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CAPITAL FREE FLOW

INTERNATIONAL CAPITAL KNOWS NO BORDERS TODAY AS INVESTORS SEND THEIR FUNDS AROUND THE GLOBE IN SEARCH OF HIGHER RETURNS

By Steve McLinden

The global playing field continues to level out in ways that even The World is Flat author Thomas Friedman had not envisioned. From Boston to Budapest, an unprecedented amount of investment pours into retail, often from the same lending pool.

The improved transparency and liquidity of the retail industry is making it a desirable investment all over the world, retail experts say. The numbers tell the tale. Last year investors ventured a mind-boggling $682 billion in commercial real estate internationally, up 38 percent from 2005, according to a March report by Jones Lang LaSalle, titled Moving Further and Faster. And about one-sixth to one-third of that went into retail, depending on the maturity of a country’s markets, the firm says.

Cross-border transactions accounted for 42 percent of this activity, up 34 percent over the previous year. Barriers to intercontinental investment continue to fall, says Scott Harris, ICSC’s staff vice president of business development.

“Money will continue to flow out of mature markets for several reasons,” Harris said. “Investors are searching for markets where there is new growth — not just retail development projects, but demographics. And in so many markets, the kinks have been ironed out and learning curves have been reduced.”

The improved creditworthiness of several major countries is driving the investment train too. Last year several countries considered to be high risk for real estate investment were upgraded to medium risk, including the Czech Republic, Hungary, Poland and Slovakia, according to ING Real Estate. Japan, Mexico and Portugal, along with Hong Kong, got elevated from the medium category to low risk. Last year was also the first in which capital values rose in all major and emerging markets, says the Jones Lang LaSalle report. Despite some forecasts of a cooling global economy, growth will probably continue to support demand for retail and other commercial real estate through at least the next year or so, observers say. Read on as SCT takes a look at a vibrant retail capital picture, focusing on the galloping markets of Asia, Europe and North America.

The view from North America

Is the froth finally overflowing the sea of capital inundating North American commercial real estate? It is too early to say, but lenders ponder the question as they proffer phenomenal amounts of capital to retail investors in North America, where at least $5 of investment chases each dollar of quality product, according to capital markets experts.

Retail real estate remains in high season, sustained by escalating interest from investors seeking hard assets and predictable cash flows. “Pension funds, hedge funds and high-net-worth investors have all meaningfully increased their allocations to [retail] real estate equity,” said Simon Ziff, president of New York City-based Ackman-Ziff Real Estate Group, an intermediary and capital advisory firm. “And as far as asset classes, I believe retail is as hot as any.”

But even if South America were added to the equation, last year’s commercial real estate investment volume ($283 billion) in the Americas falls short of red-hot Europe, though it rose a brawny 31 percent from 2005.

This is not to say that U.S. lending coffers are gathering cobwebs. Investment markets in the U.S., which boasts an eye-opening 96 percent of the region’s transactions by value and 40 percent of its global investment, lead the way.

Several factors lie behind the current whirlwind environment. Premium pricing has transformed many long-time retail property holders into sellers. And since 2000 Treasury and interest rates and spreads have tightened while Wall Street has adopted new valuation technologies in response, says James Koury, Jones Lang LaSalle’s national director of retail sales. The net effects are debt and equity products that make portfolio managers more comfortable with larger retail allocations. “Retail, which may have been 10 percent of a portfolio, is now 20 percent or even 30 percent of a portfolio in many cases,” Koury said.

Though cap rates have plunged and shopping center prices are rising, developers still get returns of between 6 percent and 7 percent on select high-end properties, says Michael Higgins, managing director of the New York City office of CIBC World Markets. “And most of this new retail has been very well accepted in the marketplace,” said Higgins. CIBC is providing $300 million in financing for a renovation and expansion of Orlando, Fla.’s Prime Factory Outlet this year, including the city’s first Neiman Marcus Last Call store.

Despite intense competition, retail funds continue to spring up. One such fund that Goldman Sachs and the Los Angeles-based Festival Cos. launched in January will invest up to $800 million in U.S. retail over the next three years, mostly in the range of $20 million to $50 million, says Mark Shurgin, the fund’s manager. “That’s our sweet spot,” Shurgin said. “We’d love to buy in the $100 million range, but there’s too much competition. We just bid on one and finished fifth.” Among the fund’s purchases are the $22 million Garin Ranch Retail Center, in Brentwood, Calif., and the $40 million Gucci Building, on Rodeo Drive in Beverly Hills, Calif.

