by David Lewis
Investing in American real estate? The prudent first ask “why?” Then they ask “how?” This five-part series on investing in US real estate attempts to answer both these questions, with special reference to US legal procedures and requirements. Future topics include the mechanics of deal-making; structuring partnerships and joint ventures; negotiating leases; and institutional loans.
In this first article recent developments in the real estate market are reviewed, along with an evaluation of the potential that US real estate investments offer British investors who may be thinking about taking the plunge for the first time or considering expanding existing holdings.
An overview of the market
The United States has traditionally been a safe haven for investors world-wide at all levels. It continues to be so. However, some British investors believe that US real estate markets hold little attraction for them on this score. These investors should reconsider their approach. After all, it was not so long ago that British investors feared that a socialist government might come to power and reintroduce exchange control, devalue the pound and introduce other controls too horrible to contemplate.
What better way to reconsider the case for US investment than to look at the results of those who have gone before? Of course, the sceptics could reply: “Yes, they did well, but things have changed. The halcyon days of the early to mid-1970s are over, as they are in Europe.”
Indeed, US real estate certainly was substantially undervalued then. Today, it is not. On the whole, those who came early did extremely well, regardless of what they bought or the prices they paid. Since then, real estate markets have changed, property prices have risen and tax laws have been amended. Despite these changes — and bearing in mind there are always exceptions — investors who examine the ground carefully, understand the markets in which they invest, consider the risks, remain patient and adopt a long-term investment strategy have in most cases profited handsomely, and still can.
Where, then, do the opportunities lie? For the UK investor interested in development projects — as distinct from projects already built or leased — the US offers a wealth of opportunity, often at significantly higher returns than are available at home. This is particularly true at the moment because interest rates and cap(*) rates are both low at present, making real estate investment especially attractive.
Examples of some current cap rates are:
- 6.5 for “triple prime”, fully leased office buildings in major commercial centres such as New York, Washington, DC, Chicago, Los Angeles and San Francisco.
- 5-6 for major regional malls.
- 8 (or higher) for good-quality “hi-tech” California industrial park properties — if let to substantial tenants.
This suggests investors in development projects should do very well. Indeed many already have.
The Japanese onslaught and other recent developments
The most important recent development in US commercial real estate has been the arrival, in force, of the Japanese. As a group, they have single-handedly changed the face of the office building market in less than 12 months to become the major contenders for prime office space. It is the Japanese who now are setting yields and prices on prime investments.
Their disproportionate impact on the market is all the more startling in view of the dramatic fall of the dollar against the Japanese yen. Despite uncertainties over the outlook for the dollar — and contrary to all expectations — there has been little appreciable drop in the prices Japanese buyers are prepared to pay, or a lessening of their appetite for commercial property in areas offering attractive yields. The plain fact is that returns are well above anything they can obtain at home.
However, Shuwa Corporation’s recent pull-out from some $300m worth of transactions has raised some questions about the Japanese-generated bull market in office buildings. In retrospect, Suwa’s strategy seems clear: their previous acquisitions have been of “triple prime” investment grade properties, as has been true of the major Japanese investors generally to date. For example, Shuwa’s acquisition of the Los Angeles Arco Plaza for $640m and Mitsui’s acquisition of the Exxon Building in New York’s Rockefeller Center for $610m. The deal which fell through was for properties of lesser quality, which, after further evaluation, Shuwa decided not to buy. While it would not be true to say that the Japanese are interested only in major buildings in city centres (see box), the Japanese are clearly interested in the finest type of properties in major population centres.
The Japanese have wrought another, and possibly permanent, change by focusing their attention on major cities. Prior to their arrival there was no significant difference between yields in primary and secondary markets — say between San Francisco and Des Moines, Iowa. Now location has become a major factor. Today, yields relate much more closely to location and region and this has brought the US office building market more into line with the sort of yield differentials common in the UK. An office building in a good location in South East England, for example, will offer a considerably lower yield than one in Leeds, no matter how well tenanted the latter may be.
Japanese investors spread their wings
Early in November 1987 Japan’s Shuwa Investments Corporation bought Westerly Place, a four-year-old, seven-storey 83,730-sq ft office building in Newport Beach, California, for $25m. Commenting on the transaction, Jack S Cooper, managing director of Bank of America’s real estate investment group which advised Shuwa, remarked:
“A current popular bit of fiction is that Japanese investors are interested only in downtown office buildings in a few major cities. However . . . the Japanese are interested in quality investment opportunities beyond the narrow stereotypes. Acquisitions by our Japanese clients include an historic office building in downtown San Francisco; an apartment complex in Hollywood; and a high-rise office building in Santa Monica.”
Earlier in 1987 Chitaka International, another Japanese investor, paid $7m for a 74-unit apartment complex in Hollywood, California. “We believe Chitaka is in the forefront of an emerging group of savvy Japanese investors who realise the inherent value of other property types, such as well-located apartment complexes and shopping centres,” was Mr Cooper’s comment.
