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Getting The Deal Through

Global overview

Joseph Philip Forte

Sullivan & Worcester LLP

Friday 03 January 2020


As in the past, the individual country chapters of this book will provide property investors and their advisers with straightforward legal guidance by each local country counsel concerning the local law and customary practices of the various jurisdictions with respect to the acquisition and sale, ownership, development, leasing and financing of property cross-border as well as any emerging trends, regulatory schemes, national government or regulatory changes or other hot topics in that jurisdiction. Yet there are often significant economic, financial, political, societal and other local, national, regional or international issues and challenges that may influence or adversely affect an investor’s decision whether to make an investment in property outside its home market.

Internal disruption

Too much capital, persistent historically low interest rates, overbuilding, excessive leverage or gearing, unsustainable property values and ever-declining capitalisation rates have repeatedly led booming property markets to crash in the past. Yet all of those are unquestionably internal factors that are endogenous to local property and national capital markets. They are the recurring incidents, developments and conditions that occur within property markets that may adversely affect properties in that market. Thus the inevitable boom and bust journey seems to be the natural lifecycle of property markets generally. It is these internal conditions and developments that property experts focus on when researching and assessing where a market is in the cycle. Is the market on the way up or down? Is this the peak or the trough? Is this a time to buy or sell? Or is it time to refinance now or best to wait for interest rates or cap rates to change? Is a particular property type an opportunity to be taken or a growing risk to be avoided? These are the types of questions investors must consider before they commit their capital to an investment in property regardless of whether it is debt or equity. They take the measure of the market from all of the obvious and not-so-apparent endogenous conditions at play. But which of those factors will be the critical component of the next material disrupter of the particular property market’s equilibrium and the initial catalyst for the undetected property market bubble to burst? Historically, it is usually too much available competitive capital to, and concentrated overbuilding of a particular property type in, a property market that precipitates a downturn. But it is not always the conditions of a particular market that cause the downturn. It may be events or developing trends unrelated to the market itself.

External disruption

Property markets can be in equilibrium with strong apparent real estate fundamentals and still be disrupted by known or unknown exogenous events or conditions developing over time. While political risk is rarely within the customary scope of property investors’ usual property due diligence investigation of the domestic market in their home country, as they are ordinarily fully aware, and albeit unconsciously assess daily, in the market context within which they conduct their property investment strategy and its execution. But with cross-border investment in the acquisition, development and financing of property globally, the array of investment risk grows and expands into the unforeseen as well as the unintended consequence of events beyond the control of the market in question. Thus the new normal for property investment – both domestic and cross-border – in the future will be affected for better or worse by exogenous as well as endogenous factors – some seemingly unrelated to property investment or financing markets.

With that in mind, the Global overview this year will update several issues that have been covered in previous Global overviews as well as address several new issues of concern.

Political context

The flow of capital for real estate investment across borders to foreign countries involves more than the domestic political risks of the particular country. And unlike typical cross-border business investment not involving property, the foreign property investor cannot readily remove the asset from the foreign country nor can it easily transfer it in an international capital market transaction.

More than ever local property investment today may be disrupted by an ever-expanding and changing parade of economic, financial, political and societal events or developing conditions:

  • the continuing fluctuation in the price of oil and other commodities and the attempt to control supply;
  • trade wars and punitive tariffs;
  • the use of sanctions as a coercive political weapon;
  • the deployment of foreign capital worldwide for strategic political purposes;
  • the slowdown of a foreign country’s economy and the revaluation of its currency;
  • the stability of cross-border economic zones and the retention of their member countries;
  • foreign government debt or deficits and unfunded future liabilities;
  • state failure and the growth of non-state actors;
  • pressures to tighten country immigration policies and exclude expanding refugee populations;
  • nuclear proliferation;
  • epidemic of cybersecurity breaches in the public and private sectors;
  • money laundering, political corruption and organised crime;
  • foreign-country housing market bubbles collapsing and damaging a country’s banking system;
  • international and domestic terrorism;
  • the stability of the foreign country banks and their national financial systems;
  • state capitalism and its enterprises;
  • corporate espionage;
  • water distribution and its scarcity;
  • climate change and resulting catastrophic events;
  • the continued growth of capital outflows for safe deposit box-like investment in foreign property;
  • the rise of nationalism, progressivism, and isolationism;
  • threatened retreat of globalisation of markets;
  • unintended consequences governments’ monetary policy; and
  • national as well as well intentional but wrong-footed international financial regulation.