Troubles in the housing market remain an industry concern (page 36). Large real estate portfolios have been routinely financing deals with debt products, leading to worries that the same leverage that has fueled profits for so long could also jeopardize future returns. But Robert Bach, senior vice president of research and client services at Grubb & Ellis, says a firewall (albeit a slightly weakened one) remains between commercial real estate and housing. “When the stock market dipped this spring due to the subprime debacle, there was talk that this was the beginning of a broad repricing of risk,” he said. “That seems to have been a head fake. Had it been the real thing … capital markets would have tightened.”

Though underwriting standards remain high in the retail lending environment, returns are getting skinny, says Charles Singletary, a partner at Austin, Texas-based Torreón Capital, which has a stake in the planned $850 million Rayzor Ranch, a retail-urban village in Denton, Texas, near Dallas.

There are other cautions. “I believe there’s still too much money changing hands for too little product,” said retail development consultant Ian Thomas, chairman of Vancouver, British Columbia-based Thomas Consultants. “What some vendors are doing is grouping the good, bad and ugly in selling off portfolios. While that’s a good way to get rid of problem centers, it’s not the best way to acquire good ones. The product still has to have sound fundamentals.”

But the current high-volume investment climate is a far cry from the inflated 1980s, Thomas says, because lending standards are higher, and there is nothing resembling a savings-and-loan-type explosion on the horizon. “The industry is still doing something right,” Thomas said. “The yardstick to all this is cap rates, which continue to trend down. A few years ago, to say U.S. centers would sell for under 5 percent cap rates was preposterous. Now we’re even seeing some at 4.5 percent, pretty much what Europe and Japan have had for years.”

Retail demand spans a broad spectrum, led by that perennial favorite, the grocery-anchored neighborhood center, followed by open-air power centers and lifestyle centers, “one or more of which are under construction in virtually every market in the U.S.,” according to Bach. There are three such projects under way in Grand Rapids, Mich., “which is a mid-sized market that gets hit with lake-effect snow all winter long.”

Cross-border investment into U.S. commercial real estate, which Bach says constitutes just 5 percent of the current market, makes more sense than ever for some countries, according to lenders. “Our dollar is so weak, they’re buying these properties at 30 percent discount and are more than happy to buy into America at these prices,” said Goldman’s Shurgin.

As for Canada, brisk retail sales have heightened the demand for retail properties in a market that is expected to stay healthy, according to a report this year from ING Real Estate. Edmonton and Calgary will see some of the strongest sales growth through 2009. Moreover, rent-growth projections in Canada remain strong, particularly for grocery-anchored centers, says ING. Canada’s few heavily populated areas limit volume-investment opportunities, says investment banker John Levy, the principal of New York City-based John B. Levy & Co.

Mexico, on the other hand, remains undersupplied, with an expanding middle class driving demand, according to ING. But Mexico is also being targeted for capital investment with renewed zeal because of improvements in real estate transparency and financial fundamentals, notes Levy.

In general, retail spending in North America will probably continue to be buoyed for years by low interest rates, migration patterns and other favorable demographics, ING says. In the U.S. supply and demand will probably remain in relative balance over the same period, with the top performers setting up shop around Chicago; Las Vegas; Los Angeles; San Jose, Calif.; Seattle; Washington, D.C.; and south Florida.

Whether the merry-go-round of ready capital will halt soon has been an increasing subject of industry conjecture, says Levy, adding that the equation of $5 for every dollar in deals “may be a gross underestimate.” He said, “Anybody in this business who is not at least a little concerned [about the frothy market] is probably kidding you.”

“Everyone is looking for value-add, and the development pipeline is expanding,” said Bach. “But the more creative the deal, the more risk there is.”

The view from Europe

Nothing better illustrates the exuberance of the European retail capital investment markets than the French-Dutch mega-deal forged in the spring. In mid-April Unibail Holding, France’s largest REIT, agreed to buy Dutch shopping center owner Rodamco Europe for €11.2 billion ($15.2 billion). The deal created Europe’s largest real estate firm in market-value terms and one of the world’s biggest property companies.

The Unibail deal was the latest in a series of takeovers — some $66 billion worth in total — that were announced over the past year by firms trying to capitalize on rising European prices and rents and a sea of cheap capital. The move, which gives Unibail 73 additional malls, from Madrid to Warsaw, seems to be an extension of an equally remarkable 2006, when Europe led the world in commercial real estate investment at a volume of $305 billion, up 44 percent over 2005, according to Jones Lang LaSalle. The firm estimates that about 20 percent of that went into retail.

