By Jahn S. Brodwin and Eun Oh, FTI Consulting Inc.
South Korean investors (largely, institutional investors) had consistently been increasing their equity investment in U.S. real estate up through 2016.
However, the real estate investment landscape is changing for South Korean investors in several ways that may signal a shift in their continued interest in this market.
Here are some issues facing South Korean real estate investors in the States and the trends that are emerging because of them.
Real estate prices are driving a move out of equity into senior and mezzanine loans. South Korean investors believe that U.S. real estate prices have risen to near-peak levels which bring concerns of the risk that values may drop.
This is causing investors to reconsider continuing to invest in equity positions and transition into senior and mezzanine loans.
A traditionally more cautious investor population, they are reluctant to add to or renew equity exposure to U.S. real estate, especially in light of the lessons learned in the 2008 financial crisis.
Rather than be in the common equity position if and when property values drop, they are seeking safety over returns, with mezzanine investments with loan-to-value (LTV) ratios between 50 and 70 percent. Protecting the principal is taking precedence over improving profits.
Senior loan investment becomes more attractive for South Korean investors. Due to growing commercial loan portfolios in a limited domestic real estate market, South Korean investment managers are looking abroad to fill their loan portfolio mandates.
Compared to other parts of the world, the U.S. debt market has become attractive to them for several reasons:
Traditionally, the interest rate in South Korea was higher than in the US, however that spread is narrowing.
The Fed recently increased the Fed Funds Rate, with the prospect of continued increases. In South Korea, increasing the rates will be tough to accomplish given the country’s domestic household debt issues. If the rates in the U.S. continue to increase while South Korean rates remain stable, the interest spread will likely narrow even further.
Europe’s interest rate environment is near zero, making the U.S. more attractive in comparison.
Life Insurance Companies favor loans over equity. South Korea’s two major investment capital sources are life insurance companies and pension funds. Unlike pension funds, insurance companies must meet risk-based capital requirements, which are also driving a move toward lending rather than equity investing.
As the “equity” designation receives a higher risk weight than a “loan” designation, equity exposure becomes a burden for investors, especially when the yield spread over mezzanine loans is not sufficiently large enough to warrant the added risk and compliance issues.
Future real estate trends for South Korean investors
Given the aforementioned factors, the U.S. real estate market has shifted for many South Korean investors going forward.
Property values may not hold up. If interest rates continue to increase without substantial rent increases, cap rates will also increase and property values will adjust downward.
Thus South Korean investors are shifting towards lending to reduce exposure.
Strong USD works against hedgers. South Korean investors typically hedge currency exposure, with currency swaps being the most popular form of hedging. In the past few years, the swap market was favorable to the South Korean won (KRW) against the U.S. dollar (USD); South Koreans swapping KRW for USD would gain small additional return. However, the strong U.S. dollar is now reversing this dynamic: hedging USD exposure recently has been a net loss to South Koreans, who must now pay the counterparty, which reduces net returns.
Recent FIRPTA rule changes do not help. The changes in FIRPTA rules have reduced the capital gains tax withholding rate for foreign investors to match that of U.S. domestic investors. Although a plus for South Korean investors, this is not a deciding factor regarding real estate investments, since many Korean investors (especially life insurance companies) focus on current yield over long term appreciation.
The Europe issue
For those South Korean investors who want to continue foreign real estate equity exposure, Europe will be more attractive than the US in 2017 for two main reasons:
With the near-zero interest rate of many European countries, typical leverage can increase the equity return by 3 to 4 percent. Even with tax leakage from complex cross-border structuring, the currency hedge can usually make up for the leakage, enabling South Koreans to expatriate an acceptable risk adjusted return back to South Korea.
However, the biggest challenge that South Korean investors face in Europe is that there is not enough product large enough to justify going through the complexity and challenges of a foreign transaction.
South Korean investors have traditionally been more conservative than other foreign and domestic investors, trying to minimize risk exposure.
The move away from common equity investments into senior or mezzanine loans is a way to continue investing in U.S. real estate assets and enjoy the benefits brought about by the stable market fundamentals and the unmatched liquidity of US commercial real estate.
Jahn S. Brodwin is a senior managing director and Eun Oh is a senior director in the real estate and infrastructure practice at FTI Consulting Inc. They may be contacted at [email protected] and [email protected], respectively. Views expressed herein are those of the authors and do not necessarily reflect the views of FTI Consulting and its other professionals.