NEW YORK U.S. investors are rediscovering their appetite for foreign real estate. Attracted by potentially higher returns, they are putting more money into overseas funds that invest in offices, malls and apartment complexes than they have in six years.
Investors moved $2.6 billion into mutual funds and exchange-traded funds that primarily invest in office buildings, hotels, and other commercial properties abroad during the first quarter of 2013. That is the largest inflow since 2007's record first quarter of $5.3 billion in new investments, according to Lipper, a Thomson Reuters company.
Direct ownership of foreign real estate by Americans is on the upswing. In 2012, U.S. institutional investors put $38.71 billion into commercial properties abroad, up from $32.8 billion a year earlier. But that's still down from the record of $100 billion in 2007, just before the credit crisis, according to real estate research company Real Capital Analytics.
Real estate returns have been enticing investors lately. The FTSE NAREIT All Equity REIT Index, a benchmark of U.S. real estate investment trusts (REITs), rose 19.7 percent in 2012, while the FTSE EPRA/NAREIT Developed ex-US Index, a benchmark of REITs and REIT-like companies from developed countries other than the United States rose 38.6 percent.
"Should (investors) be looking at non-U.S, non-core investment opportunities? Our answer is yes, absolutely," said Catherine Polleys, a partner at investment consulting firm Hewitt EnnisKnupp, a unit of Aon Plc (AON.N), provider of risk management and human resources services.
New Jersey's pension fund recently invested $500 million in a new $4 billion real estate portfolio that Blackstone Group (BX.N) is raising for real estate investments in Asia. The $72.8 billion pension fund has targeted 5.5 percent investment to real estate. Of that, 14 percent is allocated to international property investments.
"The big plus is diversification of your portfolio, number one. Number two, we actually think there's better returns going forward," said Timothy Walsh, chief investment officer for New Jersey's public pension funds. Net operating income tends to be higher oversees, Walsh said, and rates on mezzanine financing are also higher than in the United States because of the perceived risk of foreign investment.
Commercial real estate provides diversification away from stocks and bonds, and boost income while reducing overall risk because it acts differently than stocks and bonds over time. From 2001 through 2012, direct investments in real estate - buildings and other assets owned by non-publicly traded companies - had a negative 0.17 correlation to bonds and a 0.23 positive correlation to stocks, according to David Lynn, author of "Emerging Market Real Estate Investment: Investing in China, India and Brazil".
In other words, these assets tend not to move in the same direction as other assets at the same time. If an investment is negative correlated to another, it tends to gain in value while the other falls. Investments that tend to move in perfect lock step have a correlation of 1.0.
Still, investing in foreign markets is a relatively new game for most U.S. investors, so there is insufficient data to reliably show whether there is correlation or not, experts say.
"The basic assumption and belief, which is still untested, is they won't be super highly correlated with stocks and bonds in other countries," said Joseph Gyourko, a professor at the University of Pennsylvania's Wharton School of Business who specializes in real estate. "It's going to be different than owning equities on the German stock exchange."
In the United States, there were 104 global real estate mutual funds by the 2012, up from 50 at the end of 2007, according to S&P Capital IQ, the research arm of Standard & Poor's. About 5.5 percent of 401(k) retirement plans now offer a global real estate fund in their lineup, a 30 percent increase since 2007, according to Brightscope, a San Diego based firm that rates company retirement plans.
Pension funds, meanwhile, plan to raise the portion of their real estate allocation devoted to foreign investments to 6.2 percent on average this year, up from 3.5 percent in 2012, according to a yearly survey of 80 such funds by the publication Institutional Real Estate Inc.
Mega-money manager Pacific Investment Management Co, based in Newport Beach, California is getting into the game. The firm, which manages $2 trillion in assets, recently said it is targeting direct commercial real estate investments and non-securitized loans in foreign markets.
Yield-hungry investors see foreign real estate as an alternative to bonds because leases provide a higher rate of predictable income. A REIT owning top-tier office buildings in Hong Kong and Shanghai, for example, could yield 6.8 percent a year, while the benchmark Barclays International Corporate bond index yields approximately 2.5 percent.
