Is Real Estate Next?

By Allen Kenney

Like many of its counterparts in the financial services industry, Citi was submerged in red ink as 2007 drew to a close.

The stock of the United States’ largest bank had lost nearly half of its value from the beginning of the year, and third quarter losses stemming from subprime mortgage assets totaled more than $6 billion. However, Citigroup grabbed hold of a timely life preserver: a $7.5 billion infusion of capital. But it wasn’t the federal government or a private equity titan stepping in to keep Citigroup afloat. In this case, the company’s benefactor was the Abu Dhabi Investment Authority (ADIA).

With an estimated total as high as $875 billion in assets, the ADIA is the largest of a host of cash-flush sovereign wealth funds around the world. A new form of powerbroker in global finance, sovereign wealth funds—essentially state-sponsored private equity funds—have been on the investing scene for the last 30 years, since the oil boom of the 1970s in places like Abu Dhabi and Kuwait. Middle Eastern funds hold 41 percent of total sovereign wealth fund capital, with Asia contributing 31 percent and Europe accounting for 19 percent.

In its 2008 report “Preqin Sovereign Wealth Fund Review: Activity in Private Equity and Private Real Estate,” consulting firm Preqin estimated that more than 60 percent of the 50 funds in existence today have been created since 2000. Even though reporting information on sovereign wealth funds is limited, the last decade clearly has witnessed an explosion in their size, number and—most importantly—volume and complexity of investing activity. When the Citi deal was announced, acting CEO Win Bischoff even went so far as to call Citi’s new equity partner “one of the world’s leading and most sophisticated equity investors.”

As rising foreign economic powers such as China and Russia established their own sovereign wealth funds, U.S. policy-makers and pundits are devoting more time and attention to questions regarding proper regulation of these funds’ involvement in domestic markets. Meanwhile, major companies are developing strategies to capitalize on these fast-growing, enthusiastic sources of capital. Commercial real estate companies should follow that lead, according to industry analysts.

“Sovereign wealth funds are here to stay,” says Guy Langford, an accounting principal in Deloitte LLP’s mergers and acquisitions services practice who specializes in real estate. “They could be a real partner in the growth and development of commercial real estate. It’s really incumbent upon developers, managers, operators and investors in the REIT industry to build those relationships.”

Cups Running Over

In general, governments use sovereign wealth funds as a way to manage their excess cash reserves. Once government leaders determine that their countries’ coffers are spilling over, they may set up a state-sponsored fund to invest the excess money.

The China Investment Corporation, for instance, oversees $200 billion, almost half of which has been set aside for investment outside the country. With China’s 1.7 trillion in reserves growing rapidly, the investment company could see its portfolio quickly expand in the near future.

Tasked by the Chinese government with improving returns and diversifying the reserves’ holdings, the China Investment Corporation formally began operations in September 2007. Since then, the fund has made substantial billion-dollar investments in major U.S. companies, such as Morgan Stanley and Visa. Overall, the China Investment Corporation’s goal is to “pursue long-term investment instead of short-term speculation, and will achieve a balance between security and profitability,” Chinese Finance Minister Xie Xuren said during talks with U.S. Treasury Department representatives at an economic forum in December 2007.

Asian Tiger Singapore maintains two of the top 10 largest sovereign wealth funds in existence, according to data from the Sovereign Wealth Fund Institute research group. Created in 1981, the Government of Singapore Investment Corporation Pte Ltd. (GIC) oversees $330 billion in worldwide investments from the country’s foreign reserves. GIC’s vast real estate portfolio, which includes both direct and indirect investments, puts it among the top 10 largest real estate investors in the world. Temasek Holdings, which does not consider itself a sovereign wealth fund, was set up by the Singapore government in 1974. The firm now manages approximately $160 billion in assets, primarily focused in Asia.

Some of the most concealed sovereign wealth funds are tied to Saudi Arabia. The Sovereign Wealth Fund Institute’s estimates put the Saudi’s suite of funds at somewhere in the neighborhood of $300 billion. The Saudi funds include one dedicated specifically to real estate.

