Elsewhere: Assets of Reinforced Concrete

The Fruit of Globalization

According to Deloitte’s forecasts, commercial real estate appears likely to remain a solid investment in 2007, particularly in comparison to less-than-stellar returns on stocks, bonds and non-real estate alternative investments.

A recent survey by ING Bank confirms those conclusions, saying that important short-term trends suggest that over the next 12-24 months, real estate will indeed remain competitive. First, despite a forecast cooling of the global economy from a record pace of expansion, growth rates are expected to remain above trend thus supporting demand for commercial real estate. Second, the flow of capital to real estate remains strong and preliminary estimates suggest that capital flows in 2006 exceeded those in 2005. Third, real estate is becoming a less risky asset class given its improved liquidity and transparency across the world. Paradoxically, even as real estate generally becomes less risky, investors have become more creative in their search and riskier in their strategies to sustain higher returns. Finally, with real estate fundamentals generally healthy and improving, earnings growth should continue to support steady income returns. Despite the heightened competition for assets, there are still a number of excellent opportunities for investors of different styles and with different risk/return thresholds.

The universe of investment grade real estate expanded by nearly 25% between 2003 and 2005, reaching approximately US$ 8.8 trillion, ING says in the report. From 2004 to 2005, capital flows to Asia Pacific increased 38% to US$ 264 billion, flows to Europe increased 34% to US$ 262 billion, and finally, in the US, capital flows increased 9% to reach US$ 480 billion in 2005. Though capital flow figures for 2006 have not yet been released, preliminary estimates suggest that they are on track to surpass those of 2005. The outlook for real estate is generally positive in 2007, ING analysts believe.

The increased allocation of capital to real estate has impacted pricing across the world. Competition for real estate assets has increased, pushing down yields to historically low levels. In some markets, finding high-quality real estate has become problematic, and investors have been prepared to bid very aggressively for well-located real estate with stable cash flows and creditworthy tenants. Capital flows into real estate have not only increased in volume but have also become increasingly international in character. Cross border investment represented 44% of total direct commercial real estate investment transaction volumes in the first half of 2006. The US accounted for over US$ 33 billion in cross border investment, roughly 25% of the global figure. The UK, Germany and France had a combined proportion of over 40% totaling over US$ 57 billion. In Asia, Japan

accounted for the largest cross-border market, followed by China and Hong Kong.

While London remained the top global city for cross-border real estate investment last year, New York regained the number two spot, rising from third place in 2005 and fourth place in both 2004 and 2003. Washington, DC, which has held the number one or number two spot globally since 2002, fell into fourth place. Paris climbed from fourth place to third, and Tokyo maintained the fifth spot, the Association of Foreign Investors in Real Estate (AFIRE) said in recent survey. AFIRE currently has nearly 200 members representing 17 countries.

According to AFIRE, the US remains the preferred global country for foreign investors' real estate dollars; however, only 23% of respondents say it has the best potential for capital appreciation, down from 44.4% in 2005 and 53.8% in 2004. India emerges as the country having the second highest potential for real estate capital appreciation, up from sixth place in 2005. Eighteen percent of survey respondents say real estate in India provides the second best opportunity for capital appreciation. The US has always held the number one spot, but this is the narrowest margin (5%) between first and second place in the survey's history. With 15% of survey respondents' votes, real estate in China continues to rank third. Among top Asian countries for investors' dollars, Japan and China remain in the first and second slots. India moves into third from fifth while Singapore falls from third to fourth place to tie with Hong Kong. In terms of global appeal, the survey shows significant upward movement for Munich, moving from number 21 in 2005 to seven this year, and Stockholm, from 29 to eight.

Real estate experts also anticipate more transparency and liquidity on the market, especially, in the counties where investment is still seen as fraught with high risks.

Rated as low risk markets are, according to ING’s analysts, the US, Japan, UK, Germany, France, Canada, Italy, Australia, Spain, The Netherlands, Switzerland, Belgium, Sweden, Norway, Hong Kong, Ireland, Singapore, Finland, Austria, Portugal, Denmark, and New Zealand.

