Europeans are sending mixed signals about their desire to invest in REITs.

By Michael Fickes

During the second half of 2000, there were a number of notable deals in which European investors bought stock in U.S. REITs. Kimco Realty Corp., Vornado Realty Trust and Corporate Office Properties Trust were among the companies benefiting from these stock issues. Stichting Pensioenfunds ABP (ABP), the Dutch public employees pension fund, bought substantial stakes of just over five percent in both Vornado and Kimco during July and August of 2000. But does this activity indicate a growth in interest by European investors in the U.S. REIT market? Or are there still substantial barriers, both psychological and material, keeping a majority of potential investors at bay?

On the Upside

ABP has invested directly in U.S. real estate for years, but altered its strategy in the early 1990s, during the cyclical real estate downturn. According to industry analysts, the fund decided that it made more sense to make strategic investments in real estate operating companies and REITs because they provide broad systematic exposure to real estate, helping to diversify the pension plan and eliminate the need for the fund to manage individual properties.

The Corporate Office Properties transaction consisted of a $12 million issue of convertible preferred stock with a 4 percent coupon rate to a foreign investment trust located in the Isle of Man. While Corporate Office Properties lacks the geographic breadth and brand-name recognition of a Vornado or Kimco, its focus on office property in the high-growth region around Washington, D.C., may have turned the trick. "This was a friendly investor that already knew our company very well," says Sara Grootwassink, the company's vice president for finance and investor relations.

In each case, these foreign investors timed their stock purchases to match the strong rebound of stock prices across the REIT industry in the wake of the burst technology stock bubble.

Where are the Euros Going?

The February issue of Real Estate Weekly, published by Robertson Stephens in San Francisco, concludes that the "healthy U.S. property markets, and still-compelling REIT valuations have created an enticing menu of selections for European REIT investors."

Robertson Stephens believes that European investors will invest selectively, focusing on large, high-quality office, apartment and mall operators in high-barrier-to-entry cities. Likely beneficiaries of European buying will be names such as Equity Office, Boston Properties, Equity Residential, AIMCO and Simon Property Group.

According to the ninth annual survey of foreign investment in U.S. real estate, released by the Association of Foreign Investors in Real Estate (AFIRE) in January, 2001, international investors will focus predominantly on New York, San Francisco, Boston and Washington, D.C. "At no time during the eight years in which we have conducted the survey has our members' consensus about which cities are the best prospects for their real estate investment dollars been this strong," says James Fetgatter, chief executive of AFIRE.

The AFIRE survey queried members who have collectively invested approximately $45 billion in U.S. real estate.

However, the survey also detected a significant change in German investor sentiment, which suggested that German investment would decrease this year. "The falling Euro is making U.S. and non-European Union real estate more expensive," Fetgatter says. "In addition, other opportunities are competing for deutsche marks in Germany. Finally the U.S. is no longer a buyer's market as it was in the mid-to late-'90s."

How important is German investment to the overall international equation? "The Germans and the Dutch are the two primary European groups investing in U.S. real estate," says Bruce Kiley, a partner with PricewaterhouseCoopers in New York. "The other countries follow in smaller numbers."

AFIRE also explored foreign investor interest in terms of property types and discovered that retail properties slipped from second place to fourth in this year's survey, the lowest ranking earned by retail since 1996.

Office properties remained the most sought after by foreign investors, with multi-family replacing retail in the second slot and industrial taking over third place. Hotels continue to rank last in the estimation of foreign investors.

Perceived and Material Hurdles for European Investors

"Foreign investors have always moved in and out of U.S. real estate," says Lesia Bates, vice president and senior credit officer with Moody's Investor Services. "Today, the general attitude toward the U.S. real estate market by non-U.S. investors seems based on two perceptions. First, some were burned in the late '80s and early '90s and remain leery of aggressively pursuing opportunities in REITs or even the general U.S. real estate market. Second, many are concerned about the slowing U.S. economy. As a result, these investors are proceeding with caution."

William E. Hauser, portfolio manager with HVB Capital Management in New York, agrees. "There is a perception on the part of European investors that Europe will outperform the U.S. economically and in the equity markets going forward," he says. "Pick up any newspaper in Europe these days and you will read about a peaking U.S. real estate market in terms of occupancy rates and rent levels."

Hauser echoes Bates in saying that Europeans have not yet drawn the conclusion, now prevalent among U.S. investors, that the growth of public sector real estate, both through REITs and Commercial Mortgage Backed Securities (CMBS), has tended to flatten out real estate's historic tendency toward booms and busts.

