By Phillip Britt

Recent events provide directions for where U.S. REITs may be headed with cross-border transactions

A number of U.S.-based REITs are changing course to invest in real estate globally. Having solidified their domestic holdings, several U.S. companies have turned toward international markets as a way to expand their operations and meet customer needs. At the same time, the global real estate investment landscape is changing rapidly as more countries adopt REIT-like legislation, tax treaties are amended and foreign companies set up shop in other jurisdictions.

Real Estate Portfolio looked at recent initiatives by major REITs in the retail, industrial, office and hotel sectors to determine what these signposts tell us about the overall direction in which these companies are headed on a global basis and what global opportunities exist for U.S.-based real estate companies.

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Retail companies were among the first U.S. REITs to test the international waters. Several big-ticket mergers and acquisitions have made waves in the retail sector and created large companies with the experience and financial resources to aggressively expand across the globe. Simon Property Group (NYSE: SPG) and Westfield Group (ASX: WDC), both of which made significant moves recently, have been at the forefront of establishing global retail strategies. And there are a few other similar companies actively following suit.

Simon already had a sizeable international portfolio consisting of interests in 47 assets in Europe (in France, Italy and Poland) and Canada. However, the acquisition of Chelsea Property Group, Inc., (NYSE: CPG) earlier this year expanded the reach of its holdings into untapped markets, primarily in Asia.

"I do think there are a couple of opportunities in Japan that we're going to examine with the Chelsea infrastructure," according to Simon Chief Executive Officer David Simon. "We're just at the very beginning of trying to understand the Chinese retail market. It is obviously an unbelievably dramatic place. There is a lot of activity, and the population's income is increasing."

Simon executives say they're "very optimistic" about the opening of Arcadia in Warsaw, Poland, the largest mall in Eastern Europe. Although no more immediate activity is planned in Poland, the company plans additional European efforts in France.

Another retail company with holdings across the globe is Westfield. Earlier this year the concern rolled its three companies under one umbrella, creating the world's largest shopping mall owner. Westfield Group owns 123 malls in the U.S., U.K., Australia and New Zealand. And like Simon, Westfield is also expanding its presence across Europe.

Simon and Westfield are leveraging their expertise in running malls locally in these overseas ventures, according to John Kriz, managing director of real estate finance with Moody's Investors Service. "There aren't as many malls in Europe as there are in the U.S. [Westfield and Simon] have spent several years building up their skill sets in operating retail mall REITs. Now they're transferring their skills to malls elsewhere," Kriz says.

Dale Ann Reiss, global director of real estate, hospitality and construction for Ernst & Young, says Europe offers plenty of good opportunities in various real estate sectors, particularly retail.

"Retail has been the fair-haired child [in global real estate]," Reiss says, pointing to malls as the place where people spend their money in improving economies. However, she adds, there are some notable differences in some parts of the world. While Europe offers some good current opportunities for these two companies, she cautions that China presents some challenges.

Other retail REITs expanding internationally include General Growth Properties, Inc. (NYSE: GGP) and The Mills Corporation (NYSE: MLS), says Jeff Paravano, partner at Baker & Hostetler LLP, and a former senior advisor in the U.S. Treasury Department. However, he only foresees a handful of companies becoming active participants in the international retail market in the near future.

In August, General Growth (which recently announced a merger with The Rouse Company) announced its first two international deals, one in Brazil and one in Costa Rica, says Alex Berman, head of GGP Ventures, the company's international arm.

"Approximately one-third of the world's GDP is in the U.S. That means there's another two-thirds outside of the U.S.," Berman says. "We can grow in the U.S. as the economy grows, but there are a lot of parts of the world that aren't as mature."

Therefore, an experienced real estate company with significant size may have some better opportunities in underdeveloped areas, Berman says, citing good international partners as critical to understanding local markets. As part of its expansion strategy, General Growth looks for other local partners and opportunities.

"Eventually, we'd like to grow to the point where international is a significant portion of our business," Berman says. "If [international operations] are too small, you probably don't want to waste your time with them."

Along with retail, industrial is another sector that travels well. However, as with retail REITs, there are just a few primary players in the global industrial REIT space. And while other industrial companies may have sufficient size to be in the international market, they have chosen to focus on domestic opportunities.

Like retail, industrial may be the only other real estate sector where the tenant base is such that economies of scale can be truly realized through global expansion, according to Kenneth Campbell, managing director with ING Clarion Real Estate Securities.