South Korea, Mexico, Taiwan, Greece, South Africa, Poland, Malaysia, the Czech Republic, Slovakia and Slovenia are in the medium risk level. Nations where risks are still high are China, Brazil, Russia, India, Turkey, Thailand, Indonesia, Argentina, Chile, Venezuela, Romania, Colombia, Peru, Philippines and Vietnam. According to our ING’s estimates, 86.4% of the real estate universe is located in low risk markets, 4.0% in medium risk markets, and finally 9.7% is located in high risk markets.

Russia is rated as an enticing but a risky market. Meanwhile, analysts at CB Richard Ellis note that Moscow’s commercial property market, and the office sector is particular is growing very fast, but the demand still exceeds the supply. This tendency is likely to be preserved, in their opinion.

On the whole, many major cities across the world continue to see high demand for office space. Office investment grew by 30% last year from 2005 in six out of 12 leading markets. In Southeast Asia, Beijing accounted for the largest share of investment ($2.8 billion), followed by Shanghai ($2.7 billion) and Singapore ($2.7 billion). In Europe, investments soared in London ($27.6 billion) and Paris ($21.2 billion); investment in New York’s office real estate exceeded $23.3 billion.

Paris as Trendsetter

Paris has been revealed as top investment prospect, according to a joint survey by PwC and ULI. Paris leads this year’s list of top real estate investment markets in Europe, according to a report published by the Urban Land Institute (ULI) and PricewaterhouseCoopers. Emerging Trends in Real Estate® Europe interviewed 400 of the industry’s leading authorities to identify Europe’s top cities for real estate investment. Paris rates highly for both total return prospects and low risk, and thus its risk-adjusted total return prospects were judged the best in Europe. Survey respondents pointed to the city’s economic stability and sustainability, in addition to its status as a global gateway, as major reasons for its top ranking as an investment market. Ample urban regeneration and redevelopment opportunities also attract investors, noted the report. As a top market for the past several years, “Paris still has good prospects for the next two years,” the report said. Paris is a favorite among those looking to buy property as well; about 54 per cent of the respondents recommend buying office space in Paris, 57 per cent recommend buying retail, and 41 per cent recommend buying industrial/distribution properties.

Bill Kistler, President of ULI Europe remarked: “New urban regeneration projects such as D?fense district have boosted Paris, and continue to attract investors with money to spend. In contrast some of the strongest markets in 2007, such as London, are now becoming “hold” markets because they are close to the end of their cycle and there is a risk that yields will soften. Understanding local property market fundamentals is the key to successful investments in 2007 whether that is appreciating labour force issues in London in the run-up to the 2012 Olympics, or rising Eurozone interest rates and heavy levels of household debt in Spain.” ULI, based in Washington, D.C., is a global education and research institute dedicated to responsible land use. Its Europe headquarters, ULI Europe, serves the Institute’s 2,100 European members. Emerging Trends, which covers 27 markets in countries throughout Europe.

London is rated a close second to Paris as an investment market. Survey respondents named London as the European city offering the least investment risk and the best prospects for rental growth, “reflecting optimism for property value trends supported by income growth,” the report said. However concerns over the demands of major construction projects such as King’s Cross, Heathrow Terminal 5 and the 2012 Olympics may have prevented London from taking the top spot. Investors rated London a strong “hold” market, 44 per cent of the participants recommended holding office space in London; nearly 41 per cent advised holding retail; and nearly 59 per cent advised holding industrial/distribution space. Stockholm, in third place, continued to move up the list for overall investment ratings, as its redevelopment prospects continued to strengthen. It is considered a “balanced” market, in terms of an even distribution of buy and holdsell ratings: 50 per cent advising holding office space, 49 per cent, retail; and 44 per cent, industrial/distribution.

