Battle of the Game Changers

The commercial-property sector is set to undergo some significant changes in 2014. PrivcapRE’s first Special Report for the year explores the trends that will impact the performance and composition of real estate portfolios and investments globally. Investors, managers, and industry professionals interviewed in the past six months offered a mixed forecast on the year’s key trends. These include GP consolidation, the impact of new technology, risk and opportunity in Europe, the rise of the secondary market, and regulation. Some also expressed concern that the industry is repeating the “same old” mistakes, setting the stage for another crisis. However, two key trends emerged as the most likely game changers: rising interest rates and the wave of offshore money looking for a home in commercial property. As developed markets across the globe weigh the issue of rising interest rates and potential cap rate expansion, there is serious concern that rental growth won’t be able to keep pace. With faltering NOI growth, the industry is faced with the question of how to sustain some of the deals seen across the world’s core gateway markets. For example, in acquiring Manhattan’s 650 Madison Avenue, the joint venture group led by Crown Acquisitions and Highgate Holdings paid a tight in-place cap rate of just 2.8 percent, according to Real Capital Analytics (RCA). The first year pro forma cap rate is expected to be 3.2 percent. If rates rise ahead of expectations and above NOI growth, is there enough cushion in the yield to make such a deal viable in the long-term? The fear of rising rates has prompted some – including Colony Capital CEO Tom Barrack, interviewed on PrivcapRE in November – to brand investment in core markets “foolish.” But it’s not just core equity that’s affected. Rising rates will have an impact on all deal underwriting, irrespective of where it lands on the risk spectrum, and could spell trouble for owners holding floating rate debt. Despite the obvious and significant impact of rising interest rates, market players expect cross-border capital flows to have an even more fundamental impact on the industry in 2014. In the U.S., the six major metros saw a 900 percent increase in real estate investment by Chinese companies, according to RCA. A 40 percent stake in the most valuable office building in the U.S., the GM Building in Manhattan, was sold in June for $700 million to Zhang Xin’s family (which runs Chinese office landlord Soho China) and a company controlled by Brazilian banker Moise Safra. The deal valued the GM Building at a staggering $3.4 billion, including debt. Activity in London, which remains a favorite for offshore buyers, showed similar energy. The flood of foreign investment in the past 12 months is just a taste of what’s to come. As Marjorie Tsang, director of strategic research and solutions at the New York State Common Retirement Fund, suggests, the “mother of all tsunamis of capital” is on the way in 2014. The Chinese are just one among many acquisitive groups, with vehicles out of Canada, Korea, Japan, Norway, Australia, and the Middle East also vying for offshore assets. For domestic investors and private real estate managers, this presents a challenge and an opportunity. For investors, the competition for deals will only increase. Case in point: when the Chicago office property 225 West Wacker Drive sold to Seoul-based Mirae Asset Global Investments in March 2013, the Korean investor had to fight off bids from six other foreign investors and eight domestic investors. Pricing is already a concern for many in the market, and greater capital flows, particularly into prime global markets, are set to add to the upward pressure. For managers, the new capital presents an opportunity. As domestic investors become more selective and consolidate their relationships with fewer managers, new sources of capital entering the market is a welcome trend. The managers that truly succeed in cap- turing this new foreign equity will be those able to customize co-investment rights, joint ventures, separate accounts, and club funds, all while ensuring that existing investor base—and their investment strategy—remain intact. That will be tough to achieve, but managers need to embrace the opportunity and quickly learn how to play by the new rules of this ever-changing game.