Market context

Among the several different key characteristics of a market to be considered by international investors operating outside of the comfort zone of their home country in their real estate investment, there are four that seem to be most vulnerable to political pressure and undue influence: the rule of law, market transparency, liquidity, and corruption. These are not very significant in most developed markets around the world but should be seriously considered factors when contemplating investment in a developing country or an emerging economy where there may be a more pronounced susceptibility to political interference or governance failure. What the law of a country may be on the country’s statute books is not the final answer to the rule of law question, but whether the judicial system enforces the law or the executive submits to the decisions and orders of the courts will be determinative of the issue. Similarly, corruption – political or business – can interfere with market transparency as well as the rule of law, while liquidity can be impaired or eliminated by government interference in the workings of the markets. There are some geopolitical issues that are actually country foreign policies that have a cultural component and that can best be described as the politics of grievance. They are the result of real or perceived injustice – recent or historical – that will skew what should otherwise be a rational decision toward a seemingly irrational result. Russia, China and other nations make decisions and take action on this basis. Understanding the context of foreign perspective helps avoid inimical results for the investor. The investment in the market itself can be obstructed by xenophobic legal and regulatory programmes restricting or barring access to the markets. Politicians will have their reasons for imposing such burdens on investment that make no economic sense for their own country’s economic growth and development but fulfil or advance some local political agenda or be seen as righting a perceived wrong. There are numerous sources available to obtain the necessary relevant knowledge either in focused subscription reports and one-off published country papers, or special country-specific consultants who advise on geopolitical risks.

Flight to safe havens

Yet foreign investors often will proceed to invest in spite of expert advice of the potential consequences and risks to their investment. Safe deposit box investing as the investment strategy of capital preservation has an aim inconsistent with most investment models about investment returns, cash flows, value appreciation and market value. Yet political risk in the investor’s home country or with its regional neighbours will motivate diversification outside of their country to a safe haven where they can be assured that they will continue to retain all or part of their capital notwithstanding what happens in their homeland. Such investors may pay above market value on the sole basis of obtaining an asset and moving their capital sooner rather than later. They do not consider that their property investment may be worth significantly less than the amount that they invested. Similarly with the US EB-5 programme, foreign nationals who invest a certain set dollar amount in the US that generates a certain number of jobs can obtain a resident green card. The principal motivation for their investment is for them or their children to come to the US and study or live and not the real estate investment itself. The geopolitical risk for them is to stay or keep their capital in their home country where it can disappear entirely at the whim of political policy or change of government in power.

Thus, the foreign investment may hinge not so much a question of the opportunity for a better return on capital (cash flow, appreciation, interest) than at home; but the spectre of the actual return of, rather then on, capital (simply the return of all, or at least a part of the capital invested or lent).

