By Art Gering
Some U.S. REITs are finding favorable results overseas. But not all REITs travel well.
By 1999, Roseland, NJ-based Chelsea Property Group, Inc. (NYSE: CPG) had built a portfolio of dominant outlet malls across the United States. Although growth prospects still existed in the States, the company couldn't resist the tug of an alluring offshore development opportunity and positioned itself to strike. That year, the company formed Chelsea Japan Co. Ltd., a joint venture with Japanese operators Mitsubishi Estate and Nissho Iwai Corp.
"The Japanese were very big shoppers at our U.S. properties," explains Leslie Chao, Chelsea Property Group's president. "We thought it would be a great idea to take our concept to Japan."
In March 2003, Chelsea Japan opened its third property, the 180,000-square foot first phase of Sano Premium Outlets near Tokyo. In July, Chelsea opened the 170,000-square foot second phase of Gotemba Premium Outlets, also near Tokyo, and the firm also operates the 250,000-square foot Rinku Premium Outlets in Osaka.
There are more than 170 U.S.-based REITs, but Chelsea Property Group is one of the few that own and operate an international property portfolio. For most REITs, foreign activity presents a daunting challenge. The prevailing thought is that it's easier to combine skilled management teams, property specific know-how and local market savvy together in, say, Chicago or Dallas than London or Singapore.
"When we studied what the apartment market looks like overseas, it's dramatically different than in the U.S. Take London for example, where people live in an apartment for life. That's a very different model than exists in this country, where people rent apartments for three years to five years," says Dana Hamilton, executive vice president of national operations at Archstone-Smith (NYSE: ASN), which does not operate internationally.
Common Traits
Those REITs that have undertaken foreign expansion come from various market sectors but do share some similar traits. International expansion appears to suit companies with special property profiles, such as Chelsea's outlet mall concept and The Mills Corporation's distinct take on retail. "When a company has a unique product or capability, they can go into another market and it's realistic to expect them to do well because they're bringing something new to the table," says Keith Pauley, portfolio manager of LaSalle Investment Management.
Chao agrees with the need to offer an international market something it doesn't already have. "It helps not to be a commodity," Chao adds.
For Shurgard Storage Centers, Inc. (NYSE: SHU), the Seattle-based self-storage REIT, value creation opportunities exist in markets such as Europe where the self-storage concept is new. The firm has been developing 25 to 30 properties each year on the continent.
"There are more self-storage properties within 100 miles of Seattle, for example, than exist anywhere in Europe," says Charles K. Barbo, Shurgard's chairman, president and CEO. Shurgard first ventured offshore nine years ago. Today, 20 percent of the firm's properties are in Belgium, France, the Netherlands, the United Kingdom, Sweden and Denmark. It recently opened its 100th property at a location near London.
As Portfolio went to press, Shurgard announced plans to pay 32.3 million euros for AIG's 7 percent stake and 58.3 million euros for Deutsche Bank's 12 percent stake in its European operations. The company's stake in Shurgard Europe would increase to 80.6 percent when the deals close, according to the company.
Another common trait among those REITs operating overseas is relationships with tenants engaged in global trade. Two leading industrial REITs, AMB Property Corporation (NYSE: AMB) and ProLogis (NYSE: PLD) are active in Europe, Asia and Mexico for this very reason. Also, Chicago-based First Industrial Realty Trust, Inc. (NYSE: FR) owns assets in the U.S., Canada and U.S. territories.
"Industrial is one of the few asset classes where there is a strategic rationale for operating in more than one country because the customer base is very international," reasons Hamid R. Moghadam, AMB chairman and CEO. "Growth in global trade expands at two-to-three times domestic GDP. Because global trade drives our business, we cannot have just a domestic view of our portfolio."
AMB focuses on main international port and airport markets. Currently, properties are located in Guadalajara, Mexico, Paris and Singapore.
Moghadam says exceptional opportunities for his company exist in Mexico and Japan. Mexico's investment-grade rating lowers the country's risk profile. NAFTA-related trade and a scarcity of high-quality buildings relative to demand create favorable market conditions. A similar lack of supply exists in Japan, where, additionally, Tokyo's Narita Airport is one of the world's busiest air cargo hubs. In 2003, AMB expects to invest approximately $450 million in international properties. One-half to two-thirds is likely to be allocated to targeted markets, with a preference for Mexico and Japan.
