What is Up with China? Effect on the Real Estate Deals? News from the Real Estate Front in NYC

My law firm is in NYC handling real estate transactions in the US that originate from counterparties based all over the world.  A bunch of these transactions depend on money coming in from China (debt or equity or other structure).  It used to be there was always a degree of uncertainty about the viability of this capital, but this uncertainty was gradually diminishing as more Chinese players developed stature and reputation in the US.

However, there are some recent events that are hitting US real estate pertaining to the use of Chinese capital.  I cannot say we are a canary in a coal mine, but as a law firm in the thick of deals in NYC and other places in the US, I have seen the following just in the past couple of weeks:

A China law firm that I have been dealing with regularly had a client planning on doing US deals.  We were moving forward together until I received the following email:

“As you may know, recently China is facing to the emerging issues of increasing Chinese capital outflows and devaluation of the RMB.  Therefore, the Chinese government has tightened the regulation policies on out-bound investments in recent days, especially the investments by Chinese [investment funds] in the form of partnership and investments into foreign real estate markets.  This makes it difficult for the client to move forward with their US real estate projects.  They are now under internal discussion and evaluation of the situations so we may have to wait for some time.”

A friend of mine in China who is very connected to the US and the Chinese real estate industries gave me the following quote.  I respect him highly but he did not want attribution.  He said:
“….. the open tap of Chinese money for US real estate was if not shut completely this week then it is now at best left a dripping faucet.  The authorities may backtrack, or not fully implement the announced draconian controls, but the atmosphere has changed beyond recognition.”

A client of mine had its Chinese financial partner drop out of a deal due at the last minute due to the counterparty’s China office overruling the New York Office, which had approved and strongly backed the deal.

There is much more going on as well, including the new Presidential administration, the sharp rise in interest rates, general volatility in the markets due to a possible belief that the up-turn in the US economy is getting long in the tooth, public  statements from companies like Starwood that they are hitting the “pause button” on real estate acquisitions, stalled sales of luxury apartments in New York City, and much more.

As per prior Real Estate Philosopher articles, I do NOT make predictions about the future, except to state with certainty that neither I (nor anyone else) has a crystal ball; however, anecdotally it seems to be true that a fair number of investors in US real estate are indeed pulling back right now.  And the China money spigot slowing to a trickle may have a deleterious effect on pricing, deal flow and other matters pertaining to US real estate transactions.

Of course, one party’s troubles is often another party’s opportunity; accordingly, potentially all of this may spell a chance to make advantageous US real estate investments for opportunistic real estate players.  That is not of course a formal prediction but seems to be getting more likely every day.

One last point I will make about Chinese money is to distinguish between money that is “on-shore” (in mainland China) and money that is “off-shore” (outside of mainland China).  If the money is “on-shore” that likely means that it will be a lot harder to have it show up in a US real estate deal.  If it is already “off-shore” that likely means it will be a lot easier.  I don’t have the skillset to be able to dig much deeper here, but the foregoing is generally an accurate statement.  So, if you are a US player working with the Chinese right now, this should be a threshold question that you might use to gauge the likelihood of the investment succeeding.

Finally, if you have anecdotes you would like to share, I would certainly appreciate learning as much as possible.

Finally, finally, here are links to some recent articles on this subject:

A Tectonic Shift is Happening in the Real Estate World

As you may have heard by now, real estate is set to become a separate asset class on the Global Industry Classification Standard (GICS) and the S&P 500, separating it from the Financials Sector.  Notably mortgage REIT’s will be left behind in the Financials Sector under a newly created sub-industry group called…you guessed it…Mortgage REIT’s.

What are the implications of this?  I think they are dramatic and possibly one of the biggest changes to the real estate investment world since the internet popped up twenty some-odd years ago and made information freely available.

There are a bunch of articles already written on this subject, and almost all of them deal with the effect on REIT’s themselves; however, here I am going to give my thoughts on the effect of this transition on the non-REIT portion of the real estate world.

For background, please click here for some of the articles (that pertain to REIT’s).  These articles make some possibly (obvious?) points as follows:

They predict that a lot more money will now flow into REIT’s.  One of the articles points out that right now the total market cap of REIT’s is about 0B and that another 0B additional dollars will now flow into real estate due to increased real estate investment targets by major investors, such as Norway’s 0B Government Pension Fund.  I suspect there is no real way to quantify this and the number is plucked from thin air, but it does seem like “a lot” more money will indeed flow into REIT’s.

They also predict that REIT’s will become a “have to own sector” for appropriately diversified investors and, logically, REIT stocks will go up.  I will not touch that prediction.

And one of the articles states that it “will increase the visibility of real estate as a distinct asset class and encourage investors, their advisors and managers to more actively consider real estate – especially REIT’s – when developing investment policies and portfolios [and this will] likely lead to the creation of new investment products, such as active and passive mutual funds and exchange traded funds.  Advisors and managers will have more real estate fund options to recommend to their clients, likely facilitating positive capital flows into listed real estate equities.”

Here are my thoughts on the effect of this transition on the non-REIT portion of the real estate world.