“There’s a continuous and consistent increase in demand for shopping centers coming from investors,” said Alvaro Portela, CEO of Lisbon, Portugal-based Sonae Sierra. In fact, the European pipeline can’t keep up with the rising tide of investment dollars which have served to inflate center prices throughout Europe, says Portela, whose firm owns or co-owns 43 centers in Portugal, Spain, Italy, Germany, Greece and Brazil and has 14 more centers under development. Rodamco was valued at a nearly 60 percent premium over its triple-net asset value, Portela says.

Western Europe continues to lure retail investors because of its economic growth, low interest rates, quality controls and rising wages, rents and yields, says Pieter Hendrikse, CEO of ING Real Estate Investment Management (Europe). Larger portfolio allocations to retail and the ready availability of capital are creating added momentum, he says: “There’s a wall of [available] money.”

Levy says there is another overriding factor at play. “A lot of people are looking at Europe for obvious reasons,” Levy said. “They think America is overvalued and under-structured.”

Cross-border investors accounted for much of the European buying binge. U.S. investors put $18 billion into foreign commercial real estate markets last year, an increase of 51 percent from 2005, with a focus principally on France, Germany and the U.K., according to Jones Lang LaSalle. U.K. investors, in turn, put out $18 billion in cross-border investment in 2006, primarily in German properties, up 200 percent over the year before. Australians invested $12 billion, focusing on Germany and the U.K.

Germany was Europe’s top commercial real estate performer last year, enjoying a 140 percent investment increase, driven by global funds that bought 40 percent (by value) of all German commercial property traded. Jones Lang LaSalle attributes that strength to domestic sellers, cross-border investors, a recovering economy and positive yield spreads.

Europe’s open-ended real estate funds, which include individual investors along with institutions, are spurring additional activity, says Richard Bloxam, Jones Lang LaSalle’s director of European retail capital markets.

Institutional and private investors have caught on to the fact that retail, unlike nonproperty investments, can be refreshed, repositioned, re-tenanted and re-rated, Bloxam says. “A lot of institutions see retail as a defensive play.” Even with the brisk activity, Western Europe is in no danger of shopping center saturation. “That’s because most retail investment is in central cities, and projects are elaborate and expensive,” said Bloxam. “There is very little greenfield development.”

Consumer activity is enhancing market fundamentals too, says ING’s Hendrikse. Most Nordic cities enjoyed strong growth in retail spending last year, according to ING Real Estate.

But with the exception of Britain, European retail property yields may be getting a bit top-heavy, ING cautions. Further, rising interest rates and weakening consumer sentiment are adversely affecting retail markets in the U.K., where rents may have peaked, ING says.

Meanwhile, aggressive West European financiers are placing cheap capital “and hence good leverages,” says Jörg Banzhaf, the managing director of Hamburg-based ECE Projektmanagement International. In areas where there are few restrictions on new development, including Spain and parts of southern Italy, the pipeline is yielding significant new retail centers. The same goes for Eastern Europe, he says.

There is no retail format in Europe that is more popular than others, says Portela, but he cautions that a widening pursuit of lower-grade retail assets could have negative repercussions throughout the industry.

Banzhaf says a “crazy” competitive situation is beginning to unfold in parts of Central and Eastern Europe. “That, coupled with rising land and construction costs, has led to a decreasing quality of projects coming to the investment markets,” Banzhaf said. “[Investors] simply grab what they can. It seems that there’s a lot of stupid money being pumped into [Central and Eastern Europe]. Thus, a lot of these retail schemes will run into trouble.”

Central and East European countries that Banzhaf considers to be undersupplied in retail terms are Bulgaria, Romania, Russia, Turkey and Ukraine. In fact, Turkey is seeing phenomenal retail sales growth, as is Russia, which does not have much of a savings culture, says Bloxam. “With the political situation there,” he said, “there’s a mindset of, ‘We’d better spend it before someone takes it away.’ ” Investment banker Levy remains wary of Russia, calling it a “Wild West-type of investment environment.”

Western retail influence has gained a foothold in every corner of Europe, says Levy. During a recent trip to Budapest, Levy was astounded at the presence of so many American real estate companies. “There were signs for CB Richard Ellis, Coldwell Banker, Cushman & Wakefield, LaSalle Partners and several others already there,” he said. “That gives you an idea of just how globalized real estate has become.”