ProLogis' move offshore began when it developed projects in foreign locales for its U.S.-based customers. "It wasn't always our specific plan to go global," says Robert J. Watson, president and chief operating officer of the firm's European operations. "But, it was always our plan to follow our customers."
ProLogis holds full or partial ownership interests in assets located in France, Germany, the Netherlands, Spain, the U.K. and Italy, in addition to positions in Asia and Mexico. Recently, the firm began accumulating a portfolio in Central Europe.
"Today, there's more economic activity in Central Europe than the U.K. or Western Europe (because the Czech Republic, Hungary and Poland will be entering the European Union in May 2004)," Watson says.
While there are prevailing reasons for industrial companies to expand overseas, that is not necessarily the case for companies in other sectors, particularly office or lodging companies.
"As we look to prioritize opportunities for our company, we focus on the customer and what the customer is likely to need. International expansion doesn't mesh as well with that as other things we'd like to provide from a customer and operations perspective," Archstone-Smith's Hamilton says. "For a company such as ProLogis, the story is different. Many of their customers operate globally, so the ability to provide solutions with a single point of contact makes a lot of sense."
Unique Risks
So why aren't more REITs testing the international waters? In addition to the risks associated with any new market expansion domestically, there are a whole slew of new challenges that arise when targeting international markets. The obvious risks are those that arise from doing business in a different language and culture, under unfamiliar laws and in a foreign currency.
For office REIT Brandywine Realty Trust (NYSE: BDN), those are the primary reasons why the company has focused all its efforts on its domestic operations.
"The office market tends to be very much a local business, driven by a lot of local knowledge; knowing which corner is the right corner and how submarkets have evolved," Brandywine president and CEO Gerard Sweeney says. "It's hard to transplant that knowledge to a market you're not familiar with, particularly a market where you're not familiar with the geography, local market conditions and political environment. The office business is risky enough without taking on a lot of additional risk by moving into a foreign market."
Moghadam calls this "execution risk," and emphasizes the importance of engaging the most qualified local market experts. Like Chelsea Property Group, which formed a joint venture with local partners to guide its entrance into Japan, AMB has established a local presence in foreign markets by teaming with indigenous groups.
"We benefit from local insider knowledge and avoid having to build up a huge overhead by starting from scratch," Moghadam explains. "This could be done without local partners, but it would take a lot longer, be a lot more expensive and the end results would not be as good."
Financial risks also abound for REITs active offshore. One of the first questions firms must ask is how much capital to put to work. The strategies for addressing this issue vary from an even split between partners to one that requires a significantly larger or smaller equity stake.
REITs entering the European market have often sought the backing of third-party investors to start and expand operations, says Laure Duhot, a London-based principal with Macquarie Capital Partners Ltd., which initiated the Shurgard joint venture. "These REITs are mindful of the impact of overseas expansion on their investment profile and want to keep their direct exposure within reasonable limits," Duhot says.
ProLogis has maintained its investment profile and mitigated exposure by using its fund business to capitalize overseas plays. In September 1999, the ProLogis European Properties Fund began operation. At the end of the first quarter this year, the fund owned 195 buildings encompassing 38 million square feet in 11 European countries, including Central Europe. Some $3.2 billion in total assets are owned and under management in Europe; ProLogis' share is $1.3 billion.
"The fund structure is a preferable way of doing business because of how we want to engage our equity," Watson says. "It allows us to serve our customers better, construct buildings quicker and take advantage of opportunities without our own equity."
By using the fund structure and taking a smaller ownership stake, the firm has effectively traded a share of rental proceeds for fee income generated from operating the properties. ProLogis has also found a way to monetize the value of the assets, a significant accomplishment for its Central European portfolio.
"The problem with Central European markets is that there is a relatively small supply of institutional grade assets," says Andrew Wood, New York City-based principal of Lend Lease Real Estate Investments. "The markets are and probably will remain development markets. Therefore, the liquid market of known sales and comparables by which institutions justify acquisitions doesn't exist. The key opportunity there is financing development. Then the question becomes who is going to take you out."
ProLogis' Central European assets, which it develops for the fund, get "taken out" when they are contributed to the fund upon reaching stabilization. The firm receives ownership interests in the funds as part of the proceeds received from the contributions. ProLogis' Central European properties normally yield 300 basis points (bps) to 400 bps more than North American assets, as cap rates in the region have steadily declined in recent quarters, the firm reports.
