But the boom that created more than $30 trillion in value in developed countries between 2000 and 2005, according to an estimate last summer by The Economist, is showing signs of age, especially in the U.S. Those who believe the end of a speculative run up is in sight point to the current lull in sales of high-end properties and real estate agents’ growing inventories. But others believe that the market remains healthy, noting that the number of new housing starts continues to climb and properties priced under $1 million still sell quickly.

The sentiment of private investors toward real estate remains strong. However, while aggregate figures are difficult to find, private bankers and real estate investment specialists say that many wealthy families are looking to diversify their real estate portfolios by including overseas assets, both as a way to obtain exposure to fast-growing markets and as a hedge against the possibility of a downturn in the U.S. They are seeking out new real estate investment trust (REIT) markets, private equity—style real estate funds and syndicated, bespoke property investments.

"A lot of American investors are looking to disproportionately up-weight ex-America real estate, and that’s really gathered momentum over the past year," notes Peter Hobbs, London-based global head of real estate and infrastructure research with Deutsche Bank. The questions of how and where to invest depend on the individual’s liquidity preferences, return expectations and risk tolerance.

TOP VIEW:  Concerns about the U.S. housing market have prompted many wealthy investors to consider diversifying their real estate portfolios by including exposures to fast-growing countries overseas. Both developed and emerging economies have established regulatory frameworks to support real estate investment trusts, one of the most liquid vehicles for taking exposure to property markets. But those with longer investment time horizons may want to take a more direct approach, investing directly in syndicated property acquisitions or through private equity funds that specialize in overseas real estate.

The principle factor that distinguishes among the various options for investing in overseas property is liquidity. At the very illiquid end of the spectrum are private equity vehicles specializing in real estate. "That’s the least liquid form of investment because you have no control at all over the management or sale of your asset," says Willie Gething, London-based global head of real estate at HSBC Private Bank.

Syndications of private properties by private banks are also extremely illiquid. In these transactions, a bank arranges and underwrites the purchase of one or more buildings, and then syndicates the exposure among its clients, while typically charging underwriting and arranging fees. Investor demand for these types of deals–which leverage the bank’s expertise in the overseas property market–is growing strongly, Gething says, adding, "These are less liquid than buying your own building because you can only sell when the syndicate wants to sell it."

Buying your own commercial or residential property is clearly more liquid, although only for those with market-specific expertise, time to invest and a healthy appetite for risk. Further on toward the more-liquid end of the spectrum are unlisted funds, which may offer the opportunity to exit on a quarterly basis, and REITs, which can be traded every day, Gething notes.

The REIT Approach
The liquidity of REITs–securities that trade like stocks and are backed by pools of property investments–makes them by far the most popular tool for the nonspecialist real estate investor seeking exposures overseas. Many nations have established regulatory frameworks for REITs in recent years, giving investors easy access to their property markets. (See "The World at a Glance," page 64.) "There are at least 20 jurisdictions that have enacted REIT legislation in the past few years, and there are a number that are looking at it," says Stephen Blank, senior resident fellow at the Urban Land Institute, a property research organization in Washington.

While REITs obviate the need for investors to wrestle with analytically intractable and illiquid individual properties, they have several drawbacks. One is investors’ lack of control over the REIT investment portfolio. REIT managers compensated on the basis of their fund’s returns may flock to the top-performing property markets, giving their investors, perhaps without their knowledge, a dangerous concentration of exposure to a handful of countries. "When these REITs do get set up in Europe and other emerging economies in the near future, we are expecting a lot of the money to come here to the U.S.," explains Dan Fasulo, director of the market analysis group at Real Capital Analytics, a New York firm that tracks the commercial real estate market. "At the end of the day, a British REIT could end up having 50 percent in U.S.-based properties," he warns.

Another significant drawback stems from the fact that REITs are equity stakes in portfolios, not the portfolios themselves, and so are subject to the vicissitudes of the equity markets. Investors attracted to real estate because of its low correlation with traded equity, cash and fixed-income investments may be disappointed to find that technical market factors (essentially, supply and demand imbalances and broad market up- and downdrafts) impinge on the daily values of REITs as much as any tradable stock. "Investors need to be aware that REITs are far more volatile than their underlying assets," notes Iain Reid, chief executive of property investment company Protego Real Estate Investors in London. (Click images to enlarge)

"A very small proportion of the total stock market is invested in REITs, and so they can get wagged by the broader investment market on occasion," agrees Deutsche Bank’s Hobbs. However, he adds that REITs differ enough from standard equities in their fundamentals and asset characteristics to make their correlation to the broader market relatively low, at least for the moment.

Analysts at Ibbotson Associates, a Chicago capital markets research firm, found that the correlation between U.S. REITs and small-cap stocks in 2004 was around 0.26 (a correlation of one indicates that the two markets move in lockstep; a figure of zero indicates they are completely unrelated). However, the correlation between the two asset classes was as high as 0.9 in the late ’80s.