LIBOR ends

With nearly US$400 trillion of cash financial contracts and derivatives in the global markets, LIBOR is now clearly the most important number in the world. With the growing scarcity of actual inter-bank unsecured term money market funding since 2008 and the growing reluctance of the LIBOR panel banks, because of potential liability and reputational concerns, to offer expert judgement or market-based observations without a basis in actual inter-bank transactions, the UK Financial Conduct Authority (FCA), which regulates LIBOR, confirmed publicly that the existence of the LIBOR benchmark ‘could not and would not be guaranteed’ after 31 December 2021 (cessation). Having concluded that LIBOR must be replaced with an alternative benchmark rate based firmly on actual verifiable trading transaction data from relevant market participants in a ‘sufficiently active’ market of substantial volume, which would therefore be less susceptible to manipulation, national financial regulators of the five LIBOR-quoted currencies in the EU, Japan, Switzerland, the UK and the US are in the process of replacing their respective currency inter-bank offered rates (IBORs) with a risk-free (or nearly risk-free) reference interest rate for euro, Japanese yen, Swiss franc, UK sterling and US dollar transactions, and each has proposed a secured or unsecured benchmark for its subject currency. These five separate currency-specific efforts will yield five different independent benchmarks, not a single global benchmark rate as IBOR is now. How this fragmented approach to national benchmarks will affect the global financial markets cannot be predicted, given the complexity and enormous effort and daunting challenges entailed in the process of transitioning to new alternative reference rates as new benchmarks at, or possibly before, cessation of LIBOR.

While the FCA will no longer compel panel banks to sustain the publication of LIBOR after cessation, LIBOR may not cease to exist because some market participants – including the LIBOR administrator, the Intercontinental Exchange Benchmark Administration – would prefer its continuance for a variety of perceived benefits to the market and its participants, although it is unclear how such LIBOR would be determined in a continually contracting market. The continuance of LIBOR publication after cessation will be a double-edged sword, with some benefits as well as some substantial risks. Its continued existence would provide aggrieved borrowers and possibly debt market investors with a baseline from which to measure their claim for perceived damages or value loss from the transition to any replacement reference rate, as being neither a commercially reasonable equivalent to LIBOR nor the result of good faith and fair dealing. Such continuance, however, raises an even more draconian claim that because LIBOR is still published, it should continue to be the static fixed rate for the balance of a LIBOR-linked contract’s term – a zombie rate.

Notwithstanding that we know about LIBOR’s scheduled cessation and have identified in great detail the steps that must be successfully accomplished, as well as in what sequence to accomplish a transition without significant market disruption, it is nearly impossible to know or anticipate any and all of the unintended consequences of any deviation, complication, delay in or outright resistance to the implementation and acceptance of any transition plan. The inability of participants in global financial markets to deal effectively with the foregoing challenges, their possible failure to resolve the deficiencies of or to develop sustainable liquidity for any replacement benchmark in the derivatives markets and thus the failure to arrive at the ultimate goal of substituting new alternative reference rates as sustainable benchmark rates acceptable to the origination, securitisation and derivatives markets, could be virulently disruptive throughout the world financial system given the immense presence of LIBOR in every aspect of financial products.

The transition away from LIBOR could have truly catastrophic and unpredictable effects on global financial markets, as well as on LIBOR parties. Given the potential systemic risks involved, market participants – regardless of their size or the size of their portfolios or the magnitude of their LIBOR exposure – should educate themselves on the transition, understand the details of their LIBOR cash and derivatives portfolio, as well as their economic, operational and legal risks, before cessation to assure themselves as much as possible of an orderly transition of their portfolios to the new replacement benchmark.

Technology and the generational divide

Possibly the most significant impact on the future of property, its design and use will stem from the confluence of technology, innovation and the world’s continually changing demographics. As the baby boomer and echo boomer cohorts decline as a proportion of the populations of workers, shoppers, renters, homeowners and travellers around the world, property research for developers, owners, landlords, retailers, hotels and others has been principally focused on the impact that the millennial cohort of the population (Generation X and Generation Y) will have on the planned development and use of commercial and residential property. The results of their research and the adjustments made in property development and planning, as well as business plans tailored to meet millennial preferences and avoid their dislikes, may not fully account for the longer term as they are ignoring the cohort following close upon the heels of the influential millennials. Born after the mid-1990s they are known as Generation Z (or centennials or iGen) but, unlike millennials who were around before the advent of the smartphone, Generation Z was born into the world where the smartphone was already ubiquitous. Smartphones have always been part of their lives and they use them for everything they need. Specialised generational research has concluded that Generation Z and its preferences, dislikes and general approach to work and life in general are very different from the millennial generation. Thus property professionals looking to see what and how they need to adjust their development and planning for the future will need to have a two-prong approach to encompass both Generation Z and millennials. Generation Z is entering the workplace, the shopping mall, a rental apartment and life in general, not only on its own but alongside millennials. Investors should be prepared for a much quicker change than that from boomer to millennial. Failure to recognise this dichotomy may be a very costly misjudgment in the long run.