Shareholder Returns
Whatever the rationale or strategies used, a REIT's global quest ultimately will be judged by the value created for shareholders. Constituency backlash is a serious risk faced by REITs contemplating foreign activity. Concern centers on the returns international plays generate for shareholders. Given the risk factors described, the returns must be outsized compared to what the REIT would realize in the U.S, according to William E. Hauser, director and portfolio manager of HVB Capital Management Inc.
"Taking on larger risks is fine and dandy if you're going to get considerably higher returns than what you are going to get in the U.S.," Hauser says. "However, the fact is, you can't be promised that."
Brandywine's Sweeney says justifying expanding internationally would be a hard sell for his company internally, its board and particularly the capital marketplace. "It would be such a strong departure from our core strategy that I think we would have to question whether we think the risk-adjusted rates of return in a foreign market would exceed those that we think we can gather in a market with a lower risk profile," he says.
Initially, ProLogis' share of income generated from its foreign operations was given a lower multiple than its domestic income, Hauser adds, because shareholders and analysts had set the bar high.
Shareholders will have to wait to see whether international investment pays off. Individual REITs have been encouraged by the results achieved so far but the bottom line results have been modest.
Funds from operations (FFO) for ProLogis' European operations in the first quarter were $19.2 million, compared with total company FFO of $100.6 million. In the first quarter, assets in Guadalajara and Paris provided AMB rental revenues of $1.1 million, or about 1 percent of company totals. The firm aspires to increase contributions from international operations to 12 percent.
Approximately 5 percent of Chelsea's net operating income comes from Japan and the firm's goal is to increase contributions from Japan and other international markets to double digits, Chao says. The firm recently started a project in Mexico City and also has an interest in Korea, Taiwan, Singapore and Australia.
For Shurgard, initial returns on stabilized assets are running about 200 bps more than new developments in the U.S., Barbo says. "A location in the U.S. built three years ago would be making a 10 percent or 11 percent unleveraged return. That would be 12 percent to 14 percent over there."
The company has yet to make money in Europe due to its fast pace of development. "A huge percentage of our properties there are young and in rent-up," Barbo says.
One impediment REITs face in building the bottom line from international operations is the lack of tax-advantaged structures in offshore jurisdictions. "The payment of a foreign tax will not be creditable in the U.S. and will only reduce yield," says Les Loffman, the national director of REIT services for Ernst & Young.
What investors in American REITs doing foreign business should focus on is whether these firms are providing shareholders with something they did not have before. "There is certainly a higher risk for a company doing overseas business and foreign exposure might not be something an investor wants to accomplish," LaSalle's Pauley says.
The firms that are active in foreign markets possess either distinct property profiles or a compelling rationale for being overseas. As such, they defy comparisons to market-wide averages for vacancies, absorption, rental rates and the like, and tend to stand apart from other owners and operators. Shareholders in REITs holding international portfolios are, in simplest terms, not betting on the performance of the firm's properties, but on management's ability to create value in those assets.
"Could an apartment owner here buy apartments in Japan or Europe?" asks David Jellison, portfolio manager of Columbia Management's Real Estate Equity Fund. "I don't know; the situation is different. But the question would be whether the inefficiencies in the systems overseas are so great that an operator that knows what they're doing could take their expertise over there and make it work and therefore create value for shareholders."
Future Expansion
International expansion makes sense for those REITs that can rationalize the move and produce the necessary returns while preserving shareholder value. ProLogis and Chelsea Property Group, for example, have followed their customers to offshore locales. AMB, meanwhile, is fulfilling the space needs of firms involved in the global flow of goods, and Shurgard is exploiting an opportunity created by a dearth of competitive product. To some degree, each of these rationales is unassailable. For example, it's difficult for a shareholder group or analyst to reproach an industrial REIT for amassing an overseas property portfolio when the firm's customers have committed to occupy the buildings.
For REITs aspiring to be active in foreign markets, offering a property type that is not a commodity in the targeted market is a plus. Arguably, ProLogis, AMB, Chelsea and Shurgard have unique profiles that distinguish these firms from competitors and encourage tenants to regard the REITs not as landlords, but as companies that solve their space needs. For REITs that cannot claim such an advantage, real estate might best be a game to be played only in local domestic markets. Rather than questioning why, for example, an office REIT is not looking at exploiting perceived opportunities in foreign locales, an investor should acknowledge senior management's ability to understand that its concept may not travel well.
Art Gering is a regular contributor to Portfolio based in New York City.
