Riding the global wave

Global real estate investment was the focus of a panel discussion that kicked off the annual NAREIT convention in San Francsico last November. It's a timely topic, given the growing appetite among U.S. commercial REITs for real estate abroad. Will apartment REITs follow?

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Not likely in the short term, although one homegrown multifamily REIT already has a jump on the competition.

Coca Cola and McDonalds are in China, Exxon is in Saudi Arabia and retail and industrial mega-REITs have taken their expertise abroad. Isn’t it about time the multifamily industry went global, too? Archstone-Smith thinks so. With the idea it could make a lot of money for its shareholders in Europe, the apartment REIT began studying the German market several years ago.

In early 2005, Archstone-Smith’s Executive Vice President of National Operations Dana K. Hamilton moved to the Netherlands to get a better handle on investing in Europe. REIT executives knew it was essential to have someone on the ground there to establish relationships with local operators. Hamilton, who has been with the company for more than 12 years, was named managing director of Archstone B.V., a wholly owned Netherlands-based taxable REIT subsidiary (TRS) created to operate and invest in residential real estate in Europe.

It was a bold move. At the time, economic recovery in Germany was nowhere in sight. But Archstone-Smith has a history of identifying opportunities not widely recognized by others, beginning with an aggressive investment in Southern California in 1995 when that market still was deep in a real estate slump. In 2002, Archstone-Smith was the first REIT to enter Manhattan with the acquisition of the 506- unit 101 West End, leaving the multifamily investment community wondering why. That asset today is valued at more than double the $210 million the REIT paid for it.

Archstone CEO R. Scot Sellers hopes for repeat performances in Europe, beginning in Germany, where rental rates are affordable to the majority of the population and offer significant room for future increase. “The situation with rental rates today (in Germany) is similar to what existed in the U.S. in the early 1990s and rental rates are low enough that property trades at a very large discount to replacement cost. Therefore, there is virtually no new supply of residential product and it should be some time before supply comes back to the market,” Sellers explained last summer. Germany also has the second lowest home-ownership rate in Europe — 43 percent compared with the European average of 65 percent — and the bulk of the country’s housing stock is owned by either government entities or corporations, many of which are selling into private hands.

Archstone closed its first acquisition in Germany in Q4 2005, an 11- building, 822-unit portfolio concentrated in Mannheim for $44 million (e37.6 million). Last May, the REIT bought a 657-unit portfolio in the Siemensstadt area of Spandau in West Berlin from a joint venture of Cargill Value Investment and HPE, a subsidiary of GE Commercial Finance Real Estate Germany, for $50.5 million (e39.9 million). The West Berlin portfolio also includes 14 commercial properties. The
apartments boast hardwood floors, balconies and common and private gardens.

In June, Archstone acquired German apartment owner and manager Deutsche WohnAnlaghe GmBH (DeWAG). Archstone paid approximately $649 million e18 million) for 94 percent of DeWAG shares, with DeWAG management retaining the other six percent. The German company specializes in the acquisition, long-term ownership and re-sale of residential properties in the major metros of Southern and Western Germany. DeWAGs three managing directors have a combined 60 years of real estate experience in portfolio acquisitions, off-market deals and privatization of German apartment assets.

Meanwhile, foreign investment in German real estate has caught fire and shows no sign of cooling, as evidenced by recent sales, including a 1,540-unit residential portfolio that sold for e62 million to a British investor, who beat out 64 other bidders. Among those in the running were the Irish treasury, Swedish insurance companies and Canadian pension funds, all of which are new to the German market and are looking for local partners there.

“DeWAG was hotly competed for by several prominent opportunity funds, as well as a very well-respected European public real estate company,” said Sellers, who noted the final decision was based not only on price, but also on a number of intangible items.

