In response to the article penned last month in Bisnow by his colleague Peter Fuhrman, titled How Chinese Investors Can Find Long-Term Success In US Real Estate, well-known NY real estate attorney Bruce Stachenfeld has written his take on Chinese investment in the US real estate market.
Bruce has practiced real estate law for more than 30 years and his firm, Duval & Stachenfeld, works all over the capital stack. The following from Bruce includes some insight into his views on the US real estate market and how Chinese investors, and their US counterparts, can best invest in the market for long-term success.
In his article, Peter makes an important comparison about how the Chinese should be wary of buying US real estate at the top of the market and having the same results befall them as the ill-fated Japanese 20 some-odd years ago. As we real estate old-timers will recall, the Japanese bought real estate at the top of a tax-driven overheated real estate market (more on that below), and the ensuing crash in US real estate wiped out the bulk of Japanese investments and contributed to a huge Japanese recession from which arguably Japan has still not fully recovered.
In his article, Peter also mentions the risk Chinese investors will be taken advantage of by unscrupulous real estate brokers and other parties. As an example, he mentions the so-called “China Price,” which is allegedly 33% higher than what a (more savvy?) US purchaser would pay. This is definitely a risk, as foolish foreigners can rush into the market at the top and get taken to the cleaners. But the truth is there’s no more risk to a Chinese investor investing in US real estate than the risks any investor takes when entering a new market in which the investor does not have local knowledge.
I will outline how to mitigate these risks below, but before that, here are some general thoughts.
Is This The Top Of The Market?
There is always a concern in entering any market that one is investing at the top, with only one way to go. However, I do not happen to share that view for a few reasons.
First—real estate is not a uniform asset. A trophy office building in NYC (like the Waldorf Astoria above, purchased by Anbang last year for just shy of $2B) is hardly in the same market as a house in the Midwest. Real estate is an enormous asset class and there is rarely a market top or bottom in all areas at the same time. Chinese investors are investing and/or lending throughout almost all different components of the real estate market. As such, I don’t think it makes sense to assess US real estate as a whole, as being at the top or the bottom or the middle of a market cycle, although, perhaps gateway cities, such as New York, San Francisco and LA, could be seen as peaking since a large portion of foreign money has pushed up prices in these cities.
Second—even for these cities, does anyone have a crystal ball to confirm that we are really at the top of the market, for trophy office buildings in NYC, or any other real estate asset? In my publication—The Real Estate Philosopher—one of my recent articles discusses how no one can time the market and any claim to the contrary should be taken with several grains of salt. I make the point you could easily see NYC—the center of the alleged property bubble according to some investors—double or halve in the next five years. So far the so-called “smart money” called an informal top in the NYC real estate market two or three years ago.
Those parties have been sitting on the sidelines for that time period and missed out on possibly close to a trillion dollars of upside as NYC real estate has continued to soar. Is NYC real estate about to crash? Maybe, but no one can say with certainty what the market will do and market timing is rarely a good long-term investment philosophy. Finally, this decision is not one only Chinese investors make. All investors make their informal decisions about market tops and bottoms (more on this below).
Chinese Investors Are Not Easily Fooled
There are always some people who think foreigners are easily fleeced and sometimes that is true. But this is a whole lot different than being taken advantage of at a flea market in a foreign country, something many have experienced firsthand. I am personally experiencing the Chinese hiring major law firms, teaming up with major US real estate players and negotiating aggressively with their local teammates on critical deal items, such as limiting fees paid to sponsors and requiring these local players to put significant skin in the game so the local players will only benefit if the Chinese—or any non-US—investor benefits.
From my vantage point of numerous transactions, in not a single one have I seen an eager Chinese investor rushing imprudently to invest. Instead, the Chinese are informally known as difficult to lure to the dance, individuals who do a great deal of due diligence and who sometimes pull out of a transaction if it doesn’t meet their requirements. I don’t see any evidence that Chinese investors are easily fooled.