Among his responsibilities, Hauser manages HVB's Activest Lux US REIT Fund, a mutual fund composed of REITs and marketed to European investors. As a result, Hauser's concerns about the perceptions of European investors run deep.

Hauser cites several other long-term issues that affect the interest of international investors in U.S. securities including REITs. These include the differences between U.S. and international public markets, exchange rates and saturated markets.

"In the U.S., we're accustomed to open, transparent and efficient markets," he says. "But this is sometimes difficult for individual international investors to see. For example, European investors looking into U.S. markets start with a public market perspective based on the performance of public markets in their own countries. In real estate markets in particular, real estate companies have not performed well in Europe, with many companies trading at steep discounts to underlying net asset values. Some European companies are even considering going private rather than staying public."

Nor are European companies' accounting and reporting standards considered as transparent as U.S. companies, continues Hauser.

As for the currency exchange issue, Hauser notes that the relative value of European currencies compared to U.S. dollars has benefited European investors for several years. But during the early months of 2001, European currencies, pegged to the Euro, have begun to rise in relation to the dollar. "As European currency rebounds, European returns on U.S.-based assets will fall," Hauser says. "So the attractiveness of being in U.S. assets may be less this year than a couple of years ago. But again, this is a perception issue. Who's to say where the currency markets are really heading."

Another potential constraint on overseas investors has to do with the experience of German investment funds in direct property in recent years. According to Hauser, Germany stood out as one of the most active international communities investing directly in U.S. real estate during the late '90s. "Just as the Japanese were active in the '80s, the Germans were active during much of the '90s," he says. "Today, a number of German investment funds are suffering from indigestion. They bought more property than they now have investors for and they are having a hard time covering what they acquired. While other countries have in many cases been increasing their exposure to U.S. real estate, Germans, who were the largest group of buyers, are backing off, at least in direct property ownership.

"This may make it more difficult for REITs to sell stock to German investors today, because of this larger dynamic related to direct property investment."

REITs Should Sell Their Strengths

Despite such constraints, some international investors are buying REIT stocks and profiting from them. During 2000, Hauser's REIT fund delivered a positive total return of 40.2 percent calculated in Euros and 31.2 percent calculated in U.S. dollars, a better performance than the benchmark NAREIT index.

What about 2001? "I was exceptionally bullish on REITs last year," Hauser says. "Today, I'm still positive, but not as bullish."

Hauser believes that REITs can approach international investors with a strong story that begins by making clear the distinction between REITs and publicly traded real estate in other countries. REITs offer accounting transparency, strong corporate governance and an independent board of directors, he says. In addition, REITs generally pursue an investment strategy focused on single property types. In Europe, public companies are less transparent and less focused. So it's important to make these REIT benefits clear to international investors."

Kiley of PricewaterhouseCoopers recommends that REITs avoid the temptation to sell themselves as a proxy for direct ownership of real estate. Investors who want to own direct will buy direct. "REITs should sell what they are," Kiley says. "They are a real estate investment vehicle that provides a yield without management headaches, and they are an appropriate part of a fixed-income portfolio allocation."

Kiley adds that international REIT investors generally express the most interest in brand name REITs, regardless of property type. "In other words, they buy the company and the company management," he says. "And that tells you that there are only a dozen or so companies that they will focus on. For a smaller niche REIT, it's not going to happen often."

Perhaps it isn't happening often, but it does happen. Hauser's REIT fund has bought a substantial amount of Mission West Properties' stock, for example. Mission West is a California based flex-office/light industrial REIT with properties concentrated in Silicon Valley. "Generally my portfolio holds common stock in standard names," Hauser says. "The difference is that I've weighted the portfolio differently than the REIT index. Mission West is less than one percent of the REIT index, but I have five percent."

Hauser also owns larger shares of several brand name companies included in the NAREIT index. For example, Simon Property Group makes up about three percent of the NAREIT index, but Hauser's allocation is double that. And, Equity Office stands at 7.5 percent of NAREIT, but 10 percent of Hauser's fund.

Such funds do represent an equity opportunity for REITs, albeit a small opportunity. According to Hauser, only a handful of international mutual funds currently invest actively in REITs.

"The real estate appetite for many non-U.S. investors continues to be in direct real estate," says Moody's Bates. "These investors are still coming in through joint ventures and strategic alliances on the equity side and through bank loan opportunities on the debt side."

While some of these European investors may eventually move toward REIT stock, it remains, for the time being, a relatively tough sell in Europe.