Investors may also benefit from rising real estate prices, especially in the emerging markets of Asia and Latin America. They also are betting that like distressed U.S. real estate, much of which suffered from being over-valued or over leveraged, distressed European property will also recover.
"That's one of the reasons it fits nicely into a portfolio. If you have a specific view on different countries or different regions, buying the real estate is more direct to the local economy of that country, than just stocks of companies that have a global revenue base," said Jeremy Schwartz, director of research for WisdomTree Investments, which opened its WisdomTree Global ex-US Real Estate Fund ETF in 2007.
To be sure, there are risks in taking a big bet on foreign real estate. Investors open themselves up currency fluctuations, and if they are too concentrated in particular markets - especially emerging markets - they could be exposed to big political and economic risks.
The volatility of investing in real estate securities abroad can produce outsized returns, it can also magnify losses. In 2008, the year when the financial crisis hit, the average global real estate fund fell 44 percent, while diversified U.S. equity mutual funds were down 38 percent, according to S&P Capital IQ.
For those doing property deals rather than investing through specific funds, there are other dangers. Having a trusted local partner who knows how a market works is essential, experts say.
"If you land a bunch of Americans and say just go out...they're going to get slaughtered by the local guys," said Hamid Moghadam, chairman and chief executive of Prologis Inc (PLD.N), which builds and owns warehouses and distributions centers.
Foreign REITs that own top-notch property in many parts of the world tend to be cheaper than those in the United States. For example, the 83 U.S. REITs that Green Street Advisors tracks trade at 14 percent premium to the underlying value of their real estate, while the 29 European REITs it tracks, including the UK, trade at a 7 percent premium.
REITs usually trade at premiums to the value of the real estate they own because investors are willing to pay for the liquidity that REITs offer, and because the value that many REIT management teams can create through acquisitions, developments, and superior operations, Jim Sullivan Green Street managing director said.
"While the economic headlines coming out of Europe are still dour, the public market is looking ahead and sees REITs as an attractive way to capitalize on improving commercial real estate conditions a couple of years out," Sullivan said.
On top of that, some foreign companies offer larger dividend yields than their U.S. counterparts without carrying much greater risk. For example, on April 23, Simon Property Group Inc (SPG.N), the No. 1 owner of U.S. malls had a 2.6 percent yield. Its France-based peer, Unibail-Rodamco SE (UNBP.AS) had a yield of 4.4 percent, Green Street Advisors said.
That's one of the reasons why Morgan Roberts, a wealth adviser with Vermont-based Manchester Capital Management Inc, suggests his clients, who have an average of $20 million in assets, invest in foreign real estate. He sees foreign real estate providing greater returns than U.S. real estate, which is also relatively more expensive.
"The U.S., it's a little stretched right now," Roberts said adding that U.S. yields are 4 percent or lower and price-to-earnings ratios (P/E) are 15 or higher.
"Yet in international, you still see yields 5 (percent) or higher and P/Es 15 or lower," he said. He suggests investors allocate 20 percent of investments to a broad category of real estate, which includes timber, agricultural land, commercial property and their own residence. Within that, he'll often suggest up to 6 percent be in U.S. REITs and up to 6 percent in foreign REITs.
U.S. REITs tend to move more in the same direction as the stock market because, while they may own real estate, they are still publicly traded equities. From 2001 through 2012 REITs were correlated at negative 0.02 to bonds but positive 0.71 to stocks, Lynn found.
Consequently they have had limited appeal to defined contribution plans, said Winfield Evens, director of investment strategy for Aon Hewitt's outsourcing business.
Only 20 percent of 546 U.S. plans surveyed in Aon Hewitt's 2011 Trends & Experience in Defined Contribution Plans DC plan sponsors offer any type of REIT fund. When a REIT fund is available, just 2 percent of those in the plan use the option. Aon Hewitt does not break out figures for global real estate funds.