Different investment motivations result in different pricing decisions. If you lived in a country where you knew there was a decent shot the government might confiscate your wealth and you had a great deal of discretionary investment capital, I think you would logically worry about your capital. If you could put this money into the largest real estate market in the world and in a country where, at least so far, the government hasn’t acted in this manner and protects private property rights, how much would you pay for this privilege?
Of course that is a vague question; however, I think it is fair to say as a very logical and intelligent investor, you would pay more than someone sitting in the US who has the benefit of not having these political and governmental concerns in his/her home country. I think this is obvious. Accordingly, many non-US purchasers of US real estate might logically pay more than local purchasers for the same real estate based on their risk/reward profiles. This is not unique to Chinese investors—it applies to all foreign investors who are experiencing political and economic turmoil in their home countries. These are by no means naive or irrational fools. Instead, they are logical persons making appropriate risk/reward assessments.
As a New York real estate attorney, I have watched wave after wave of foreign investment wash ashore—often correlated to the degree of unpleasantness and uncertainty going on in the home country and the understandable desire of the citizens to offshore their money to a safer harbor—i.e. the US investment pool. So, it is certainly plausible that Chinese investors will pay more than US investors due to the different governmental and other situations in the two countries, but this is not evidence that the Chinese are being taken for a ride.
As for the so-called “China Price” that implies Chinese will pay 33% more for US real estate than local players, I must admit, I had never heard the words “China Price” until I read Peter’s article.
Creative And Intelligent Investing
More than once, I have seen Chinese companies try to meld their customer base back home with their investment in US real estate. For example, I have seen Chinese homebuilders trying to build homes in the US and sell to Chinese customers. I have also seen Chinese investors acting on business plans in which they seek to buy hotels in the US and then sell hotel rooms and/or condos created out of the hotels to Chinese buyers. And there are other examples of this behavior as well. Full disclosure that none of the deals I reviewed actually closed; however, my belief is that deals of this nature have been occurring. Will these investments work out? I don’t know, but it is not crazy or foolish behavior.
Intelligent First Investments
Some Chinese are insisting they make their first investment in so-called “GP capital” (i.e., investing in the sponsor of a real estate transaction, as opposed to investing as a limited partner). In this manner, the Chinese investor can put a relatively small amount of money to work and then learn the business from a local player before committing larger dollars to future projects. Others are investing in fund-type situations with emerging managers in which they back (or seed) a fund for the emerging manager and receive effective partial ownership of the manager in all his investments.
Others invest as just straight-up limited partners. In each of these situations, the consistency is that the Chinese investor cannot make—or lose—money unless the US counterparty that is spearheading the deal makes or loses money. So, other than fees paid to the sponsor for doing the work on the deal, their fates are aligned. This is a recognition that the local player always knows more about the real estate market than the non-local investor. It is a pretty smart way to invest.
I also see Chinese players making relatively low loan-to-value first mortgage loans either directly or as co-lenders with US lenders. This is the safest part of the capital stack and another intelligent way to enter a market for the first time.
What About EB-5?
This is a flashpoint for discussion. My sense is there is a perception in China that there is a higher standard of living and more personal freedom in the US, which makes many Chinese want to emigrate to the US. The EB-5 program—for an investment of about $500k—provides an opportunity for them to do so. If you lived in China and could afford it, how much would you be willing to pay for this privilege?
My guess is the EB-5 area is probably the place with the most potential for abuse of Chinese investors. I don’t know this for a fact firsthand—I just read the articles that have allegations against domestic players preying on unsophisticated Chinese individuals. However, even in this area it appears to me most of the players who have raised the bulk of the EB-5 dollars are major, and reputable, real estate players in major markets.
Will the EB-5 investors make money? That will depend on the specific transactions. However, after the relevant waiting period, the investors will likely get their green cards, which is a primary motivation for the investments.