It’s not just foreign governments setting up sovereign wealth funds, though. Some U.S. states boasting abundant natural resources have created their own funds. For example, the Alaskan government established the Alaska Permanent Fund Corporation in 1976 to manage the proceeds from the state’s mineral-related revenues, such as royalties and lease rentals.

As sovereign wealth funds have proliferated, their total assets have grown at a strong pace of nearly 25 percent annually for the last three years, according to data published in April by Global Insight, a London-based firm specializing economic and financial analysis. Global Insight estimates that the funds’ total worth reached $3.5 trillion in 2007, or roughly one quarter of the United States’s gross domestic product. That total surpasses the combined holdings of all hedge funds and private equity funds in existence, according to Global Insight. Assuming growth trends hold up, sovereign wealth funds’ total value will surpass the economic output of both the U.S. and European Union within 10 years, the consulting firm’s projections show.

“The most notable feature of the sovereign wealth fund investor universe is the huge amount of potential for further growth,” says Tim Friedman, Preqin’s head of marketing. “The aggregated assets managed by sovereign wealth funds have increased by more than 50 percent over the past year, and that rate of growth shows no signs of abating with the price of oil continuing to stay high.”

Mainstream Investing

Although sovereign wealth funds’ recent forays’ into investing in companies under stress certainly have generated significant media coverage, observers note that the funds like to keep a relatively low profile. In practice, this tends to translate into a vanilla investing approach that produces solid and steady long-term returns.

“Many of these funds invest in mainstream, stable assets and fully understand the risk-return spectrum,” says Barden Gale, vice chairman of real estate for private investment firm Starwood Capital Group.

Historically, according to Langford, sovereign wealth funds have kept an “under-the-radar” investment profile, preferring “large investments in mature businesses” to flashier deals. Brad Setser, a fellow with the Council on Foreign Relations who studies sovereign wealth funds and emerging market economies, shares Langford’s view. He characterizes the recent spate of opportunistic aid as an aberration from sovereign wealth funds’ track record. “The dominant strategy of most of the existing funds has been to hold a relatively broad-based investing portfolio,” Setser says. “In general the fund managers have seen themselves as portfolio managers, rather than investors in companies.”

Langford notes that sovereign wealth funds have tended to focus on passive investments that produce non-controlling interests of less than 10 percent of a company’s equity. Many of these investments have been concentrated in brand-name companies. In the case of the Citi deal, for instance, ADIA was attracted by the opportunity to buy a good-sized stake in a well-established company.

“We see in Citi a highly respected company with a premier brand and with tremendous opportunities for growth,” said Sheikh Ahmed Bin Zayed Al Nahayan, ADIA’s managing director, at the time of the deal’s announcement. “This investment reflects our confidence in Citi’s potential to build shareholder value.”

Even for sovereign wealth funds’ higher-profile investments in 2007, however, the terms of those deals seem relatively unassuming—outside of the massive dollar amounts involved. For example, ADIA agreed that it would not own more than a 4.9 percent stake in Citi, nor would it have special ownership rights or a role in the financial services company’s management.

Langford and Setser posit that one reason for the hesitance towards splashy investments is that some foreign governments have grown wary of causing a political scene. For an idea of what these governments are trying to avoid, think back to the uproar in 2006 when the management of six U.S. seaports was taken over by Dubai Ports World. The deal touched off a contentious national security debate in the media and on Capitol Hill. Eventually, the United Arab Emirates-based company agreed to sell the assets, rather than face a potential move by Congress to scuttle the deal.

Partnering Up?

So what does all this mean for commercial real estate? Companies around the world should start preparing to absorb substantial capital inflows from foreign sources seeking a variety of ways to invest in real estate.

“A number of the funds have been taking an interest in real estate, both in their own countries and abroad,” says Rachel Ziemba, an economic analyst with research firm RGE Monitor, who speculates that the funds currently allocate 10 percent of their holdings to real estate and will continue to do so. “Real estate is going to continue to be a significant asset targeted by sovereign wealth funds, if for no other reason than that it’s part of a diversified portfolio.”

