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New investment strategies for European groups.

While 1992 will show a general decline in overall vacancy rates and a noticeable improvement of the volume of investment activities, it will still be considerably different from the anticipated expectations of the industry. High expectations have fueled high disappointment, which have caused European investor groups - especially Germans-to reexamine their investment strategies.

In 1990, when the domestic real estate market went into paralysis, European investor groups had begun their analysis. In 1991, when domestic investors were in a denial phase, European investors recorded a few cautious transactions. Although that in 1992 a general acceptance for more transactions was prevailing, the anticipated benchmark for European investments could not be reached. Particularly Germans, that our firm is dealing with, had aleady established their "game plan" in 1991, by focusing not only on bottom-up but also on top-down portfolio analysis. This new strategy still did not achieve their acquisition goals. Their intents were to invest more money then they actually did. Even though they were familiar with a tightened financial and regulatory environment, because of their experience with the one in the early 80's caused by the German "S&L Disaster" (involving the "Reiffeisen Bank"), our European investor groups were not able to take full advantage of prices that might never again be this severely discounted.

The main reason for this "partial" investment success is the disparity between seller motivation and buyer valuation methods. In a market where the word "appreciation" has become exotic and where residual value is nominal, buyers have adopted a more conservative basis of valuation, resulting in values far below the seller's expectations. This is particularly true since European investors apply very conservative discount rates and capitalization rates to current cash flow. Their allocation to real estate is a specifically yield driven decision. With actual yields of 9 percent p.a. for a riskless short-term deposit in any German bank, it is quite understandable that new acquisitions -regardless of the geographical area -with less than 11 percent (on residential) or 15 percent (on commercial) cash on cash returns, are not even considered. In addition these investments must have at least a 70 percent (residential) or 85 percent (commercial) occupancy.

Another reason why the European Investors have been more cautious than anticipated is because of the general climate of the market that makes one deal with "distressed property portfolios". With many institutions and the RTC unloading real estate in mass quantity, these deals require an intense screening and a very costly due diligence process. Together with the countries leading portfolio analysis firm, Rye, New York-based Real Estate Evaluation Services, Inc., our firm has looked at a number of portfolios in the past 12 months. As most buyers observed, we found these institutions to have an unrealistic, or regulatory-constrained, view of real estate values. Also most of these portfolios contained some properties that are never again going to be viable. Sometimes these properties were so bad that their negative value would have impacted the rest of the portfolio.

In addition to the above mentioned structuring requirements, all intended acquisition require highly complicated financial engineering proceedings. This is due in part to the financial environment in Europe, and because sales prices are continuously dictated by balance sheet concerns and government regulators. Furthermore this environment is continuously impacting the determination of values. Appraisers already are having a hard time to establish evaluations through the comparative sales approach. They don't know whether the sales price was the result of a forced sale or was actually fair market value.

Because of the above mentioned circumstances, the approach for a revision of the European's investment strategies turned out to be trifold:

1. The 1993 Asset Mix: Since values of commercial real estate began plunging in late 1989, they have fallen steeply at an average of about 30 percent throughout the country. With this market still plagued by an overbuilding overhang and banking overregulation, the European investors will be favorably in-clined towards residential real property. Our clients have set their portfolio benchmark to 80 percent for high-end multi-family projects. Of their committed funds, 10 percent will be allocated towards commercial real estate, primarily office buildings in major metro market areas with a strong and credit-worthy tenancy.

Also in the hospitality industry our investors are trying to improve their returns. Our firm's recent figures indicate that at least 60 percent of US. hotels are still losing money, and overall hotel values have dropped 37 percent in the last five years. Low prices and property values in combination with some existing financing and a growing demand despite flat supply, make it an ideal time for hotel investors that are about to enter the market. For investors that are already actively involved in the market, as Europeans have been for many years already, the new slogan is: "Improving returns by looking for alternatives to traditional brands." In order to do so, our firm's investor groups have allocated 7 percent of their entrusted finances towards that goal.