Avoiding The Fate Of The Japanese
As I noted above, Peter spends some time in his article describing the fate of Japanese investors, which invested at the top of the market in the 1980s (for example, Mitsubishi buying Rockefeller Center, pictured, in 1989 and then walking away from the $2B investment in '95). But does that have anything to do with the Chinese investing today? My sense is: not a bit. The Japanese just blew the timing. I don’t think they were foolish, although hindsight may make them appear that way. They overpaid, as did many US investors, and got crushed by a major market crash brought on by the elimination of a special tax law loophole in the US that was plugged in the late '80s.
It is noteworthy that it wasn’t only the Japanese that got economically destroyed in the early '90s. Everyone in US real estate was hurt. I remember these times un-fondly—it was awful. The business of real estate just about disappeared from the world for close to five years. I joined just about everyone in losing my job and having to scramble to stay employed. Certainly, the Japanese didn’t rush in as fools and get taken advantage of. Everyone—in hindsight—got pulled into a bubble brought on by a foolish tax law in the US that allowed investors to write off more than their investment. Older-timers in the real estate world will remember that this resulted in “see-through” buildings and the inevitable crash.
Are there signs that the above scenario is happening again today and that a crash is imminent? There is absolutely no way to know. However, there is no reason to conclude that just because the Japanese bought at the worst moment in real estate history in the past 100 years, the Chinese will suffer the same fate.
So What Should Chinese Investors Do?
OK, now it is time to address what Chinese investors actually should do if they want to invest in the US. Here is some free advice.
1. Don’t rush in. Come for a visit to the local market. Learn as much as possible. Get different points of view. Knowledge is power—especially in the investing world—so get as much knowledge as possible. Avoid relying on the perceptions of others and, to the extent possible, see firsthand the markets that you are investing in.
2. Make sure that—at least at first—all investments are made with local partners that have significant skin in the game, so your interests are aligned with someone who knows the market much better. In this regard, it is important to understand whether the local partner will actually keep his/her stake or syndicate out a portion of his/her investment. If the latter, then the local partner’s risk shrinks. This is a point to be carefully analyzed and negotiated.
3. Piggy-back on others as much as possible at first—consider the ideas I mentioned above, such as investing in GP capital and other structures. See how these early deals unfold before committing significant capital to future deals.
4. Get good (and un-conflicted) legal advice on the local laws. China’s laws differ from US laws in material respects. It is important to have knowledgeable US counsel on hand to provide guidance and advice.
5. Along these lines, make sure counsel and other advisers are experienced in negotiating business deals of the type at hand. The legal advice and background information may be simple, but it is absolutely critical to have advisers who know what is “market” and what can, and cannot, be reasonably negotiated. Otherwise, deals can turn into an endless morass.
6. Retain a highly experienced tax adviser who has deep cross-border expertise. Engage this consultant as early as possible, because sometimes a first step into a new jurisdiction can cause unexpected tax trouble in the future. This cannot be overemphasized—this is not a place to skimp on by getting cheap advice.
7. Don’t trust brokers or anyone who stands to profit from an investment without putting his/her money at risk. No offense to the brokerage community is intended here. However, prudent investors should not blindly trust parties who are motivated to close a deal rather than ensure that the buyer gets a good price.
8. Don’t try to time the market. I really think that on a long-term basis, market timing is a bad investment strategy that will underperform in the long run. Instead, just decide whether the asset in question makes sense according to your—and your local partner’s—underwriting.
In contemplating my above advice, it is important to be mindful of the fact that my suggestions are not unique to Chinese investors in the US. It is the exact same advice I would take—or give—if I were investing for the first time in a market other than NYC where I am located.
Note: I give credit to Victoria Zhou for writing this article with me—it was a team effort. Victoria joined my firm, and our Chinese Real Estate Law practice, only a month ago from the highly regarded Davis Polk law firm. In addition to her real estate skills, I note that Victoria is fluent in Mandarin and grew up in the “infamous” (her word) real estate town Wenzhou, in the coastal area of southeast China. She gives me advice and perspective I would not otherwise have.