may yet enter the US market.