First – I hate to be obvious myself; however, I do think that overall this change means that a lot more money will flow into the non-REIT portion of the real estate world.  Real estate will be considered its own asset class and investors of many different kinds will take it more seriously.  Investment professionals will steer their clients into these investments to a greater degree.

Second – I think this will to some extent move real estate closer to a place where, for more parties, real estate assets are thought of by many like “widgets” that happen to be in the general category of “real estate”.  This is because many, new, investors will want some vague concept of “real estate” in their portfolios, without knowing (or even likely caring much) what the underlying real estate really is.  In other words, much real estate will be invested in by parties that have no idea exactly what they are investing in.  I will call these parties, who are buying real estate for diversification of investment reasons, “Diversification Purchasers”.  To be clear here, I do not think Diversification Purchasers are necessarily “dumb money”; instead, they are potentially very intelligent parties who may recognize that they have no real ability to analyze real estate assets and, accordingly, will want a diversified portfolio that includes real estate in it without specificity as to the exact nature of the of the assets themselves.

Third – I suspect that this latest development will “never, ever” change.  Things like this (i.e. real estate now being a separate asset class) never, ever reverse course, so my sense is that this change is here to stay forever…

Fourth – my suspicion is that a lot of money will slosh towards the (perceived) safest part of the capital stack where the theme is (perceived) safety in yields, as this will be the easiest to sell to the Diversification Purchasers.  Returns for core and other income-producing real estate will likely fall if this is the case.  And, since “core” often consists of assets priced for perfection, there is a good shot that Diversification Purchasers will lose money from time to time, even when they think they are buying the safest alternatives.

Fifth – I suspect that this change in asset class for real estate is brought on by interest rates staying so low for so long that real estate, with higher yields, looks better and better by comparison.  Sometimes changes like these are made at exactly the “wrong” time in the market, so I wonder whether this is the bell ringing that interest rates are finally about to go up?  But I don’t dare predict this.  Many people much smarter than me have predicted that interest rates will go up (for sure) over the past eight years and they may be smart, but so far they have been wrong in that prediction.

Sixth – since there will likely be an increase in the number of parties buying real estate without really knowing what they are buying (i.e., the Diversification Purchasers) – and possibly inadvertently paying top dollar for it for diversification – it will make a lot of sense for “players” in the real estate industry to buy or develop real estate and package it for sales to these Diversification Purchasers.  I suspect that this is a good real estate strategy that will become better and better over time.  Sort of an enhancement on “Build to Core,” it will essentially be “Build to Diversification Purchasers”.

Seventh – it will be plain old dumb to compete with Diversification Purchasers.  They simply will have a different motivation to purchase than a sophisticated investor in the real estate world.  Accordingly, if you have a fund that is buying core assets – or assets close-to-core – it will get harder and harder to acquire assets of this nature at prices that are within logical and traditional underwriting, since there will be more and more Diversification Purchasers competing for it.  So, I suggest – don’t compete with the Diversification Purchasers – sell to them or manage their money in a public or private vehicle.  I wonder here whether possibly public non-traded REIT’s will come into greater vogue.

Eighth – it will be more and more important to be “the guy who creates value”, as I pointed out in my earlier articles in The Real Estate Philosopher.  If you can create value, then the products you create will be in more demand than ever from Diversification Purchasers.  However – I think, a bit sadly – the pressure will be on you to “create” real estate assets that fit into the “checked boxes” of the Diversification Purchasers, so innovation may become harder to justify.

Ninth – the companies which are advising the Diversification Purchasers will do better and better.  Diversification Purchasers will logically gravitate toward the biggest and most well-regarded advisors and, in turn, those advisors will be able to increase their market share.  If you are starting a career, this will likely be a good place to get a job.

Tenth – I suspect there will be more and more deals that are huge in size, as more money-manager-type “elephants” that are really financial services providers wade into the real estate area.  They will need to have very large portfolios to provide necessary diversification to their investors.  They will probably not want to acquire these portfolios piece-by-piece, but instead will want to gain control of them in one fell swoop.

Eleventh – I suspect that the regulatory changes sweeping the real estate world will increase significantly.  Over time, as real estate looks more and more like a part of the financial services sector, it will become more and more regulated like the financial services sector.  This will be a good thing for lawyers, compliance officers and other parties who work in this part of the industry.

Twelfth – “average performance” will become the goal for most real estate money managers catering to Diversification Purchasers.  Since the Diversification Purchasers are not (almost by definition) looking to outperform, they will want a diversified portfolio that includes an “average-performing” class of real estate.

These are my thoughts. Of course, I likely will be right in some of them and wrong in others; however, one thing is for sure, and that is that as real estate becomes a separate asset class there will be a significant impact on the real estate world (both the REIT and non-REIT portions).  All of us – lawyers, as well businesspersons – would be well advised to be perceptive about how this will affect our businesses so that we will benefit from the changes afoot, rather than the converse.