To better focus our analysis of the continuing and growing influence of Generations X, Y and Z on property as well as on its design and uses, it is best to catalogue the existing, incubating, potential and possible sea changes, unlike any previous, that will flow from their unconditional adoption of the internet of everything and the resulting sharing economy:

Retail

The steady growth of e-commerce is having a devastating impact on malls and retail stores in many countries. Yet it has not replaced nor will it necessarily replace bricks-and-mortar retail as malls mutate into destinations with fast and slow venues, food, bars, entertainment, merchandise showrooms and pick-up or return centres for e-commerce retailers, electronic device stores and similar service outlets, while others randomly repurpose as urgent care centres, medical or educational facilities, government offices and other never-intended uses because of local needs.

Industrial

The growth of e-commerce has of necessity led to the growth and development of industrial properties in city centres and surrounding areas as warehouses and distribution centres for e-commerce retailers for same-day delivery, including grocery distribution.

Office

The growth of co-working and shared open workspace is and will continue to have an inevitable effect on office development, as employers downsize their space needs and avoid taking on any additional space for future growth because of the ability to move into co-working space as the need arises without significant capital expenditure. In an effort to compete with space-sharing companies such as WeWork, office landlords are developing their own co-working and shared open space in their existing buildings to offset the downsizing trend and compete directly with the space-sharing companies for their own tenants’ needs, as well as providing for short-term occupants who may grow into space within the building, Given the recent financial troubles of WeWork, the co-working model may be under greater scrutiny by lenders and investors and have to adjust.

Residential

The millennial generation gravitating to city centres and willing to take much less space has led to the development of micro-apartments and school-like dormitory residences with shared kitchens and common areas, as well as traditional multi-family residences. Nonetheless, recent property finance surveys indicate a counter trend in that millennials are becoming the majority of homebuyers in and outside the city.

Hotel

The hotel industry has been quick to offer cheaper hotels with smaller rooms and few if any amenities other than their conscious placement in areas with bars, restaurants and entertainment that cater to millennials but also have serious electronic and digital support and capacity. There will inevitably be some consequential collateral damage to the hotel industry and its future growth from the meteoric growth in the usage of Airbnb across the globe.

Infrastructure and transport

Artificial intelligence and the eventual development of the driverless car will have greater effect on the development of cities when situated in the millennials’ sharing economy by rejecting the ownership of cars, hence encouraging the development and growth of public transport together with its related support infrastructure. Ignoring the revenues generated by parking fees and fines for municipalities, the infrastructure of the average street will need less road surface, less or no parking, more bicycle paths, new designated shared car pick-up and drop-off sites (like existing shared bicycle sites) and more pavement space resulting in the need for new types of interconnected traffic control. Moreover, with the development of drone delivery services, which is now being tested in certain areas, office, retail, hotel, industrial, multi-family structures and residential homes will need to be refitted to accommodate sending and receiving drone deliveries.

Unfortunately, the legal regimes and regulatory regimes of many countries that would govern these innovations, as well as the necessary infrastructure to accommodate them, is not keeping up with, and is seriously lagging behind, the ever-accelerating technological developments themselves. Moreover, often the innovations, while adopted by many, will almost always be met with significant resistance by those who see such advances as disruptions and attempts to ignore the current rules and who will seek to delay, or even ban, their adoption. This has been what Uber has faced in some countries and cities around the world.

