By Steve Bergsman
Photo Illustration By Marc Simon

Can REITs build their shareholder base by attracting foreign investors?

While foreign investors have been attracted to U.S. real estate for some time, only a small percentage of that capital has been allocated to U.S.-based real estate investment trusts. History has shown that when confronted with a choice of investing in a company that owns and operates real estate assets or investing directly into real estate, foreign investors have typically chosen the latter. Although the percentage of new U.S. real estate investments made by foreign interests more than doubled from 4 percent to 8.3 percent between 2001and 2002 (and has remained steady at 8.3 percent so far in 2003), only a fraction of that was invested in REITs, most of it being direct investment in hard assets, according to Real Capital Analytics, a New York-based research and consulting firm.

Part of the problem for foreign investors looking to invest in REITs has been the strength of the dollar, says Cydney Donnell, a managing director with EII Realty Securities, Inc. in New York. "When the dollar is high, U.S. stocks are less attractive. As the dollar weakens compared to the euro, U.S. investment will become more appealing. If the Europeans see the value of the dollar reaching a plateau, foreign interest in U.S. REITs will pick up."

And the primary reasons cited for investing in U.S. public REITs: dividend\return, liquidity and diversification, according to the 2002 "Foreign Investment Survey" conducted by the Association of Foreign Investors in Real Estate (AFIRE).

In fact, some of the bigger REITs, such as AMB Property Corporation (NYSE: AMB), have attracted sizeable foreign investment. Of the 67 million AMB shares publicly held by institutional investors, about 10 percent, or roughly 6.7 million shares, are in foreign hands. ABP Investments U.S. Inc., with just over 3 million shares, and European Investors, Inc. with about 1.5 million shares, are AMB's two largest foreign investors.

Investment Impediments

Currently, foreign investors own $70 billion worth of U.S. commercial real estate assets (approximately 3.1 percent of the total inventory by market value), according to AFIRE. And, until 2002, the capital flows from foreign investors were heading south.

Part of the reason for this, besides the strength of the dollar, has been the nature of foreign investment in the U.S. According to Real Capital Analytics, a majority of foreign capital that flows to U.S. real estate targets office buildings, which has been a slumping sector since the bubble economy burst in 2000. As a comparison, in 2002, 83 percent of foreign investment was in office buildings as compared to just 23 percent of all REIT investment in real estate.

Netherlands-based ABP Investments is one of the five largest pension funds in the world and an active investor in U.S. real estate. In 1998, ABP Investments U.S. was established in New York, because, as the company's mission statement noted, "the market for fixed income securities and real estate are highly developed in the United States and offers many opportunities. It's important for us to be present on the spot here."

ABP Investments U.S. manages between $20 billion and $30 billion in U.S. assets (hedge funds, fixed income and real estate), reports Barden Gale, managing director for its real estate unit. "My guess is roughly 5 percent of all U.S. REIT stocks are owned by foreign investors, and ABP accounts for a significant amount of that. We have invested approximately $6 billion in U.S. REITs and real estate operating companies."

Asked if foreign investment as a whole in U.S. REITs was increasing, Gale could not say for sure as flows are "dynamic," meaning some years are stronger than others. As for ABP Investments, it holds to a fixed total allocation to real estate with fluctuation as to geographic distribution.

While the dollar has slumped in comparison to the euro and would indicate a higher attractiveness of U.S. REITs, REIT shares have been trading very high. "If you take a look at the valuation of U.S. REITs, they are probably near an all-time high even on a price-only basis," Gale says. "The dollar is cheap, but you are buying in at steep prices. Is that good, bad or indifferent? You have to make up your own mind. We don't believe it is necessarily bad, but it definitely isn't great."

