Real Estate of Mind: Key UK and US Real Estate Insights for GCC Investors in 2023 | King and Spalding
Following our inaugural Real Estate of Mind roundup (see here) of industry trends earlier this year, as 2022 draws to a close, we’ve hit the road again to connect with clients and friends. to Bahrain, Kuwait, the United Arab Emirates and Saudi Arabia to see what 2023 holds for GCC investors investing in international markets.
The article will focus primarily on the UK, with a section on the US, as we are delighted to have had our US partners on the road with us this time around.
Thank you to our customers and friends for their thoughts and valuable advice. We would welcome further comments.
So here’s our second roundup of Real Estate of Mind…
Insight 1: always identify assets
In the last roundup, we highlighted interest in assets such as logistics, industrial, student accommodation and commercial offices. Appetite remains high in these sectors, but we have seen a new area of interest for GCC investors emerge – the build-to-rent sector. These assets are purpose-built rental communities, designed from the ground up for the rental sector, offering security of tenure to tenants as well as professional management services.
The build-to-rent sector (known as “multifamily” in the United States) is a well-established investment sector for GCC investors investing in the United States. Conversely, historically in the UK ownership of property has been essential. As the cliché goes, an Englishman’s home is his castle. However, as real estate becomes more and more expensive to buy and interest rates rise, the concept of ownership is becoming more and more out of reach for most people and this attitude needs to change. Forget castles; rental housing is the only option available to many. There is also a change in the British mentality in terms of flexibility – whether it means not wanting to be tied to a particular job or place or a particular lifestyle. The combination of these factors has paved the way for a large rental market and the growth of the construction for rental sector.
The build-to-let sector is not a new asset class for the UK market, but it is certainly an asset class of increasing interest to our clients and friends at GCC.
Insight 2: Cash is King
Following the introduction of the actual and proposed tax cuts earlier in September, we saw the pound plummet to its lowest level against the US dollar in over 40 years. Although this has affected the confidence of international investors to some extent, there is no doubt that assets are now much cheaper if purchased in US dollars (or currencies pegged to the US dollar). Therefore, there are opportunities for those with cash that can benefit from the dollar exchange rate.
The exchange rate has depreciated property in the UK considerably, and those with cash are looking for opportunistic acquisitions without obtaining bank financing (mainly because these financing costs are currently very high, currently sitting at 6-7 % all in rate for 5 years fixed term). These investors will then seek to refinance themselves as the financial market in the United Kingdom stabilizes.
Insight 3: The price is right, after adjustments
Over the past few months, the general consensus has been that UK property prices cannot continue to rise at current levels. It is believed that inflation, an increase in financing costs and the prospect of a recession will drive down property prices. We’ve heard estimates that such a price reduction is likely to be between 10-20%. Although this is not yet translating into actual transactions, the market is currently experiencing a 5-10% reduction in prices.
Idea 4: Sustainability
Logistics continues to be a favored sector, but the supply and demand issue means that the returns required for GCC investors are not achievable. We discussed last time the development of these logistics assets. This time we heard about the upgrading of existing logistics assets to, firstly, comply with new UK regulations and, secondly, add capital value at the exit against those assets. This is particularly interesting if the investments required to update the relevant asset are minimal and therefore have no impact on overall returns.
GCC investors are aware and focused on the impending UK regulations and the real need to comply with them in the very near future. This is very much in line with the oft-cited popular data that “80% of the buildings that will be around in 2050 have already been built today“.
Insight 5: Debt funds
As mentioned last time, the creation of debt funds to provide both senior debt (mainly in the UK) and mezzanine debt (mainly in the US) to property borrowers continues to be viewed as a real alternative to direct investments in real estate. The importance of obtaining legal and tax advice to navigate the legal, regulatory and tax framework cannot be stressed enough here.
Insight 6: The United States
Finally, a few observations from our US colleagues noting that the majority of GCC investment continues to go into the US real estate market (in terms of actual deal numbers and volumes).
Inflation pushed the Federal Reserve into action, which dramatically raised interest rates in 2022. The magnitude and speed of the increases created price dislocation in the housing market and increased the cost of borrowing. Therefore, some investors are considering alternative strategies in the short to medium term.
There has been a significant slowdown in trading volume, both due to price uncertainty and changes in capital markets. As mortgage debt has become more expensive, buyers’ underwriting does not support previous valuations based on static income and capitalization rates, and therefore buyers are willing to pay less for the same assets. We are seeing prices drop for some properties and offers being re-traded on price, particularly where the due diligence period has not expired.
In addition, rising interest rates have put pressure on homeowners with imminent debt maturities. These owners plan to refinance with conditions that are often much worse than the current credit facility. For some homeowners, rising interest rates have a negative effect on covenants and interest payments for unhedged variable rate loans. These properties are at risk of being overexploited and under water.
Another chilling effect on transaction volume is that lender underwriting standards have tightened and there are fewer lenders in the market than in the first part of the year. This is a double whammy for the property buyer or owner, as the financing available is not only more expensive, but also more difficult to find.
Depending on how interest rates affect liquidity in the US market, there may be buying opportunities for well-positioned investors.
The Committee on Foreign Investment in the United States (CFIUS) has broad review authority over transactions involving non-US investors in US businesses and assets, including real estate. Notably, in February 2020, CFIUS implemented the final regulations of the Foreign Investment Risk Review Modernization Act of 2018 (FIRMMA), which expressly authorizes it to review controlling and non-controlling foreign investments in real estate. Prior to the enactment of FIRRMA, CFIUS could only review a real estate acquisition if it was part of a transaction likely to result in a foreign investor’s control of a US business. CFIUS jurisdiction continues to be expanded and clarified, most recently through an Executive Order issued on September 15, 2022 by President Joe Biden. The bottom line is that CFIUS exercises substantial authority to define and act on national security risks as it deems necessary or appropriate. When investing in the United States, CFIUS counsel should be consulted to understand the latest applicable rules and regulations.
In times of distress, in our experience, the likelihood of disagreements between parties increases, for example between borrowers and lenders and between owners and asset managers. When a business is in trouble, every penny counts and parties will look for every way to save money and increase revenue. Those contracts that were negotiated in good times and put into the draw will now see the light of day. Many precedent-setting court cases have stemmed from a financial crisis, and we expect court cases and litigation in general to increase as we navigate the current economic cycle.
And finally, with the recent appointment of Rushi Sunak as British Prime Minister, all eyes will be on the budget plan due on October 31. Sunak’s first and arguably most important job will be to reassure markets that Britain has a credible economic plan.