A German property investment boom is predicted, taking two spots in the top ten for the first time in the report’s four year history. Munich has risen 13 places to fourth place while Hamburg rose five places to be the ninth top investment prospect for 2007. Lyon rounded out the top five investment markets, with many respondents viewing the city as an attractive lower-cost alternative to Paris. More than 56 per cent of the respondents recommended buying office space in Lyon; more than 62 per cent, retail; and more than 47 per cent, industrial/distribution properties.

Other cities listed as strong “buy” markets: Madrid, Barcelona, Hamburg, Istanbul and Moscow. Other cities with strong “hold” ratings: Copenhagen, Edinburgh, Vienna, Brussels, Dublin and Amsterdam. In addition to Stockholm, other cities with relatively balanced buy-sell-hold ratings: Helsinki, Zurich, Milan, Prague, Rome, Lisbon, Warsaw, Athens, Budapest, Berlin and Frankfurt.

Emerging Trends noted that prospects for profitability were considered favourable for real estate firms of all types, and the report showed that buyers outweigh sellers by two to one. Despite some concerns about foreign investors bidding up prices, few respondents indicated that European real estate is “in the grip of completely irrational exuberance,” the report said. “The assumptions people are making may be optimistic, but not fundamentally ridiculous or irrational.”

Henrik Steinbrecher, European real estate leader, PricewaterhouseCoopers, said: "Despite predictions of a calmer investment environment in 2007 and single-digit returns, equity capital is continuing to pour into the European real estate sector. This trend is expected to continue with strong growth flows from the Middle East, Asia and Australia. Increases in debt capital are also expected, however, rises in interest rates may keep the market in relative balance."

The report noted that the “chase for higher yields” is causing investors to look at alternative investment properties as varied as petrol stations, student housing, marinas, motorway services, prisons, car parks and windmills – “anything producing income.” Income-producing infrastructure – such as toll roads, airports, and port and rail facilities – is singled out as a particularly promising investment type. Sustainability is gaining importance among investors and developers. While tenants have yet to demand “green” buildings, a major issue is “when the occupiers are going to take it (sustainable development) seriously,” the report said.

New World’s Decline

While concerns persist that the economic expansion in the US will slow in 2007, commercial real estate continues to ride the momentum of five consecutive years of investment gains and consistently solid market fundamentals. “This is an economy that has lots of resilience,” remarked Doug Duncan, chief economist for The Mortgage Bankers Association, during its annual commercial/ multifamily convention last month in San Diego. Duncan pointed out that the economy in the last few years has fought off 9/11, a recession and global terrorism. Indeed, the economy grew at 3.5% in the fourth quarter of 2006, but if the housing and automobile

figures are stripped away, real GDP for the quarter rose to a robust 5.8%. This year, a conservative projection of 100,000 new nonfarm payroll jobs will be created each month, according to Grubb & Ellis. One-fourth of those jobs will be generated in office buildings, absorbing 55 million to 60 million sq. ft. of space in 2007. That would outpace office completions by at least 10 million sq. ft. and push the nationwide vacancy rate down to 13.2% from its current 13.6% — the fourth consecutive year the vacancy rate has declined. Five central business districts — in Seattle, San Francisco, San Jose, Calif., Miami and New York’s Midtown — should post double-digit gains in Class-A asking rents in 2007, while 20 other CBDs will enjoy rate increases of at least 5%, compared to just nine CBDs last year.

A poll conducted in late 2006 by National Real Estate Investor and Coldwell Banker Commercial among developers, owners managers and corporate real estate professionals has revealed that 71% of respondents planned to purchase real estate in 2007, up from 49% in 2006. Analysts at Cushman & Wakefield (C&W) report that vacancy rates dropped in late 2006 to 10.6% for Class A office space and to 14.5% for Class B and C properties.

Land of the Rising Sun

After a decade when the game seemed permanently over, someone finally hit the reset button on the Japanese economy, and the Tokyo office market is once again heading up, up, and away.Until a few years ago, Tokyo real estate pros say that most tenants looking for a new office were trying to find someplace smaller. Now, they are in the market for bigger and better space, according to Mikihisa Hirai, president of Atlas Partners Japan Ltd., a major asset manager. Hirai believes the improving economy is behind the shift.

