Foreign Investment in U.S. Real Estate: “The Spigot Is On”

Summer 2014

“They’ve all come to look for America,” sang Simon and Garfunkel back in the 1960s, and their lyrics continue to ring true. They — the Canadian, Chinese, Australian, European, Korean, Singaporean and Middle Eastern real estate investors — have been coming to America in ever-increasing numbers for the past couple of years. In an uncertain world, the U.S. commercial real estate market is the most sought-after on the planet because it is large, liquid and perceived as a safe haven for the long term.

Now that many U.S. commercial real estate markets are on an upswing in occupancy, rents and valuation — while Canadian markets are at a more mature point in the real estate cycle and the Chinese economy has slowed down — they look particularly attractive.

It isn’t just the gleaming canyons of Manhattan that foreign investors crave, nor is it just already-built Class A properties. Some investors are branching out of the gateway cities of New York, Washington and San Francisco to look at such not-quite-secondary markets as Seattle, Houston, Chicago, Los Angeles, Atlanta and Denver. Others are eagerly pursuing joint ventures with U.S. developers that have impeccable track records to own or build highly complex developments.

Some notable examples:

  • Cindat Capital Management Co., a subsidiary of China Cinda Asset Management, is partnering with Zeller Realty Group in the $304 million purchase of 311 South Wacker Drive, a 65-story, 1.3 million-square-foot Class A office tower at the gateway to Chicago’s West Loop. Cindat owns 70 percent of the venture.
  • Shanghai-based Fosun International acquired One Chase Manhattan Plaza in New York from JPMorgan Chase for $725 million late last year. This was the largest purchase of a New York building by a Chinese investor to date. 
  • In Brooklyn, Greenland Holdings Group of China is purchasing a stake in the Atlantic Yards project, the largest commercial real estate development in the U.S. to get direct backing from a Chinese company. Shanghai-based Greenland Group is said to be making a contribution of roughly $200 million in exchange for a 70 percent equity interest in the Forest City Enterprises development, not including the Barclays Center and a residential building already underway. Completion of the deal is expected this year; it is subject to regulatory approvals from the Chinese government and the Committee on Foreign Investment in the U.S. (According to JLL, Greenland Group’s goal this year is to generate up to 25 percent of its revenues from overseas.)
  • Oxford Properties Group, the real estate arm of the Ontario Municipal Employees Retirement System (OMERS), is partnering with the Related Companies to develop the 17-million-square-foot, 28-acre Hudson Yards mixed-use development on Manhattan’s Far West Side. Time Warner already has committed to moving its headquarters to a new office tower there. (For more on Hudson Yards, see “Building a NYC Neighborhood Atop a Rail Yard.”)
  • Oxford also is purchasing 450 Park Avenue, a 33-story, 330,000-square-foot office building in Manhattan’s Plaza District, for $575 million. Oxford’s aim is to develop and actively manage a $10 billion portfolio in the U.S. by 2018.
  • Also in Manhattan, at Time Warner Center on Columbus Circle, Abu Dhabi Investment Authority, one of the world’s biggest sovereign wealth funds, is investing alongside the Singapore Sovereign Wealth Fund and Related Companies, the lead developer of Time Warner Center, to buy Time Warner’s 1.1 million square feet of space for $1.3 billion. Time Warner will lease the space back until 2019. Abu Dhabi and Singapore are said to be funding 80 percent of the purchase price.
  • Gaw Capital Partners USA, an entity of the Hong Kong-based private equity firm Gaw Capital Partners, is raising $500 million to invest in office and hotel properties on the East Coast as well as in what it calls “knowledge- and innovation-based” markets such as Portland, Oregon, and Austin, Texas.
  • Callahan Capital Partners and Ivanhoe Cambridge, the real estate investment arm of the large Canadian pension fund manager Caisse de Depot et Placement du Quebec, acquired the 47-story, 963,600-square-foot Wells Fargo Center in downtown Seattle.
  • Sight unseen, Dongdu International Group of Shangai acquired the 1920s-era 38-story David Stott building and the Detroit Free Press building in downtown Detroit, for $8.95 million and $4.025 million respectively, at auction last September. It plans a $50 million redevelopment of the Detroit Free Press building into apartments and retail space.
head shot of Dan Fasulo

Dan Fasulo

According to Dan Fasulo, managing director of Real Capital Analytics, foreign investment in U.S. commercial real estate has “exploded” in the last 24 months, much as it did from 1999 to 2001 and from 2005 to 2007. “It’s coming from every direction and every continent,” he said.

