In spite of the disruption the U.S. commercial real estate market has faced over the past several years, cross-border investors continued to view it as one of the best places in the world to put their money. Then, however, came the Federal Reserve’s multiple interest rate hikes, rising inflation and recession fears. By the end of 2022, it was already evident foreign investors were pulling back a bit on their acquisition activity in the United States.
According to a recent report from research firm MSCI Real Assets, last year, cross-border investors accounted for 5 percent of overall commercial real estate investment sales volume in the U.S., down from 9 percent the year prior. In addition, these investors became net sellers of property—they acquired real estate assets worth $34.8 billion, but sold interests in U.S. real estate valued at $46.9 billion, marking the largest such decline since before the Great Financial Crisis. The largest share of these dispositions involved multifamily properties, totaling $14.6 billion, reported MSCI. The influx of capital into the U.S. real estate sector from Canada, the number one cross-border buyer, fell by 48% in 2022. South Korea, Germany and Switzerland also all posted double-digit declines. From the top 10 list of cross-border buyers of U.S. properties, only two—Japan and Spain—significantly increased the volume of money they spent last year.
In a Summer 2022 Pulse survey published by the Association for Foreign Investor in Real Estate (AFIRE) which was conducted last July, 80% of surveyed investors said that the impact of higher interest rates and rising inflation on the market was worse than they anticipated and 77% said they expected the U.S. to experience a recession within the course of this year. Yet, at the same time, 55% of surveyed global investors said their company’s allocations to U.S. commercial real estate were either on track or ahead of where they expected them to be.
So, what exactly is happening to cross-border investors’ capital-raising and allocation plans for U.S. commercial assets? WMRE spoke to AFIRE CEO Gunnar Branson to get a more detailed view of that corner of the industry.
This interview has been edited for length, style and clarity.
WMRE: Over the past few years, foreign investors remained optimistic on the outlook for U.S. commercial real estate and largely planned to either keep their allocations stable or increase them. Have you seen any change in that sentiment over recent months? If so, what does that change in attitude look like and how widespread it is?
Gunnar Branson: I think the longer this period of uncertainty lasts, the more careful investors, not just foreign investors, but investors in general, will be. Institutional investors are facing the denominator effect in terms of allocations to real estate [when the relatively high valuation of their real estate holdings compared to other investments makes them over-allocated to the sector]. So some investors are holding their real estate investments, or pausing, if you will. They remain, generally, based on research that we do internally, enthusiastic about U.S. real estate investment and certain that they will remain at or above their previous level of investment. But, certainly, with the Fed raising interest rates, and uncertainty about the economy, they are being more careful. And there are also not a lot of trades happening today. There’s a general sense of waiting.
WMRE: Do those trends apply across all types of foreign investors—private players, institutional investors, government funds? Or does their effect vary, depending on the investor group?
Gunnar Branson: It's dangerous to paint all investors with a broad brush. The smaller family offices, the larger private investors—again, very difficult to paint with a broad brush, but if you are going to generalize—I’ve seen more family offices being more entrepreneurial in their approach and investing in asset classes and markets that perhaps the pension plans will not. They can be a little bit more flexible.
The other problem that international investors are having, is that with the currency and interest rates being what they are, say in Germany or South Korea, it’s suddenly making some of the deals harder to pencil out. Maybe it’s temporary, but it’s slowing some enthusiasm.
WMRE: You mentioned Germany and South Korea. Can you give examples of more counties that are particularly affected by currency and interest rate issues, or, on the other hand, have been less affected by them?
Gunnar Branson: Everyone, to a certain extent, is going to be affected by these changes, it’s just a question of what their required yields are. And there is, for example, more interest from investors from Latin American countries in protecting their capital [by placing it in the U.S.], some of it has to do with political changes there. You are seeing consistent commitment to U.S. real estate from Europe, from Canada and from countries in Asia Pacific. But it’s one more thing that makes it difficult to make investment decisions than perhaps it was when those headwinds weren’t there.
WMRE: Have you seen a change in how much money foreign investors are able to raise for funds targeting U.S. real estate. Has there been a significant change, up or down, compared to the dollar volume of funds being raised last year around the same time?
Gunnar Branson: I don’t have any data on that yet. You might want to take a look at Preqin. It may be premature at this point to say one way or another.
WMRE: Are foreign investors devoting a significant portion of their money to debt strategies right now, in addition to equity ones? Have you seen a change in how attractive investments targeting debt have become?
Gunnar Branson: Certainly. Over the last couple of years, you’ve seen an increase in debt strategies from private equity players. Certainly, it’s one of those times when debt becomes more appealing. It’s difficult for me to find a large institution that is not, in some form or fashion, doing it. Everyone of size, has at least some sort of debt strategy they are pursuing. To some extent, the movement into debt is something that you see at this point in the cycle. It’s difficult to move equity because of a lack of transactions, but you can move into some of these markets through debt. And a lot of people feel that debt is a good position to be in at a time of uncertainty. This is what we see through every cycle, when we are in a period like this that’s not an aggressive growth period. No one has called a recession yet, but we are not in a ‘go, go’ period,’ so it is logical that you are seeing more interest in debt. And it’s not just this year. It’s been increasing over the past couple of years as we’ve been in a period of transition and uncertainty.
WMRE: What are some of the biggest challenges for foreign investors who might be trying to raise money for U.S. real estate investments right now? Is everyone experiencing similar issues, or do these challenges differ depending on where in the world these cross-border investors are located?