		U.S. Withholding Tax Rates on REIT Ordinary Dividends AS OF JULY 1, 2003

To the extent that the euro now has greater buying power, that could be a significant enhancement for foreign investors. About 18 months ago, Chicago-based Macquarie Capital Partners LLC was working with two large German institutional investors looking for U.S. property investments. At the time, "their view was the euro was dramatically undervalued and the dollar over-valued so they didn't invest," recalls Don Suter, managing principal with Macquarie Capital Partners. "But they are investing today. And I think you will see more of that."

Another impediment to foreign investment, particularly by European investors, in U.S. REITs, is that many investors were already burned once.

"A number of European investors came into our product, particularly in 1997 when it was launched," says William Hauser, director and portfolio manager of HVB Capital Management Inc. in New York. Hauser oversees the company's European-listed mutual fund that invests in U.S REITs. "At that juncture, investors were of the view that they could have their cake and eat it, too. They were looking for capital appreciation, strong price growth and solid dividend yield."

Unfortunately, Hauser says the same investors didn't understand that publicly traded real estate stocks can suffer in a market downturn like any other public equity, which is exactly what happened 18 months later. "That left a bad taste in their mouths, especially at a time when stocks were skyrocketing. Investors didn't understand the risk associated with real estate securities so they walked away from the experience feeling rather burned."

A Place for U.S. Investment

While there has been a steady flow of capital into U.S. real estate from foreign investors, as noted, most of this has been in direct property investments. There is not a lot of money flowing into REIT common stock from investors outside the U.S., right now, opines Macquarie's Suter.

“Investors didn’t understand the risk associated with real estate securities so they walked away from the experience feeling rather burned.” —William Hauser

Formed in 2001, Macquarie is a real estate investment banking boutique that focuses primarily on raising private equity for public and private real estate operating companies and funds. Operating in the U.S., Europe and the Middle East—as well as Asia and the Pacific Rim though its partnership with Australia's Macquarie Bank—the firm sources institutional capital in most of the important real estate markets around the world

"Yes, some foreign investors have made investments in REITs," says Suter, "but most are investing in U.S. real estate through other structures." Of those non-REIT structures, one of the most popular has been the joint venture.

In May, Macquarie put together a joint venture between Developers Diversified Realty Corporation (NYSE: DDR) and an investor group led by Kuwait Financial Centre-Markaz (a Kuwaiti publicly traded company).

"A lot of foreign investors want to own hard assets in the United States because of safety and because of yields," Suter says. "You can earn a higher return on a U.S. shopping center than you can on a European one. And you can earn a higher return on an office building in the United States than you can on one in Paris, London or Frankfurt."

Yields of Gold

Whether an investor is from the U.S. or Germany, a main attraction to investing in a publicly traded REIT is the strong and reliable yield. More than upward share price movement, yield is a universal attraction to investors around the globe, says EII's Donnell.

"A lot of the interest in U.S. REITs has been yield driven, especially given the spread between the 10-year Treasury in the United States as compared to dividend yield by REITs. The spread is at a 10-year high now, nearly 350 basis points," observes Anthony Paolone, a REIT analyst with JP Morgan Chase.

Greg Whyte, a managing director with Morgan Stanley, shares that viewpoint. "There has been an increased appetite for REIT stocks by most foreign investors, although an allocation by U.S. pension funds is probably much more significant than the international allocation. Still for foreign investors, REITs have offered attractive yields. In the type of investor environment we are sitting in right now, given where interest rates are and the type of returns investors are expecting, REITs are a fairly attractive alternative."

Whyte adds that there are other reasons why U.S. REITs would be attractive beyond yield. He says REITs diversify foreign investors' exposure to international real estate markets and it can be done through a vehicle that is liquid, boasts professional management and gives daily valuation of the investment.

"Some foreign investors place money in global real estate mutual funds that have an allocation to the United States, given the significance of this market in global terms. Those investors don't have much of a choice over investments," Whyte says. "Others are looking to get exposure to U.S. real estate and will buy into REITs instead of land and buildings."