Last year, foreign investors made close to $40 billion in direct commercial real estate investments, 15 percent less than they did in 2007, Fasulo said, adding that this figure does not count investments in private equity funds. By mid-March of this year, the 2014 total had already reached $9 billion, with billion-dollar deals in the pipeline still to be counted.

“These are sophisticated investors,” he said. “They are paying market prices, but not overpaying. As of now, the spigot is certainly on.” One example of investors’ broadening view: one of Fasulo’s German clients is investing in Pittsburgh, Chicago, South Florida and Las Vegas.

Canadian Investors Still On Top

According to a recent JLL “International Capital Sources-U.S. Inflows” report, Canadian investors are still the top foreign sources of investment in U.S. commercial real estate, followed by China and Australia. Canada accounted for one-third of the $38.7 billion of foreign capital invested in U.S. real estate last year. And while Canadian pension funds are major participants, JLL noted that the bigger players of late have been Canadian real estate operating companies (REOCs) and REITs.

According to Canada’s Office of the Superintendent of Financial Institutions (OSFI) for Canadian pension plans that fall under the federal Pension Benefits Standards Regulations of 1985, there is no specific limit on the percentage of a pension fund’s assets that can be invested in real estate, Canadian or foreign. Rather, the amount that a plan invests in real estate must meet the “prudent person” test. (There had been a quantitative limit on resource and real estate investments, but the limit was eliminated as of July 1, 2010.)

Following closely behind Canada as the top foreign investors in the U.S. are China, Australia, Norway, Singapore and South Korea, according to JLL.

Foreign investment accounts for 10 percent of all capital invested in commercial real estate in the U.S., a percentage that could accelerate, JLL believes, if more investors expand into value-add and opportunistic investments. JLL projects that Chinese total investments in commercial real estate outside China could pass $10 billion this year. If history is any predictor, much of that total will be invested in the U.S. and the U.K.

According to JLL’s Global Real Estate Transparency Index, two big factors are driving foreign investment in the U.S.: increased allocations to international pension funds in countries such as Australia and Malaysia and the rise of ultra-high net worth individuals (UHNWI) in the Asia Pacific region, seeking to preserve capital sourced from nontraditional investments and secure it with commercial real estate.

Educating Investors About the Process

head shot of John Sullivan

John Sullivan

The law firm DLA Piper represents such clients as Fosun, Greenland Group, Oxford and sovereign wealth funds. It also handled more than 20 Israel-related transactions with an aggregate value of over $2 billion last year. John Sullivan, partner and chairman of the firm’s Boston real estate group, explained that these clients often have an investment horizon of multiple decades.

“They have a lot of money, and are looking to diversify,” he said. As a safe haven with an abundance of high-quality assets, the U.S. represents a good fit for long-term investors, he added.

DLA Piper’s key role is to counsel its foreign investor clients about how the real estate process works in the U.S.; for example, by making clear which parties have which rights in joint ventures. The firm also helps clients navigate complex tax issues, particularly for newer entrants who need more assistance in structuring tax-efficient deals, Sullivan explained.

Although tax rules vary from country to country, he said, in a hypothetical case of a $1 billion project, for example, the entire investment might not be funded with equity; it could be divided into equity and inter-company debt, and funded through another jurisdiction. An investment entity might be set up in Luxembourg; that entity then would invest in the entity in the U.S. Investors also might use private REITs as a tax planning vehicle, Sullivan added. (See “More FIRPTA Facts" below.)

Sullivan commented that one of the firm’s most challenging roles is to manage investors’ expectations about how the real estate investment process works here, versus their own country’s conventions. The most rewarding part is learning the perspectives of people from other parts of the world.

“Commercial real estate is truly becoming a global business, with an increasing global flow of capital,” he concluded.

Singing the FIRPTA Blues

Perhaps it is an indication of just how attractive U.S. commercial real estate is to foreign investors that transaction volume continues to increase steadily despite the onerous tax regulations they confront in order to invest here.