Whether these trends in the attitudes of millennials and Generation Z represent a fundamental shift, only the future will tell. With smart technology and big data, some believe that co-working and shared workplace are the future of the office. Yet some tech employees have started to resist working in open-plan offices and ‘hotelling’ without designated desks. But if millennials’ and Generation Z’s views on privacy in communication and the interconnectivity permeating their personal, academic, political and professional life in social media are any indication of future trends, they will have a consequential effect on the use of property, and should be carefully considered in every property investor’s analysis.

Climate change

In a more diverse global vein, probably the single most significant concern of millennials and Generation Z, as well as those who agree with 97 per cent of the world’s scientists, involves the potential negative impact and possible dire consequences of global warming on our planet. While not perfect, the Paris Accord adopted by nearly 200 countries in 2015, and signed by 187 counties, is an international effort to develop a uniform scheme, albeit voluntary, to mitigate, adapt to, and finance the reduction of greenhouse gas emissions and encourage climate-resilient development. Despite the growing evidence of the increase in more powerful hurricanes, typhoons and other storms; in rising temperatures; in vast forest fires; in more severe droughts; and in rising sea levels causing devastating flooding of coastal and other low-lying areas not previously flood-prone, the US, a current signatory, has given notice that it will withdraw from the Paris Accord by November 2020 and has already begun adopting contrary policies. Nevertheless – regardless of a particular country’s political stance as to climate change being a real threat, overblown, too costly, a global cycle unaffected by the acts of mankind or a scientific hoax – given the potential real consequences, owners, developers and lenders as well as other investors should understand and appreciate fully the physical environment of, and surrounding, their investment. Consequently they should decide – with the assistance of independent qualified third-party experts such as engineers, architects, climate specialists, etc – to acquire, develop, improve or adapt land in the context of the possible negative effects of continued global warming on the site of their investment.

Conclusion

Identifying and assessing risk has and will always be a crucial part of investing in property and its financing – whether patent or latent, endogenous or exogenous. Investors must always investigate and evaluate the identified risks for a property investment as to their magnitude, probability and consequences (direct or indirect). If the investor decides not to avoid the risk but embrace it, then it must determine how to best minimise, mitigate or, if possible, eliminate the risk to the property investment. How the property investment or financing risk is approached and invested into depends on several factors: who is investing; where they are investing; what they are investing in; how they are investing; and finally, but most importantly, why they are investing. Today regulatory and demographic risk management as part of an investor’s strategy is more often an executive suite discussion and decision rather than a traditional compliance analyst’s modelling and checklist completion.

The lessons of the most recent global financial crisis must not be ignored as to the interconnectedness of international real estate investment. Today, political events, whether intentional government action or political disorder, in one seemingly isolated market can very quickly become a geopolitical risk of a magnitude affecting investors in all markets globally. Capital flight to safe havens has three unintended but logical consequences:

  • the introduction of a political risk mitigation premium that foreign investors will pay to assure the capital finds a home in their quest for capital preservation;
  • pushing domestic investors in the safe haven country out of the market because of such purchases distorting market values and sellers’ price expectations; and
  • the resulting underinvestment of the fleeing capital in the foreign investor’s home country leading to further destabilisation and political turbulence.

Yet, regardless of the impact of technology and demographics, the legal regimes of each country that this publication surveys each year will remain the critical consideration prior to any investment in property or the financing of the development or acquisition of property in that country. Whatever trends or systemic changes occur, understanding the law is the precondition to and often the determinative aspect of property investment cross-border.

Global capital flows for international real estate investment will continue to have unexpected consequences for the foreseeable future. As a result, global investors in international real estate markets must include in their due diligence not only the traditional orthodox risk management analysis but a sophisticated and high-level assessment of the geopolitical atmosphere of the countries and regions and the complexities of geopolitical risk where they intend to allocate and invest their capital, not just maximise their return, but also the return of their capital with an informed exit strategy before they enter the market. Forewarned is forearmed.


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