After more than a decade of weak performance, the Japanese business climate is on the rise again — exports were up about 15% in 2006 — and that sharp turnaround in what is still one of the world's largest economies is bringing the Tokyo market back to life. Rents in some high-profile properties have risen as much as 50% in the last three years. Vacancies are at 14-year lows, standing at 2.8% for all grades of office properties.

The rental market in the central wards is so tight now that even a savvy real estate player like Macquarie Global Property Advisors had a hard time last fall when it went looking for new office space. “Three years ago, we could have the luxury of comparing three to four properties and make a choice. But today, the thinking is that if the space is good enough, grab it,” says Shigeaki Shigemasa, a partner with Macquarie.

Believing there's even more to come, investors in some cases are now paying double what they paid three years ago, according to CB Richard Ellis (CBRE) Japan data. “That sort of aggressive level of bids indicates people are pinning their hopes on quite aggressive rental growth,” says Ben Duncan, representative director, CBRE Japan. Encouraged by results like these, foreign investment is flowing into Japan very quickly now — maybe too quickly for its own good, in a market that some say can still be tricky for Western investors to negotiate.

“Many new investors are coming from overseas, and I see some of them having a very difficult time placing their money,” says Shigemasa of Macquarie. “I see some of the players paying a bit too much money, or placing their investment in the wrong place.”

Investors like the prospect of more rent growth in a market which Hirai believes has minimal downside risk because vacancy rates are never very high in Tokyo. Even during Japan's worst recession in the post-war era, vacancy rates never rose above 15% because Japanese companies are much more reluctant to let employees go during a downturn. Foreign investors, Hirai says, see Tokyo as both a good investment in its own right and also as a way to gain indirect exposure to Asia's fast-growing emerging markets, such as China, while avoiding the volatility that goes along with investing there.

American funds bought earlier, before the recent rise in real estate prices, according to Duncan. These days, however, Australian firms backed by pension money are leading the charge. “The Australians are having a pretty hard run at the moment,” he explains. Japanese investors are also quite active. “The Japanese are very much back in their own market again,” says Duncan. J-REITs are contributing to the buying pressure. Since they were first launched five years ago, Japanese real estate investment trusts have grown dramatically.

There are now 38 J-REITs on the Tokyo Stock Market, which collectively hold more than 4.1 trillion yen in assets or $8 billion, according to a report by Colliers Hallifax, a Tokyo real estate advisory firm affiliated with Colliers International. Colliers and other experts predict continued growth for J-REITs.

Jones Lang LaSalle anticipates a doubling of the total J-REIT market cap in the next three years. This growth may have an even larger impact on prices than might be expected, experts say, because J-REITS are not allowed to build — only to buy — which limits their focus to existing building stock.

ramatic turnaround

The current excitement has been a dramatic change in a market that, until recently, seemed as if it would never recover. After years of 70% or 80% annual jumps in the late '80s, commercial real estate prices in Tokyo fell by more than 80% in the early 1990s, along with most of the shares on the Tokyo Stock Market.

Tokyo commercial real estate, like most of the Japanese economy, never really regained any positive momentum for a full 10 years, a period Japanese now refer to as the Lost Decade. Even near-zero interest rates were not enough to jump start real estate investment, or any other part of the economy.

Just a few years ago, some real estate market watchers were so discouraged that they had reportedly begun to worry that conditions would worsen even more as Japan's many Baby Boomers began to retire, according to Shigemasa. By the time the office market recovery began in 2003, no one believed it at first. Gloom had prevailed for so long that local investors didn't understand that conditions really had finally changed, says Duncan of CBRE.

Investment advisors say that despite the run-up in the world's largest office market, the buying opportunities are still relatively attractive compared to alternative investments. Although cap rates on Class-A properties have shrunk to less than 3%, advisors note that they are still higher than Japan's ultra-low borrowing rates, which are still among the world's cheapest. Current yield on the 10-year benchmark government bond is a mere 1.72%, compared with 4.78% in the U.S. and 4.91% in the United Kingdom. At the same time, vacancies are tight, particularly for Class-A office space. As of the third quarter of 2006, Class-A office vacancy stood at 1.5%, according to CBRE figures, and all-grade office vacancies registered 2.8%, the lowest in 14 years.