INTERNATIONAL ALTERNATIVES
VEHICLE		PROS	CONS	RETURNS
REITs		• Very liquid. • Low correlation with individual equities. • Low fees. • Market pricing	• Significant correlation with broad equity markets. • Equity market volatility.	• Global average outperformed equities by a factor of five since 2001.
Private Equity Property Funds		•Management by pro-fessionals with signifi-cant local market knowledge. • Reasonably liquid (lock-ups of 1-2 years).	• Annual management fees of 1-3 percentage points. • Asset valuations are not always transparent.	• Varies depending on quality of manager; in high-growth markets, competent managers may see 15-30 percent annual returns, though with significant market risk.
Syndicated, Bespoke Transactions		• Potential for very high returns.	• Illiquid (must wait for entire syndicate to agree to sell). • Fees are not often transparent. • Lack of diversification leaves investors with significant market risk.	• Varies depending on market and competence of manager or lead investor.
Direct Investment		• No intermediary to pay. • Potential for very high returns.	• Major commitment of time and effort. • Complete exposure to property market risk.	• Varies depending on market and competence of investor.
Derivatives-based Structured Products		• Potentially liquid market with transparent market valuations of underlying asset portfolios.	• Nascent market, concentrated on European assets. • Fees not transparent. • Complexity risk.	• Returns on existing products (around 6 percent) are not spectacular.

REIT investors are also dismayed to find that technical factors cause the market prices to diverge from the actual values of their real estate assets. In the last several years, U.S. REITs have traded in a range from a 25 percent discount to their net-asset value to a 25 percent premium, depending on investor sentiment, Reid says. However, since REITs tend to throw off bondlike cash flows, they tend to be less volatile than the broader equity markets.

REIT backers also tout the level of price disclosure and transparency the instruments bring to the property market. In their absence, the market would suffer from the same lack of portfolio transparency and performance data that dogs other alternative asset classes. "As publicly traded companies, [U.S. REITs] are required by regulatory agencies to file standardized financial reports and to follow generally accepted accounting principles," says Michael Grupe, executive vice president of research and investor outreach for the National Association of Real Estate Investment Trusts, a trade group in Washington. They are also scrutinized by investment analysts. REIT markets in other developed economies have similar disclosure requirements, and investors can expect comparable regulatory and analyst scrutiny. However, investors in emerging-market REITs may have to settle for less.

The Direct Method
The diversified portfolios backing REITs reduce risk, but also dampen returns. Investors with higher risk tolerances and access to outstanding real estate investment expertise may prefer to shoulder bigger risks in the pursuit of making outsized returns.

Peter Smedvig, the patriarch of the Norwegian oil drilling family, set up his own private equity firm, Smedvig Capital, in 1996 to invest his family’s money. To date, the business has committed more than $250 million to over 50 investments, and is in the process of partnering with Protego Real Estate Investors to set up a fund that will invest in properties throughout Europe.

John Hewett, Smedvig Capital’s chief executive and cofounder, says the crucial factor is finding best-in-class property managers. "Here, it’s about being led by the right individuals rather than being led by the right product," he says. While Smedvig has avoided emerging-market property investments to date, Hewett believes the firm will expand in that direction once it finds the appropriate expertise. "That is something that we are starting to take a look at with third-party managers," he says.

Setting up a firm to pursue property investments makes sense only for those with significant family wealth, like the Smedvigs. But there are a host of third-party private equity outfits pursuing international property investments. One is McKinley Reserve, a specialist in emerging market developments, based in Hilbert, Wis. McKinley’s subsidiaries develop major property initiatives, often in conjunction with host governments. Todd Thiel, its chief executive, says McKinley is working on developments in Jamaica and Dubai. McKinley aims to provide investors annual returns of more than 20 percent, Thiel says. "You don’t get those kinds of returns without stepping into a world that’s a little foggy, but we like to think we have the ability to mitigate that risk," he says.

"You don’t get those kinds of returns without stepping into a world that’s a little foggy."   –Todd Thiel

Those seeking vehicles with more liquidity than traditional private equity firms, but who want access to the best fund managers, may consider unlisted funds. "Someone with an investment portfolio in the hundreds of millions of dollars will have the option of investing in some of the funds managed by large firms like Goldman Sachs or Morgan Stanley," Blank says.

Synthetic Strategies
The REIT market is currently the only venue for investors seeking to gain liquid exposure to property markets on a global basis, but this could change if the nascent property derivatives market gets off the ground. In the U.S., the Chicago Mercantile Exchange plans to launch the first residential housing futures and options this quarter. The contracts will reference a handful of regional U.S. indices; if they succeed, most expect the exchange to offer contracts referencing foreign indices as well.

Meanwhile, a small but significant over-the-counter property derivatives market has emerged in Europe. It allows professional investors to enter into agreements with investment banks to pay a fixed or floating rate of interest in return for the performance of their chosen property index. UK data company Investment Property Databank (IPD) offers a number of European property indices on which these deals are based.

If you have a sophisticated private equity manager that has a good track record, then you’re more apt to go into the international funds.   –Roland Stephenson

Investment banks are also offering structured notes that pay investors the return on a given IPD index. Last year, for example, Barclays Capital teamed up with Protego Real Estate Investors to launch a series of Property Index Certificates. The investments are listed on the London Stock Exchange and pay returns based on IPD’s UK annual index, comprised of retail, office
and industrial property. However, the performance of this instrument has been lackluster. Last year, it returned a little more than 5 percent, after fees of about 15 basis points.

The main driver for these instruments is the desire to give investors pure-play exposure to the international property markets, without the technical-factor contamination and volatility that mar REITs. Their backers hope these instruments will eventually better reflect the real promise–and returns–of a diversified global real estate portfolio, without being submerged by fees or bedeviled by transparency issues.

John Ferry, based in Edinburgh, UK, is a senior correspondent for Worth.

Art by John Webber.

Additional Information
 The Private Advantage
 The World at a Glance