"Industrial properties tend to be in that broad business of logistics and that is why companies like AMB Property Corporation (NYSE: AMB) and ProLogis (NYSE: PLD) have really grabbed hold of cross-border transactions in a big way," Campbell says.

With a heavy international involvement predicated on the needs of their global customers, AMB and ProLogis have built on the growth in worldwide trade, growth that analysts don't expect to slow any time soon. The two companies are now making strong in-roads in China.

As global trade grows, there is an increasing need for modern, efficient Class A distribution/logistics infrastructure, according to Kriz.

Not only has AMB added major acquisitions/developments in Asia, Europe and Mexico, but all of those properties are fully leased, according to Hamid Moghadam, AMB chairman and CEO.

"All our companies (customers) are global," Moghadam says. "What we've done is follow the customers. That may not work with other property types."

One of the areas expected to have the most growth potential is Europe. According to a ProLogis research study, many major European companies are exploring the possibility of opening multi-country distribution facilities where one or two of these facilities would serve Western Europe and another one or two would serve Central Europe.

In the company's second-quarter earnings report, Vice Chairman and Chief Investment Officer Irving F. Lyons III pointed to increased worldwide leasing activity as the primary reason for increasing the company's guidance for development starts for 2004 to approximately $1 billion, up from the initial guidance of $800 million to $900 million. The increase is being seen in the volume of build-to-suit transactions in Europe and Asia and improving conditions in North America, Lyons says.

In response to the growing demand in central Europe, modern, large warehouses and distribution centers are being built throughout the region, concentrated mostly in or near the region's capital cities—Warsaw, Prague and Budapest, the ProLogis report adds.

A need for better industrial space isn't limited to Europe. Though Japan's economy has been soft for more than 10 years, a turnaround is underway, which should help drive demand for industrial properties there, Moghadam says, adding that one only has to look at Wal-Mart's announced expansion plans for evidence of Japan's improving economy and need for a better distribution infrastructure.

Beyond expanding in Japan and Singapore, Moghadam expects the company's next phase of growth to be in the untapped (for AMB) Eastern European market.

However, Kriz doesn't expect other U.S. industrial REITs to follow in the footsteps of AMB and ProLogis, citing ample opportunities in the U.S. Another factor preventing other U.S. industrial REITs from expanding internationally, according to Moghadam, is lack of size and established presence. AMB and ProLogis have spent years overseas establishing relationships, learning cultures, etc. That takes time and a capital commitment that would be difficult for smaller industrial REITs to make, Moghadam adds.

While AMB and ProLogis focus on warehouse properties, other industrial REITs include a wider range of properties, so they still have room to grow in the U.S. before going international, says Michael Brennan, president and CEO of First Industrial Realty Trust, Inc. (NYSE: FR).

"Two basic questions you have to ask yourself when considering international expansion are: Are you running out of opportunities in the U.S.? And are the returns better overseas?" Brennan asks. "For some companies that are focused on only one type of industrial property, there may not be as many good opportunities in the U.S. We have developed multiple capabilities here (bulk warehouse, light industrial, flex and manufacturing facilities)."

Going overseas would magnify the risk without providing a significantly better return than the 17 percent that First Industrial currently is enjoying in the U.S., Brennan says.

When Strategic Hotel Capital, Inc. (NYSE: SLH) was conducting its road show for its initial public offering, one of the company's prime selling points was its diverse portfolio of international and domestic property holdings. However, there's a difference of opinion among analysts and industry executives as to the benefits of going overseas for lodging REITs.

Ernst & Young's Reiss sees plenty of opportunity on a worldwide basis for the hotel sector. According to Reiss, investments in foreign properties can provide U.S. investors with a currency hedge. Additionally, there are a large percentage of independent hotels overseas, providing opportunities for multinational hotel operators to add these properties under their flag, she says.

The opportunities for hotel operators differ from country to country.

In France, for example, some European hotel companies are starting to look at opportunities outside of Paris, according to Philippe Parfait, vice president of the Invest in France Agency, North America. But for now, he says, the interest has come from European companies and not companies from the U.S.

Accor has saturated the French market, providing opportunities for other hotel operators, because hotel customers want to have a choice, Parfait says. Interestingly enough, other hotel operators didn't want to venture outside of Paris until Accor had tested the waters.

Similarly, the hotel market in Warsaw could also present opportunities, says Tomasz Klodowski, managing director of Stewart International, Poland, which provides title and related real estate information services in 30 countries.

