Martin Sumichrast

The tight market for institutional grade properties in the U.S. has forced most of the major foreign investors to consider some creative alternatives to their typical mode of invest­ment. We have noticed a distinct depar­ture from the types of real estate invest­ments considered by the British, Japanese and Dutch in the past.

Some of the market characteristics influenc­ing these foreign investors’ decisions are:

• Institutionally acceptable properties in the United States have essentially been bought up. The demand for such properties greatly exceeds the supply.
• The U.S. market is overbuilt in virtually every segment and market, under traditional stan­dards of measurement.
• Price competition for quality properties is fierce, with auc­tions for such properties com­monplace. In today’s world, a portfolio is more valuable than a single property.
• Traditional sources of financing for real estate are in a state of flux, with banks and thrifts having significantly pulled back in their involvement.

Foreign investors are finding that they must now consider other ways to increase the level of their real estate investments. They may move toward different products (e.g., industri­al arid mixed-use projects), different geo­graphic markets and new types of investment.

The two most evident trends are the emer­gence of innovative investment techniques, such as the use of participating debt and convertible debt, and the willingness of for­eign investors who demanded full equity ownership in the past (e.g., the Japanese) to accept partial ownership as a means of expanding their portfolios.  These trends are illustrated by some major transactions which have occurred recently.

The much publicized investment by Mitsubishi Estate Co. in the Rockefeller Center is indicative of the recent willingness of Japanese investors to accept less than full equity ownership in existing properties. The Rockefeller Center properties are owned by a U.S. corporation, but the properties are also subject to a convertible mortgage from a third party lender. If the lender exercises the conversion privilege, it could obtain up to 71.5 percent of the ownership of the Rockefeller Center properties. Mitsubishi acquired a 51 percent interest in the corpo­ration that owns the underlying property. Therefore, Mitsubishi’s ultimate interest in the properties could be as low as 14.5 percent (51 percent x (100-71.5 percent)), if the lender exercises its conversion privilege. Of course, the stock acquisition could be the first step in a staged acquisition of the underlying property, assuming Mitsubishi attempts to acquire the convertible mort­gage from the third party lender. Although this particular transaction may have been motivated more by the Rockefellers’ desire to sell than by investor demand for the prop­erties, the ultimate structure of the transac­tion highlights the fierce competition for quality properties among investors.

- Martin Sumichrast

A proposed Chicago transaction involved the purchase and leaseback of land coupled with a convertible/participat­ing loan to the seller/lessee for the purpose of renovating a major office building which occupied the land. The principal amount of the loan was for approximately 80 per­cent of the fair market value of the proper­ty and the fixed interest rate component was approximately 100 basis points below the market rate. This transaction is notable for the following reasons:

• It combines equity ownership with convertible/participating debt.
• It is for the rehab of a partially occu­pied property as opposed to the acquisition of a fully leased property.
• The financing structure is attractive to both the lender and the borrower in that the borrower receives cash from the transac­tion nearly equal to the current fair market value of the property, and the lender receives an opportunity to participate significantly in the appreciation of property with a modestly reduced fixed interest rate.Similar transactions are being syndicated and offered institutional investors in the European and Japanese markets.
• A recent large unit syndication of a mixed-use project in  Houston, which was jointly marketed to both U.S. pension funds and Japanese investors, illus­trates several other interesting trends:The emergence of the Japanese syn­dication market, as an alternative to direct equity investment.
• The competition between U.S. pen­sion funds and foreign investors for similar types of investments.
• The expanding focus on non-office properties.
• A growing interest in the right prop­erties in previously distressed markets.

These are just a few examples of the current direction of the marketplace. This move­ment toward different product and geograph­ic markets and away from outright equity ownership will continue as the major foreign investors and U.S. pension funds realize that they must continue to seek out innovative investments if they are to maintain the growth of their real estate portfolios.