Gunnar Branson: Similar to what we’ve said before, challenges may be the pause [in activity], the denominator effect, that LPs may be pausing at this point. However, there is a lot of active capital raising going on. Certainly things have remained active, the question on people’s mind is “how active will the second half be?” At the same time, there’s some enthusiasm about potential distress acquisitions in some markets for capital raising strategies. We just have a period of heightened uncertainty about what’s happening. It’s not good or bad news, it’s more of a sense “Gee, I don’t know yet.” It does slow velocity to some extent. Generally speaking, in periods like these, most investors will be a little more methodical about what they are doing, things will be questioned multiple times. It doesn’t mean capital raising isn’t happening, it’s just more challenging than in previous years because of the crosscurrents of economic and geopolitical environment.
WMRE: AFIRE’s investor sentiment survey usually looks at what foreign investors view as the biggest challenges they are anticipating in investing in U.S. assets. What seem to be their biggest concerns right now about?
Gunnar Branson: I think the report that we put out in September is consistent with where they are right now. That has not substantively changed. There are a lot of different things that are in that. And there is a wide variety of issues they are looking at.
WMRE: What types of assets and markets do foreign investors seem to be gravitating toward right now? How do they compare to what they were pursuing over the past few years?
Gunnar Branson: When you look at surveys of the last couple of years that we’ve done, what’s interesting, from the markets perspective, you are seeing a shift back to New York City being a big market. New York has been down at number five for the last couple of years, with markets like Austin, Dallas, Atlanta being higher. Those cities continue to do well. However, what you are seeing, for a variety of reasons we are still trying to uncover, is New York and Washington, D.C. are rising in foreign investors’ eyes. So, some of the more traditional gateway markets are becoming more attractive.
In terms of assets, we are seeing a shift from “all office, all the time” to an increasing focus on multifamily. And they are indeed expanding that portion of their portfolios. After multifamily, industrial continues to be a favored asset class, especially when it comes to specialized assets, like data storage. Interestingly, office through the last couple of years, has continued to drop in desirability. And it’s no different this year. It continues to be in this area of uncertainty. But it is at this point of “Gee, do I really want to buy everything I can find? Probably not.”
Hospitality continues to do well, and I think it is driven by the incredible rebound in consumer travel, even though business travel continues to lag.
Retail continues to be a challenge, although you’ve seen some transactions over the past six months. So, it’s not as bad as people have said. That’s not to say that it’s a no-brainer, it’s certainly nowhere near the kind of confidence we’ve seen in multifamily.
In terms of strategies, I think what you are seeing is people are waiting to see if there are going to be distressed opportunities. It’s difficult to imagine it would be as robust as we’ve seen in some other recessionary periods, it’s probably not going to be the early 90s. But most investors understand that these periods are when you find some of the more exciting long-term yields. So, this is the time when a lot of experienced investors are keeping their eyes open. Periods like this, when there is a valuation shift, when a mark-to-market has to occur, the question is: what kind of value change are we seeing? How much of it is transient, how much of it is permanent? No one knows.
WMRE: We’ve been hearing from some domestic investors that they are stepping away a bit from multifamily acquisitions because they feel valuations in that sector have become overly high, in spite of its promising long-term prospects. Are you seeing anything like that among foreign investors?
Gunnar Branson: Certainly, there’s a lot of discussion how in some markets you are seeing some over-valuation in multifamily. I think most investors feel comfortable with it, given continued demand for housing in the United States. That’s an ongoing discussion, I don’t know if that’s settled at this point. It is the most desired asset class that they can find, it continues to be pretty much at the top of most investors’ lists. Execution is everything, right? I would be loath to characterize a movement as a pullback at this point. It certainly depends on what’s going to happen. I do know, as of the end of January, when we were doing our survey, multifamily was at the top of their lists. And that’s not just apartment buildings, it’s things like single-family rentals (SFRs) as well.
WMRE: There are multiple big U.S. players who are active in SFR and BTR today. But are there now foreign companies as well that are investing in that space, outside of Brookfield?
Gunnar Branson: I think SFR is being accepted as a legitimate extension of the apartment, or multifamily, or residential space. It has become an institutional investment. It’s done at scale, at scale that’s not dissimilar to having an apartment building. I have spoken to investors who’ve stopped talking about it as apartment and then “this-and-that,” and they talk about it as housing, they see this as a spectrum of rental housing investment.
WMRE: What kinds of returns are the investors AFIRE communicates with looking for in U.S. real estate? Have those return expectations stayed stable or has there been a change to account for a new market environment?
Gunnar Branson: They are approaching their assessments of their expectations the same way a domestic investor would. I think that is part of the normal investment process, as events on the ground alter, there might be some [changes] in expectations. But that depends on when those expectations were set. But I don’t think you will see a notable difference between domestic and non-domestic investors in terms of how they are approaching their expectations.
WMRE: Are there any important trends you are seeing emerge in the sector that maybe we have not touched upon?
Gunnar Branson: A growing trend among particularly European and Canadian investors are concerns about what fits their ESG goals, more concerns about climate risk from storm damage and water shortages. These are top of investors’ minds. That pressure is going to continue and it’s going to really raise the state-of-the art in real estate over the next five to 10 years. Covid did not diminish the focus on sustainability. If anything, it has increased in the last couple of years, and we expect it to increase in the years to come. This is again, a generalization, but I do think you see European and Canadian investors expecting a higher level of sustainability in any asset that they acquire.