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STATE CAPITAL

SOVEREIGN WEALTH FUNDS ARE GETTING INVOLVED IN INTERNATIONAL RETAIL REAL ESTATE

By Curt Hazlett

Until last year, sovereign wealth funds had made relatively few headlines. These little-known funds, run by the governments of some of the world's richest exporting nations, usually moved with little publicity as they invested the mountains of dollars and euros they had amassed from sales of their oil and manufactured goods.

Then came the subprime crisis and a series of high-profile investments that made sovereign wealth funds the talk of the financial world.

First, in November the Abu Dhabi Investment Authority paid $7.5 billion for a 4.9 percent stake in Citigroup. Two months later the Government of Singapore Investment Corp. bought 4 percent of the same company for $6.9 billion. On Dec. 19 China Investment Corp. bought a $5 billion share of Morgan Stanley, and on Christmas Eve Singapore's Temasek Holdings took a stake in Merrill Lynch that could run as high as $5 billion.

Analysts said the funds were taking advantage of fire-sale equity prices created by the credit crunch and a faltering U.S. economy. And it appears there is plenty more buying to come, they say. With estimated assets of some $2.5 trillion, sovereign wealth funds are aggressively seeking investments that will yield above-average returns as they seek to diversify their huge portfolios out of such traditional holdings as U.S. Treasuries.

Where the funds turn next is of more than academic interest to many sectors of the world economy, including retail real estate. Indeed, analysts say that as REIT valuations fall and capital becomes more constrained, sovereign wealth funds may well see a chance to profit by investing in retail development in some form or another.

“I think we're on the cusp of some very interesting times ahead,” said Guy Langford, the real estate and hospitality leader for Deloitte & Touche's mergers and acquisitions services practice. “The sovereign wealth funds are a big new pool of capital. I think soon enough you'll start seeing transactions. They are growing in size, they are spending more, and they have a mandated allocation of part of their funds toward real estate, predominately commercial.”

There are signs, in fact, that a movement toward retail real estate is already under way. In December The Related Cos., developer of New York City's Time Warner Center, announced that it had received a total of about $1 billion in debt financing from three Middle Eastern investors: an affiliate of the Abu Dhabi Mubadala Development Co. investment agency, Saudi Arabia's family-owned Olayan Group and an unidentified sovereign wealth fund. Goldman Sachs and MSD Capital, the money-management firm of Dell founder Michael Dell, bought stakes too, about $400 million in total.

Related said each of the parties will invest in future developments, an arrangement it said will lend it more flexibility and allow additional growth. “As the industry continues to move toward bigger, more complicated development transactions, these new financial partnerships ensure that Related has a ready and deep source of capital to take advantage of virtually any opportunity, regardless of size or scale,” Stephen M. Ross, Related's chairman, said at the time.

A few weeks after that announcement, the Government of Singapore Investment Corp., or GIC, announced that it had built up a stake of just over 3 percent in British Land, the U.K. REIT whose portfolio totals about $33 billion, more than half of which is in retail properties. GIC was already an active investor in office REITs around the world.

“All of a sudden this has become topical, although at this point what will happen next is conjecture,” said Bernard J. Haddigan, senior vice president and managing director of Marcus & Millichap's National Retail Group. Haddigan says there are two likely circumstances in which sovereign wealth funds might invest extensively in retail real estate. The first scenario, which he called “defensive,” would probably involve a REIT or developer needing “help to avoid a problem” — in short, a bailout. The second would involve strategic alliances in which funds provide capital and “align with a professional entity that clearly has a track record of performance.”

Haddigan says most retail REITs would be more likely to fall into the second group. Despite sharp declines in their net asset values, “it seems to me that most of the major retail owners are pretty well capitalized, so I don't think they would need large infusions,” he said.

At the other extreme, he and others point to Australia's Centro Properties Group, the fifth-largest owner of shopping centers in the U.S. Centro announced in December that it was having difficulty refinancing its debts. “Centro is going to be a very interesting one, in that there will be many investors looking either to pick up individual assets or even the broader business,” said Langford. “Those assets are now at such a deep discount to NAV that a seasoned real estate investor could probably extract immediate value from them.”

Langford says he believes that sovereign funds are likely to be passive investors in retail real estate rather than active participants in development projects. “These funds have a lot of money, but they don't have pools of investment professionals with a lot of deep industry expertise and the ability to run a deal,” Langford said. “So one scenario that's viable is for them to team up with private equity during a period in which private equity is finding it tough to finance deals. Another is seeing them team up with a capital-constrained strategic player in joint venture arrangements that would facilitate future development.”

Increased investment on the part of these funds would not come without scrutiny. Their purchases of stakes in U.S. financial companies has already prompted debate about how much foreign ownership is acceptable, and it seems likely that discussions will grow more heated if the investment trend grows.

That said, Lawrence Yun, chief economist of the National Association of Realtors, says he believes that increased investment is positive for commercial real estate in general, because it will effectively set a floor for valuations. “It just means there will be additional demand for properties,” Yun said. “They will become an increasingly important player, perhaps substantially important.”

Whichever investment course the funds choose, it is clear that they are not going away. In an analysis released last year, Morgan Stanley predicted that sovereign wealth funds could total $12 trillion by 2015.

Haddigan, for one, sees their potential impact as part of the long-term shift of the real estate business. “Twenty-five years ago it was really a local business,” Haddigan said. “Today it has become a national business.” The sovereign wealth funds “raise the question of whether we are now going to jump over and become more of an international business.”

And in time, he said, “there will be a lot of capital coming in that will drive value for U.S. investors.”