The remaining 3 percent will be assigned for management improvement issues and renovation, modernization and extension or environmental matters within their existing U.S. portfolio.

2. The 1993 TargetMarkets: As expected, the southern California real estate market for example will not make anybody's buy list, as its market has yet to hit bottom. But in some areas such as Colorado and Texas, where prices have started to turn up, some prudent investments seem to be justified within the near future.

On the other hand, the multi-family market in Colorado Springs for instance, is going to be of great development interest because of it's dried up inventory.

And even the Northeast market will remain on the Europeans buy list. Although this market seems just about to scrape bottom, and investments still take some courage, cities like New York, and interestingly enough Washington, appear to be of further interest for our European equity sources.

3. The "Strategic Alliance" With Local Market Players: Given our client's set allocation target, asset mix and their money ready to go, an alternative to the given European-Buyer's Environment is to be found in a "Strategic Alliance" where money meets the entrepreneur. Future investment opportunities in residential as well as other commercial products and for development as well as existing assets, call for a partnership between European investor groups and a carefully selected local developer / owner / manager.

This selection process, which our firm is currently involved in, is quite extensive. The identification of a potential "Joint Venture Partner" is only the first and easy step in this large-scale undertaking. Because of the actual environment in which most of the developers / owners are cash short and asset long, they lend themselves easily to the intended approach and it is them, making the first contact with our firm. From there on we have to take over and are trying to find out if they are willing to go the "long and winding road" of the discovery process and are willing to disclose to the equity partner the rest of their empire. Once the "Joint Venture Partner" has been accepted by our investor committee, the advantages of a common going-forward are imminent:

I. A developer / owner can bring the "owner's perspective" to an assignment. Given that these European investors are so-called "absentee owners" we found it not enough to have only a very good management taking care of the day-to-day operational and functional control of the asset. A developer / owner may be more sensitive to cost savings and relentless in the search for operating efficiencies.

II. From a strategic management and turnaround point of view, the alliance with a developer / owner can outperform the large management firms because of his faster reaction time. Negative property perceptions such as off-center sites at a location without "destinational value" or a poor marketplace image can be counteracted more efficiently. Especially in cases where troubled buildings are to be acquired and revitalized, the appropriate skills and short response time has shown to be beneficial to such projects.

III. The developer / manager-constructing of tenant improvements, leasing, managing the leasing process and even disposition assignments represent only some of a variety of opportunities, that over the holding period will sum up in substantial, value adding activities. And because there is a general understanding that conventional divisions between property operations and asset management have been blurred, the focus is now on key tenant relationships and holding value, not housekeeping standards.

IV. The imminent marketplace presence of a developer / owner will prove to be advantageous. Especially for absentee investors it will represent the edge in their endeavors for future acquisitions. In addition, a more in-depth local knowledge, and "lean and mean" developer approach to property issues will certainly result in a reduction of excessive due diligence procedures and will ease the way towards a better evaluation of the project's feasibility and marketability.

There is no doubt that European investors still consider the United States as their biggest target market because it is further along in the recovery cycle than European markets.The actual climate however, and the abundance of inventory on the market, are making today's real estate decisions more strategic and more complex. Therefore a reevaluation of the European's investment strategies as to the intended asset mix and the envisioned target markets for 1993 was required.

More importantly, there is now a general acceptance on behalf of private and institutional European investor groups for involvements together with recognized local players. In order to implement the intended investment goals and still be able to obtain long-term value enhancements, the combination of an investor group / equity source and a highly qualified developer / owner / management team, with in-depth local market knowledge, seems to be the right approach. Through a strategic alliance with a local developer / owner, whether through a permanent structure like a joint venture or partnership or even on a project-by-project basis, these European investor groups will be able to respond more adequately to the needs of the actual investment environment, turn newly acquired properties around, and create value through performance.
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Title Annotation:European investors become more conservative in approach to New York, New York real estate
Publication:Real Estate Weekly
Date:Feb 17, 1993
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