There is a very strong representation from international operators and investors that may be willing to exit in a very overbuilt market, Klodowski says. This provides room for new investors to acquire those assets. "Some of the best opportunities in the sector present themselves during difficult times," he says.

Kriz, however, says that U.S. hotel operators can best meet the needs of shareholders by capitalizing on domestic opportunities. Outside of Strategic Hotel and a few other larger companies, most U.S.-based hotel REITs have little or no holdings overseas, and are unlikely to change their focus, Kriz says.

For Strategic Hotel, its international holdings in the Czech Republic, France, Germany and Mexico played a key role in its presentation to potential investors. The company's shares started trading June 24. The company's stock opened at $14, a little below the initial asking price of $15 to $17, and closed the first day's trading at $14.35. The stock price had dipped to $13.58 by the close of trading Oct. 5.

Focusing on international holdings was important for Strategic Hotel, according to Reiss, to show that the company is a global player like Starwood Hotels & Resorts Worldwide (NYSE: HOT).

For those hotel REITs not looking to expand into international holdings, Michael A. De Nicola, executive vice president of FelCor Lodging Trust Incorporated (NYSE: FCH), says one of the main reasons is the tax differences in other countries. The taxation of foreign holdings usually more than outweighs any additional benefits of overseas holdings, De Nicola says.

"It's clear to us that U.S-based properties present a better opportunity. We're not going after international markets," says De Nicola, adding that he expects most other U.S. hotel REITs will keep their focus domestic as well.

The exceptions tend to be those REITs that already have an established international portfolio, he says. Another exception could be tax-free exchanges (section 1031) of property in certain countries. FelCor, for example, plans to reinvest assets of a recent sale of Canadian property into other Canadian holdings to take advantage of the tax-free exchange.

Even though it does have a presence in foreign markets, Greg Larson, senior vice president of investor relations at Host Marriott, says he expects the company to continue to focus primarily on the U.S. Host Marriott has 95 percent of its assets in this country and enjoys returns 2 percent to 3 percent better than they would be elsewhere, Larson says. If economic conditions were to change so that overseas returns trump those of domestic returns, Larson adds the company would reconsider its strategy.

While the retail and industrial sectors appear to be in the international fast lane, the office sector, like the majority of the hotel sector, is proceeding with caution. U.S. office REITs typically see better development potential domestically than overseas, according to Kriz. He adds that most U.S. office REITs don't have experience operating in overseas markets, and, since local knowledge is so vital, that expertise takes some time to build. With what they consider an underdeveloped market in the U.S., Kriz says he doesn't expect U.S. office REITs to look overseas any time soon.

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"We don't have any focus on international property; we don't see any competitive advantage in it," says Mitchell E. Hersh, president and CEO of Mack-Cali Realty Corporation (NYSE: CLI). "In order to expand in other countries, you have to consider working with local [foreign] partners. Different countries have different currencies and different styles of doing business. We feel our best opportunities are in the areas that we know."

A good example of the reluctance of U.S. office REITs to look overseas can be seen in the recent sale of Canary Wharf, the property company that owns the London Docklands' high-rise office complex in London. There were several bidders for the property, but REITs weren't among them, Reiss says. The property itself was attractive, according to Kriz and Reiss, but the high price of the property made it unappealing to U.S. office REIT operators.

Reiss adds that opportunity funds, such as the Morgan Stanley-led fund that won the Canary Wharf bid after an 11-month process, are able to use more leverage for their money than listed U.S. REITs—as much as $10 for $1, rather than $2 for $1—so they're better able to purchase office properties. This same capitalization issue also applies to other properties but higher leverage is typically needed in order to offset underperformance of office properties.

Reiss expects opportunity funds to continue to be the major investors in office properties overseas, while office properties in the U.S. are attracting investments not only from U.S. REIT operators, but also from operators of "REIT-like" entities overseas.

Doug Herzbrun, senior managing director of CB Richard Ellis Investors LLC, adds that even though Canary Wharf was an attractive property as far as investors were concerned, it and other international office properties tend to be underperforming assets when compared to other forms or real estate.

"There is a real disconnect between what investors pay and the performance of the international office assets," Herzburn says. He expects the office sector to continue to underperform for the near future.

Another factor limiting the need for U.S. office REITs to expand into other markets is that their tenants typically do not have the same brand loyalty seen in retail or the operational needs seen in industrial.

"A Fortune 500 company can rent space from a company in New York, but they are not terribly concerned if they rent space from that same company in Los Angeles or London," Campbell says. "Office tenants are much more fungible around the world than industrial or retail tenants."