The view from Asia

International capital markets are more bullish than ever on retail investment in much of Asia. And if industry projections are correct, there is a lot more cash where that came from.

Though discretionary spending may be on a slight decline in portions of Australia, the U.K. and the U.S., it will rise in the near term throughout much of Asia, where ravenous appetites for Western retail formats show little hint of abating, international retail experts say.

Commercial real estate investment totaled a record $94 billion last year in Asia, and though that was but a third of the volumes in Europe and North America, it was nonetheless a 41 percent spike, according to Jones Lang LaSalle. “Improved transparency is helping to enhance liquidity throughout Asia, and the emergence of several retail funds, such as ING’s Asia Retail Fund, have created demand for stabilized investments,” said David Hand, the managing director of Jones Lang LaSalle in Beijing.

Asia markets that once were closed to cross-border retail investment and influence are opening up in a big way, Asian retail experts say. What’s more, shopping center developers in such places as South Korea, where there has been a cultural reluctance to embrace Western retail, are now exploring North American-style settings and floor plans for projects.

Retail funding is increasingly international, Hand says, “with key sources being the rest of Asia, with the U.S. and Australia remaining strong. Another growing trend in China is for developers to secure funding from their home markets, making activity even more international, with fund sources ranging from Israel, Belgium and the U.K. to Ireland and Turkey.”

The Asian markets last year were dominated by Japan, where transactions surged 128 percent to $52 billion, representing 55 percent of the region’s total investment. Driving that robust volume were the world’s lowest interest rates, yield spreads that compare favorably with those of other Asian regions and a growing confidence in Japan’s expanding economy, says Guy Poulin, vice president of Asia investment in the Shanghai office of Ivanhoe Cambridge.

Much as in North America and Europe, investment capital in Asia is plentiful, although products that meet investor requirements are not. “Every week you read that a new fund has been created to invest in Asia,” said Poulin.

Changes in corporate real estate philosophies should help drive further Asian investment, says Jones Lang LaSalle. Much of continental Asia retains significant real estate assets on corporate balance sheets, unlike in the U.S., where less than 25 percent of corporations own their real estate. But Jones Lang LaSalle says sales and leasebacks of shopping centers and other commercial properties will increase as more Asian companies opt out of the real estate game to free up capital.

The Asian lending environment varies widely, because such factors as savings levels, banking systems and domestic liquidity can change abruptly from country to country, says Hans T. Sy, president of SM Prime, the Philippines’ top mall owner and operator firm. “But, in general, there is a flight to quality.” The lending environment in the Philippines has improved significantly in the past five years, with interest and mortgage rates falling to the mid-to-high single digits, he says.

SM draws investment from pension funds, hedge funds, high-net-worth investors and cross-border investors from all corners of the globe, says Sy. But the bulk of the investments are from foreign institutional funds “who tend to buy SM stock as a proxy to the market,” he said. Among SM’s international financiers are China Banking Corp., Citibank, Deutsche Bank, JPMorgan Chase and Shanghai Bank.

In Asia’s other emerging retail markets, the retail projects in lending favor are those backed with strong socioeconomic fundamentals, and international mass-merchandisers such as Ikea and Wal-Mart, department stores such as Parkson and Isetan and luxury goods retailers such as LVMH and Richemont, says Hand. Vietnam’s and China’s second-tier cities are starting to generate more retail investment and development, he says.

But retail projects have veered off target in some cities in China, which is home to seven of the world’s largest retail centers. Nowhere is that more apparent than the South China Mall, in central Dongguan, a factory city of 6 million, just north of Hong Kong. Mall officials expected 100,000 daily visitors, but as of April it was getting just a tenth of that.

Retail consultant Thomas, who did some early consulting work on the project, came away frustrated that the mall’s developers failed to secure major anchors before building. “It was a ready, fire, aim approach,” Thomas said. “The Chinese are very good at building and land assembly, but in this case they showed a basic disregard for the most important fundamental: leasing.”

Most Chinese developers lack expertise in retail, says Ivanhoe Cambridge’s Poulin. “They believe bigger is better, when most of the time, they should say small is beautiful,” Poulin said. The most common problems are construction scale, lack of phasing, poor design, poor management and poorly implemented leasing programs, Poulin says. Asian developers who decide to form partnerships with leading global service providers on their retail projects “will outperform the market,” he said. “It requires exceptionally high inputs in terms of human and financial capital to manage a shopping center well today.”

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