Tax changes affect US investors
If Shuwa’s withdrawal momentarily surprised the market, changes in the Tax Reform Act of 1986 created tremors. No longer the favoured child of tax-writing legislators, the Tax Reform Act stripped away many of real estate’s more egregious advantages, reducing the disparities in tax treatment between real estate and other types of enterprise. The main tax changes are as follows:
(1) Depreciable life of buildings has been extended to 31 1/2 years, except for residential rental property for which it is 27 1/2 years. Previously, the depreciable life was in most cases 19 years.
(2) The investment tax credit which was available on capital equipment has been abolished. This reduces the tax benefit of new construction, given the considerable cost of major mechanical components such as escalators, elevators, and heating, ventiliation and air-conditioning systems.
(3) The key advantage which all “tax shelters” used to offer has been abolished. Taxpayers can no longer offset the annual depreciation allowance, which was nothing more than a tax fiction, against unrelated income such as salary, interest and dividends. This restriction does not, however, apply to non-close companies, and there are limited exceptions available to certain individuals.
(4) The preferential tax rate on capital gains has been abolished. This used to be the source of a further advantage of “tax shelters”, since the depreciation benefit referred to above would comprise part of the gain on disposition of the property in question. But such “phantom” gain would be taxed only at the lower capital gains tax rate.
(5) There has been a dramatic limitation placed on depreciation as a tax deduction owing to a change to the “at risk” rule. Briefly, the new rule states that the total depreciation deduction which a taxpayer may enjoy is limited by the amount which he personally has at risk. For example, where the seller of a property accepts a promissory note secured by a lien on the property, the amount of the note is now deemed to be not “at risk”. This substantially limits the deductibility of depreciation benefits in many real estate sales.
(6) The top marginal rate for individuals has been dramatically lowered from its previous level of 50% so that, in any event, the economic value of depreciation benefits has been considerably reduced. Beginning this year, the highest marginal rate will be 28% (33% for some taxpayers, although the effective tax rate can never exceed 28%). While it is virtually certain that rates will increase after the November presidential election, they are unlikely to return soon to their previous levels.
The net result of these changes is that the tax advantages previously available only to US individual investors have mostly been stripped away, leaving a more level playing field for overseas investors. Economic benefits rather than tax considerations now drive most real estate transactions in the US.
The real estate industry’s lobby groups vigorously opposed these and other changes, warning they would herald Armageddon in the property investment market. Although they have undoubtedly had an impact on apartment buildings and on small office buildings in secondary or tertiary locations, they have had little impact on the construction industry or on the value of investment grade properties.
Apartment projects spark investor interest
Until recently, major institutional funds tended to stay clear of apartment projects. Easy to acquire and manage, they were seen as more appropriate for small investors. In addition, the $9bn apartment building industry received a blow in 1985 when the use of tax-free industrial revenue development bonds — which were essentially subsidised loans to apartment builders — were eliminated. Now, some of the major funds are moving back into apartment projects, which are increasingly being seen as promising investment vehicles.
The current list of investors in apartment projects is impressive. Prudential Realty Group Inc (not related to the UK Prudential) plans to invest some $300m in apartment projects during the next 12 months. In the last two years Metropolitan Life Insurance Co has invested around $100m in apartments and the Massachusetts Pension Reserves Investment Management Board invested $50m in apartments in 1986.
By American standards these amounts are not very large, but they do represent a significant increase over previous investment levels, a clear indication that institutional investors and fund managers are seeing apartments as a promising opportunity. Aetna Realty Advisors Inc, for example, recently launched a $200m investment fund for the specific purpose of acquiring apartment projects. The fund was sold out in three months.
The demographics suggest that there will be a considerably larger demand for apartments, condominiums and townhouses by the year 2000 (an increase of about 14% over 1987). There is obviously a danger that a flood of funds could again cause an excess of supply. However, that risk can be minimised by investing in the most desirable areas. The high cost of land is likely to discourage competition, as well as making high rents achievable, given the even higher cost of houses in surrounding neighbourhoods.
As far as single-family housing is concerned, one of the fastest-growing regional economies in the US is Southern California. Between 1985 and 1987 it grew three times faster than the US market as a whole.
One major home building company here reports that sales were up 44% in the September quarter over the comparable period of 1986, with a record $97m in sales in November.
Over the past 12 months more than 360,000 new jobs have been added in California and unemployment in Los Angeles is at its lowest point since July 1979. The growth in population and job opportunities is obviously putting upward pressure on residential prices and attracting substantial new investment.
The ingredients for success
We have not yet reached the point where Japanese investment is enough by itself to underpin commercial real estate values. The stock market crash has therefore raised the question of future trends in the US real estate market. It remains to be seen whether property will soon regain some of the appeal it lost to equities, or whether a general lack of investor confidence will erode the market values of all but the highest quality properties.
Notwithstanding such uncertainty, over the longer term the main attraction of US real estate remains: the United States is the biggest, most advanced, most diverse and probably the most politically stable economy in the world. For those with an eye on demographics, highly rewarding rates of return can be achieved. The chances of success are enhanced for those who are willing to make a substantial commitment in terms of time and resources, both human and financial (but primarily the former) and who plan their acquisitions in the US as part of a long-term strategy.
(*) Cap rate in the US is equivalent to yield in the UK and is calculated by dividing the purchase or sale price by net income, ie after operating expenses but before debt service. Obviously, the lower the cap rate the higher the price, and the greater the profit potential that new developments offer.