Tax Neutral Investors

In addition to dividends and diversification, REITs are appealing to some foreign investors because of tax considerations. According to Macquarie Capital, of the five largest foreign sources of investment in U.S. real estate (Germany, Netherlands, Middle East, Canada and Australia), only two have historically invested in REITs, Netherlands and Canada. About the only other country source that invests in U.S. REITs so readily is the U.K.—but that has been relatively recent due to changes in the U.S.-U.K. tax treaty (see the "REIT Reality" section in the May/June Portfolio). (Editor's Note: As Portfolio went to press, Germany was in the process of considering legislation that would remove an impediment to German investors owning U.S. real estate stocks.)

“A lot of foreign investors want to own hard assets in the United States because of safety and because of yields,” Suter says. “You can earn a higher return on a U.S. shopping center than you can on a European one.”

"The British have just eliminated the withholding tax in the treaty between the United States and Britain," Donnell says. "If you are a pension investor in Great Britain and Holland you are on equal footing with pension investors in the United States."

Dividends paid by U.S. REITs on or after March 31 to U.K. investors and U.K. pension funds will be under the new treaty, explains Morgan Stanley's Whyte. "I would expect a greater appetite for U.S. stocks by U.K. pension funds."

"We have already seen a pick-up in interest from Great Britain," Donnell says, "which is probably because we have seen a lot of press there lately about the rule changes."

Unfortunately for German investors, there have historically been no such advantages—although that might change soon. In mid-summer, the German Ministry of Finance introduced legislative reforms for the antiquated public investment fund and taxation laws, Hauser says. The document is being vetted publicly now, both Houses of German Parliament also need to review. Passage before year-end with introduction in early 2004 is an optimistic goal, according to Hauser.

"These new rules integrate fund investment and tax matters—which have always been dealt with separately," he says. "Under the current format, rules on fund taxation are often diametrically opposed to those on investments—creating unfathomable difficulties."

As for Dutch investors, they have long been able to invest efficiently in U.S. REITs because of that country's tax treaty with the U.S. Normally, the withholding tax rate on ordinary REIT dividends (as of January 2003) is 30 percent if the non-U.S. shareholder does not reside in the U.S. or if there are no income and capital tax treaties between the U.S. and the country where the shareholder resides. A Dutch pension trust has a zero percent tax rate on ordinary REIT dividends.

For a list of U.S. withholding tax rates on REIT ordinary dividends for countries across the globe, see the chart on page 25.

It would seem that a beneficial tax treaty would mean a world of difference to foreign investors and the attraction of U.S. REITs, but that is not always the case. Canadian, U.K. (new), Swiss and Venezuelan pension trust investors share the same zero percentage tax advantage, but the latter two countries are not necessarily major sources of investment in U.S. REITs. In addition, another 30 countries have income and capital gains tax treaties in place that have a withholding tax of anywhere from 10 percent to 25 percent.

Although AFIRE does not have any statistics on specific foreign investment in REITs as a separate data point, Jim Fetgatter, AFIRE's chief executive, says, "the largest group of foreign REIT investors are Dutch pension funds. Germans are significant investors in the U.S., but their tax treaty laws have made it more advantageous to invest directly. The Australians are relatively new REIT investors and the British may emerge in the future.

To Invest or Not To Invest

Taxation is only one of the factors as to why a foreign investor might or might not decide to invest in U.S. REITs.

Foreign investors often use a top-down methodology to decide how, when and with whom to invest, suggests John Roberts, president of AMB Capital Partners. Basically, that means foreign investors consider all of the following factors:

• Asset Class: Do we want to be in stocks, bonds, real estate or alternative investments?
• Investment Vehicle: Given current pricing, do we prefer direct or indirect approaches?
• Property Type: In what types of property are we under or over-weighted?
• Structure: Whose track record and co-investment approach appeals most?
• Global Diversification: How much is allocated to the U.S.?
• Tax Efficiency: Can we structure the venture to meet the domicile-driven tax considerations of each partner?