In 1980, the U.S. Congress passed the Foreign Investment in Real Property Tax Act (FIRPTA) to tax foreigners’ gains on income from and sale of U.S. real estate and other real property. FIRPTA requires withholding from a foreigner’s rental income as well as withholding from a foreigner’s gains (or losses) on the sale of U.S real estate. When an investor buys U.S. real estate from a foreign seller, the investor is responsible for ensuring that 10 percent of the purchase price is withheld (although the seller owes the taxes).

What makes the tax particularly disagreeable, real estate professionals say, is that the double taxation (in the U.S. and in the investor’s home country) is not imposed on investments in other asset classes, such as stocks and bonds. In the most recent Association of Foreign Investors in Real Estate (AFIRE) member survey, 76 percent of respondents said that FIRPTA tax relief would spur their investment in U.S. real estate; 41 percent projected a major impact, while 35 percent said the impact on their investments would be positive.

Some relief may, in fact, be on the way, although it is moving at a glacial pace. In June 2013, the U.S. Senate introduced the Real Estate and Jobs Act of 2013 (S. 1181), which would amend the IRS code. It would allow foreign investors to take a greater ownership position in publicly traded U.S. real estate investment trusts (REITs) without triggering FIRPTA. In 2004, Congress created a safe harbor rule that permits foreign investors to hold up to 5 percent of a publicly traded REIT without imposing FIRPTA’s discriminatory tax rules. The bill would increase the ownership safe harbor threshold from 5 to 10 percent. The House quickly followed suit in July, introducing the same proposed legislation as H.R. 2870. Both bills were referred to committee, where they have remained ever since.

Dan Fasulo of Real Capital Analytics called these tax issues “a nightmare,” adding that “we have a totally antiquated system, a double taxation program.” Without FIRPTA burdens, he noted, “there would be significantly higher investment in real estate.” 

Why the U.S. is Attractive: Stability, Security, Capital Appreciation

Despite tax burdens, the U.S. remains the most stable and secure country for foreign investment by a wide margin over the second most popular country, Germany — the widest margin since 2006. That was one of the findings of the 22nd annual survey of the 200 members of the Association of Foreign Investors in Real Estate (AFIRE). Member firms representing 21 countries have an estimated $2 trillion or more in real estate assets under management globally. The survey was conducted in the fourth quarter of 2013 by the James A. Graaskamp Center for Real Estate at the University of Wisconsin School of Business.

table showing the 1014 AFIRE U.S. investment snapshot

Among the findings:

  • The U.S. remains the country providing the best opportunity for capital appreciation, by a 26 percent margin over second-ranked Spain.
  • The U.S. leads the rankings for planned real estate acquisitions in 2014, with 48 percent of respondents projecting a modest increase in their U.S. portfolio size and 20 percent projecting a major increase. No respondents projected a major net decrease.
  • Investors are extremely positive about the direction of the U.S. real estate market. When asked how their perspective on the market had changed since the beginning of 2013, 65 percent said it had remained the same while 30 percent said it was more optimistic.
  • Significantly, 66 percent of respondents said that they supported increased investment beyond the prime U.S. gateway markets.
  • See the table above for several “top five” lists from the 2014 AFIRE survey results.

More FIRPTA Facts

The Foreign Investment in Real Property Tax Act (FIRPTA) was enacted in 1980 to combat perceived unfair advantages for foreign investors in U.S. real estate. It imposes significant taxes on dispositions of U.S. real property interests. One strategy that a non-U.S. real estate investor may employ to avoid this tax is to hold its U.S. real estate investment in a private REIT. Then, when it wants to sell, it is able to sell the interests in the REIT rather than the underlying real estate. If the REIT qualifies as a domestically controlled REIT or if the REIT is non-controlled with respect to foreign government investors (such as certain sovereign wealth funds), the gain on the sale of the REIT allocable to the foreign investor should be free of U.S. tax under FIRPTA. In addition, depending on the availability of tax treaties and/or IRS Code Section 892, any operating income passed through such a REIT as ordinary dividends may qualify for favorable withholding rates, sometimes as low as zero, according to John Sullivan, partner and chairman of DLA Piper’s Boston real estate group.