Gale notes that the expected asset growth among sovereign wealth funds will produce a swell of investment in REITs, both in the U.S. and abroad. Based on the fund’s general equity allocations to broad-market investment vehicles alone, REITs will see an inflow of investment, he says. Additionally, Gale points out that just a small percentage dedicated to REITs from the ever-growing sovereign wealth war chest would still be a big number.

Preqin’s report illustrates sovereign wealth funds’ fondness for real estate, finding that more than 60 percent of the funds are active real estate investors. Of that group, almost 70 percent are involved in indirect forms of real estate investment. Additionally, 95 percent engage in some form of direct investment strategy, and nearly 40 percent have created their own dedicated real estate investment arm.

“Look at the top 20 sovereign wealth funds, and then look at how many of them have meaningful allocations towards real estate,” Langford says. “The list goes on and on.”

For instance, the Alaska Permanent Fund Corporation currently dedicates 10 percent of its total assets to real estate, allocating 80 percent to direct investment and 20 percent to publicly traded real estate securities. CEO Michael Burns says he doesn’t foresee that changing anytime soon. “Real estate has been a very good source of returns for us,” he says.

In the past, much of sovereign wealth funds’ real estate investment has involved one-off acquisitions of top-tier properties in global gateway cities like New York and San Francisco. More and more, however, the funds are turning to emerging markets in places like Asia as a way to diversify their assets and exposure, Ziemba says. Going forward, she says, this will translate into few “white elephant” acquisitions of high-visibility properties in places like London and a continued quest to expand into new markets like India.

A Matter of Trust

Langford foresees the funds building stronger partnerships with REITs in the near future. In his meetings with the different sovereign wealth funds, Langford says managers have expressed a definite interest in finding options that would give them broader real estate investment opportunities, which would include publicly traded real estate securities.

The continued accumulation of sovereign wealth funds’ capital eventually will force them to make larger investments and seek out the most efficient ways to deploy their money in real estate, he says. This is likely to make indirect forms of real estate investment even more appealing, rather than continuing to build up portfolios of directly owned properties.

“The more probable outcome is that the funds will invest in commercial real estate companies with good track records,” Langford says. Langford also speculates sovereign wealth funds might look to form partnerships to oversee their owned real estate, another condition favorable to REITs. As an example, the Alaska Permanent Fund Corporation has teamed with mall REIT Macerich (NYSE: MAC) on a series of major retail acquisitions, such as The Shops at North Bridge in Chicago and Tysons Corner in the Washington, D.C., area. Burns notes that these investments would have been impossible without a knowledgeable operating and development partner.

“We’re not mall operators,” he says. “With assets that complex, we were absolutely convinced that we would need a partner that is going to be able to operate them, and Macerich certainly is.”

Setser points out that one of the biggest reasons financial services companies were able to tap into sovereign wealth fund capital during the latest downturn was that banks already had a long history with them. Likewise, if commercial real estate companies want to capitalize on the opportunities presented by sovereign wealth funds, experts agree they should start reaching out now; it’s a foundation that has to be laid one brick at a time.

“I don’t think you’re going to find a scenario where they’re going out there to buy up multi-billion dollar REITs with alarge stake on day one,” Langford says. “A company might start with a joint venture and then grow the relationship from there.”

Gale notes, however, that outreach efforts on the part of individual real estate companies might be difficult. Instead, he recommends a coordinated, industry-wide initiative among REITs and commercial real estate companies to open up a dialogue with sovereign wealth funds.

Michael Grupe, NAREIT’s executive vice president, research and investor outreach, says that the association considers sovereign wealth funds not unlike the different kinds of major institutional investors, such as retirement plans and endowments, even though sovereign wealth funds “may have their own investment mandates and objectives with respect to investment risks and returns.” As such, he says NAREIT would include such funds in its outreach and communication programs in all appropriate ways.

“The benefits of portfolio diversification across the core assets of stocks, bonds, real estate and cash are largely transparent with respect to the type of investor, including sovereign wealth funds,” Grupe says. “The benefits of real estate investment through REITs and publicly traded real estate are available to investors of all kinds, including investors from outside the U.S. in general and sovereign wealth funds in particular.”