Additional Links:

Real Estate Takes Its Place as the Fourth Asset Class

GICS Classification of Real Estate  

Real Estate to Receive Dedicated Sector Classification

Everything You Need to Know About the New Real Estate Sector Coming to the Global Market In September 

Real Estate Strikers Out on Its Own in the Stock Indexes 

Real Estate to Be a Sector on Its Own

Uniqueness – The Bane of Fundraising

I have seen this time and again. Someone uses their brainpower to come up with a cutting-edge idea for real estate investment. It is a niche (a “Power Niche” as I call it), or a way of looking at real estate that no one has done before. It seems pretty cool, but the lament is that “investors won’t go for it”, so, alas it is just not viable.

If the fundraiser doesn’t just throw in the towel at this point, the next question is whether the fundraiser should “tweak” the business model (or maybe in other words ruin the cool and cutting-edge part of it) so it will look like other investments and thereby become appealing to the target investors; or stick to his guns and try to find investors, even though most prospective investors will not be willing to take the plunge. That sounds kind of terrible too – like the sheepherder throwing in the towel and just deciding to follow the sheep.

As an aside, I don’t mean to imply that the investors who reject the new ideas are foolish. They are not dumb at all. Indeed, the prospective investors are smart to avoid the newfangled investment idea for the simple reason that if they all stick together and perform in an “average” manner, they will remain employed and their lives will continue on (probably happily) as they were before. If, however, they take on the risk of the new idea (and all new ideas have enhanced risk as well as enhanced reward), and it goes poorly, they may be out of a job.

I had been noticing and thinking of this irony – or paradox – for years, but then Todd Zenger wrote a really interesting article in The Harvard Business Review called The Uniqueness Challenge, which explains this conundrum in a very readable and understandable manner. He calls it the “Uniqueness Challenge” and that does describe it very well, as it is always a “challenge” to be “unique”.

I note that my law firm took this Uniqueness Challenge by making the determination to be The Pure Play in Real Estate Law®, thereby taking the enormous downside risk of being different (and unique). We “burned the ships” with this strategy and, fortunately, it worked out exceptionally well. At the time we did it, we were very nervous about it, but now looking at where we stand in the marketplace it seems so obvious – what were we worrying about?

So hats off to Mr. Zenger for his article – it is well worth reading.

Now we have this conundrum—this irony—this paradox. The question is how to solve it. Here is my best shot at it:

At the outset, I wouldn’t tweak (i.e. ruin) the business idea to appeal to investors. That is just like the sheepherder throwing in the towel to follow the sheep – and, in this case, even the sheep would (sheepishly) maybe admit privately that they don’t disagree with the strategy – they just don’t want to take a risk where the risk/reward isn’t to their benefit.

I will – very reluctantly – admit that tweaking/ruining the strategy’s novelty might be the optimal short-term economic strategy, and may result in more immediate fund-raising success. But where is the fun in that? What is the point? Where is the break-out upside? It isn’t there. You are just conforming to be like everyone else.

However, I wouldn’t waste a lot of time on a strategy that is doomed to failure either. If you know that the main investor group just can’t invest in your idea, probably for the reasons I outlined above, don’t spend two years with a fruitless private placement memo trying and failing to raise a billion dollar fund that is doomed to failure or, worse yet, that a Blackstone-type party will do itself if they like the idea. Nor would I use a straight-down-the-middle fund-raising advisor either, as such an advisor would advocate you soliciting the mainstream investors who will likely not be able to say “yes” for the reasons outlined above. Overall, the odds are stacked against you and you could waste two or more years of your life being essentially jerked around and come up empty.

What I would do is approach those who are outside the normal channels, i.e. instead of pension funds, insurance companies, endowments, and similar parties, I would look towards high net worth individuals, family offices, and investment funds that make it their bread and butter to seek alternative investments and that are deliberately set up to not follow the herd. There are a lot fewer of these parties, and the way forward will be tortured, like following a narrow bending path up a mountain; however, I think the chances of success are much higher.

As an outgrowth of this strategy, I would also dial down my fund-raising size dramatically. Instead of visions of billion dollar funds dancing in your head, consider a fund of, say, $25,000,000. All you would want is the bare minimum for a “proof of concept” and an amount you can invest quickly to confirm the strategy is doable. Once you have that, it will likely be a very different story when you go back to the mainstream investors. They will likely change from skittish to eager very quickly.

If you follow this strategy, the only thing you can be sure of is that you don’t know what will happen. However, a strategy where you don’t know what will happen is a lot better than a strategy that is likely doomed to failure (as is the straight-down-the-middle strategy), so mathematically, this strategy is optimal. Also, if things go badly, you will spend a lot less time and money failing.

By the way, if “you” mainstream investors are reading this when you are visited with a Uniqueness Challenge, consider giving the guy presenting to you a break. Maybe this is your big chance to stand out from the herd yourself. Maybe this is a time for you to take a chance too…

If you are a reader of The Real Estate Philosopher and have thoughts on this, feel free to email your thoughts to me and maybe I will put them out in the next article as a follow-up piece.

Finally, if you have an outside-the-box idea in the real estate world that perhaps rises to the level of a Uniqueness Challenge, I hope you will give me a call or shoot me an email. There is nothing I like better than trying to figure out how to make unusual, different and unique ideas successful.