One consequence of having the lowest vacancy rate in the world is that it's also one of the most expensive markets in which to rent. Average rents were $89.60 per sq. ft. in the third quarter of 2006, according to a recent survey by the International Tenant Representative Alliance Real Estate Group (ITRA). Among large cities ITRA tracked, only London was more expensive. Manhattan, by comparison, was a bargain at $44.50 per sq. ft. Prices are high for several reasons. First, most companies want to be located in central Tokyo with easy access to the train lines that commuting employees rely on. Many are also quite conservative when it comes to site selection, and don't really consider the possibility of moving to suburban sites or to relatively nearby cities such as Yokohama.

The total amount of Class-A stock is also extraordinarily limited. Class-A represents only 16% of the market, compared with 50% to 60% in most major cities, according to Duncan, and there is a limited pipeline for new buildings. Other Japanese cities have somewhat similar dynamics but to a lesser extent, according to Shigemasa of Macquarie. In Osaka, for example, there is only a 2% vacancy rate for Class-A office space.

Few U.S.-based investment managers have penetrated the Asian property markets as decisively as Morgan Stanley Real Estate. Whether the firm is buying stakes in a Bangalore developer or securing skyscrapers in downtown Tokyo, the real estate arm of the world's third-largest securities firm has cobbled together a geographically diverse real estate platform over more than a decade. Including its Asian interests, Morgan Stanley currently manages $60.5 billion in real estate assets.

Leading the charge of the Asian campaign is Manhattan-based managing director Sonny Kalsi, who oversees more than $40 billion in offshore real estate. The firm became involved in Japan in 1997, when it began buying defaulted properties from Japanese banks.

In 2005, Morgan Stanley spent $8 billion on Japanese office and hotel properties. Office property values in Tokyo have tripled over the past three years. Recently, Morgan Stanley has shifted its focus eastward to where the explosive Chinese and Indian economies are spurring heavy demand for commercial real estate.

“There are some really great economic stories unfolding in China and India. Plus, these markets are still very inefficient,” says the 39-year-old Kalsi. The Chinese economy expanded 10.2% in 2006, while India's grew by 8%. By comparison, the U.S. economy grew at a healthy 4.8% clip.

Kalsi believes that growing pains, such as limited transparency and cultural obstacles, still offer plenty of real estate opportunities to the savviest investors. Last year, the firm invested $68 million in Bangalore, India-based Mantri Developers Ltd., which develops residential and commercial properties across the world's second most populated nation.

Mantri represents Morgan Stanley's first Indian real estate investment. Kalsi believes that Morgan Stanley's minority stake in the firm will help Mantri grow its burgeoning development business and that a future IPO for the firm is possible.

The Chinese market presents similar opportunities. In June, Morgan Stanley spent $387 million for a 10% stake in Shimao, a Chinese development firm. Like Mantri, it too is a private company that could test public waters in the future.

Since 1991, Morgan Stanley has launched six real estate opportunity funds that have raised more than $17 billion combined. Two of the funds are weighted toward the Asian markets. None of the funds — each has been oversubscribed — has been liquidated to date.

One big question is how the Asian economic story will pan out. Overheated economies are a major concern, but Kalsi isn't losing sleep over the matter. He sees the risks, but he also believes that Morgan Stanley has minimized its exposure by taking a prudent investment approach.

For example, Morgan Stanley is still reluctant to back direct ownership deals, especially in markets like China where heavy restrictions make investing in assets a challenge. Instead, he prefers that the opportunity funds buy partial stakes in operating companies that own and develop commercial properties in the region.

“We've taken the view that it's more comfortable for us to invest in companies rather than direct properties,” explains Kalsi. “And we only see demand for new product increasing throughout markets like China and India.”