“We underwrote DeWAG to produce ongoing leveraged returns after taxes in the high single digits,” said Sellers. The per-unit price was 33 to 50 percent more than the REITs previous two acquisitions in Germany, proving location is as meaningful abroad as it is in the U.S. Sellers said there’s a dramatic difference between owning assets in Frankfurt, Munich, Mannheim and Berlin.

The DeWAG portfolio consists of 7,000 units in 50 different locations. “The larger more vibrant cities like Frankfurt, Munich, Hamburg, Stuttgart, Dusseldorf and Cologne are cities DeWag either has in its portfolio or is in the process of building a significant presence in. They are the ones with the greatest demand for privatizations and rental upside,” said Sellers, who plans to capitalize on both opportunities.

The condo conversion business may have slowed in the states, but for- sale product is scarce in Germany. “When the apartments were owned by the corporate or municipal entities, there was no option for residents to purchase their homes. This has resulted in significant pent-up demand for this privatized product in the right markets and locations,” said Sellers.

Archstone-Smith chose not to be a converter during the condo conversion craze here at home, while selling entitled land to ground- up condo developers and assets at very low cap rates, and reinvesting in markets like Manhattan. But the privatization business in Germany is a much different business than condo conversions in the U.S. “Assets for privatization in Germany are purchased at market cap rates and, in some cases, at even better yields than market,”said Sellers. “There’s almost no speculation in the market, very different than what we’ve seen in the U.S. It’s an under served market and the margins are very good — 30 percent or better in many cases — and you still receive an attractive yield that grows during the privatization process. Contrast that with the situation in the U.S., where the acquisition yields for condo conversion are very low and there’s a lot of speculation in the market, which disrupts overall market dynamics, and the proforma margins to converters without price escalation were typically in the 12 to 14 percent range.”

Sellers also sees opportunities to acquire assets in bulk on a wholesale basis and resell some at a profit, while retaining the most attractive. “We purchased DeWag with a robust acquisition pipeline and plan to capitalize on it, confident we can build a business around managing money for others in the acquisition and operation of residential assets in Europe over the next several years, beginning in Germany. It’s not unreasonable to believe this could be a multi-billion dollar business for us in terms of assets under management,” he said.

REIT execs think the investor side of German residential real estate offers stable returns that grow at approximately the rate of inflation with essentially very little downside. “European and German residential product is highly sought after by European investors, but there are very few investment vehicles or opportunities for investors to allocate significant capital to this asset class,” said Sellers. The business could require a lot of capital, which he thinks is best raised on a third-party basis. “That model has been pursued successfully by other companies, not in the apartment business per se, but in other asset classes, and we looked at that as a data point. For this reason, we’ve always anticipated pursuing our investment activities in Europe through a separate vehicle that we will retain an interest in but would be majority- owned by others, and we would obviously get paid appropriately for investing the capital and operating the properties,” he said.

Before the company could begin raising third-party capital for its European investments, company execs realized they needed a capable presence in Europe, an aggregate of about e300 million of well- located residential product and a European management team. Those benchmarks have been achieved.

Meanwhile, Archstone-Smith has been watching the development of publicly traded markets in Europe as something the REIT hopes to participate in. A bill introduced late last year by Senator Orrin Hatch would amend U.S. REIT rules to provide that income from, and interests in, foreign-qualified REITs would be treated as qualifying REIT income. That bill is expected to pass early this year.

Some two dozen countries have or are in the process of allowing REITs, including Italy, the United Kingdom and, most recently, Germany. But, in an effort to reduce the pressure for future rent hikes, German officials excluded housing assets constructed before January 1, 2007 from the scope of the G-REIT bill, defining rental housing as any property with more than 50 percent of lettable area in residential use. The German cabinet passed the bill just as several large residential portfolios are being readied for market, some private and some government owned. A recent Pricewaterhouse-Coopers study found that four out of ten German cities want to sell their residential portfolios. Meanwhile, REIT advocates in Germany vow to push for inclusion of housing properties in REIT portfolios.