lehr thesis final
TRANSCRIPT
The Impact of Sovereign Wealth Investment on the
Commercial Real Estate Investment Market by
Robert Joshua Lehr
B.S. Civil Engineering, Oregon State University 2007
MBA, IESE Business School/Duke’s Fuqua School of Business 2014
Submitted to the Program in Real Estate Development in Conjunction with the Center for
Real Estate in Partial Fulfillment of the Requirements for the Degree of Master of
Science in Real Estate Development
at the�
Massachusetts Institute of Technology
February, 2016
©2016 Robert Joshua Lehr All Rights Reserved
The author hereby grants to MIT permission to reproduce and to distribute publicly paper
and electronic copies of this thesis document in whole or in part in any medium now known
or hereafter created.
Signature of Author_______________________________________________________
Robert Joshua Lehr Center for Real Estate January, 2016
Certified by______________________________________________________________
Walter Torous Senior Lecturer, Center for Real Estate - Thesis Supervisor
Accepted by_____________________________________________________________
David Geltner Chair, MSRED Committee, Interdepartmental Degree Program in Real Estate Development
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The Impact of Sovereign Wealth Investment on the Commercial Real Estate Investment Market
by Robert Joshua Lehr
Submitted to the Program in Real Estate Development in Conjunction with the Center for Real Estate on January 8th 2016 in Partial Fulfillment of the Requirements for the Degree
of Master of Science in Real Estate Development
ABRSTRACTThis thesis explores the relationship between Sovereign Wealth Fund participation in the United States and office risk premium. Over the past 10 years the commercial real estate industry has been the benefactor of a shifting tide in equity capital formation. Sovereign Wealth Funds, proliferating over the past 15 years, have discovered that commercial real estate is a well aligned asset class along side equities, bonds, and other alternative assets. With that said, Sovereign Wealth Funds are not typical sources of equity. Unlike private capital, sovereign capital receives special treatment in their home county as well as most recipient countries. For example, some advantages that Sovereign Wealth Funds enjoy over private sources include the following; no disclosure requirements, no stock/stake holders to report to, and limited or zero taxation. Additionally, due to the extreme ground swell of foreign reserves and current account balances, there is nearly zero obligation for the return of capital. With no direct need for a return of or on capital, many of these Sovereign Wealth Funds operate under an effective “indefinite” time horizon. Finally, as government entities, there may be non-economic strategic goals when informing the investment decision. Combining these issues of limited transparency, preferential taxation, limited discloser requirements, indefinite investment horizon, and non-economic motivations, Sovereign Wealth Funds have a clear pricing advantage over privately sourced investment funds. After achieving a statistically significant regression model, this thesis quantifies the magnitude and character of this advantage by looking at the estimated market risk premium paid as a result of Sovereign Wealth Fund participation.
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TABLEOFCONTENTS
ABRSTRACT 2
CHAPTER1:INTRODUCTION 5
Motivation 5
PurposeandThesis 6
Methodology 8
CHAPTER2:DEFINITIONANDHISTORYOFSOVEREIGNWEALTHFUNDS 10
History 10
Function 11
Classifications 11
InvestmentProfile 15
SovereignWealthInvestmentandLargestFunds 16
CHAPTER3:HISTORYOFSOVEREIGNWEALTHFUNDINVESTMENTINUSCOMMERCIAL
REALESTATE 18
History 18
RecentTrendsandNews 21
CHAPTER5:DATAANDMETHODOLOGY 26
Approach 26
DataSource 28
Analysis 30
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CHAPTER6:ANALYSISANDRESULTS 33
AnalysisOverview 33
SovereignWealthInvestmentintoSixMajorMetroMarkets 34
SovereignWealthInvestmentEffectsonNon-MajorMetros 37
SovereignWealthInvestmentintoUSTotal 39
CHAPTER7:DISCUSSIONANDCONCLUSION 41
RegressionFindings 41
PremiumPaidfromSovereignWealthFundParticipation 44
ReasonsforIntramarginalInvestmentProfile 47HoldPeriod 47YieldChangeImpact 49TimeMitigationofRisk 53StateCapitalism 57
Summary-FromtheInvestor’sPerspective 62
BIBLIOGRAPHY 65
APPENDIX 67
AppendixA:IIEScoreMethodology 67
AppendixB:Listof2008IWGCountries 70
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CHAPTER1:INTRODUCTION
Motivation
The world’s capital landscape is shifting. In the 1980s commercial real estate enjoyed a
boon from new access to institutional equity capital from life insurance companies,
pension funds, endowments, and other institutional sources. Since that period the only
significant expansion in the commercial real estate capital markets has come from the
debt side with the proliferation of Commercial Backed Securities (CMBS). CMBS was a
variation on an existing Asset Backed Security (ABS), which was created by the
Resolution Trust Corporation (RTC) to liquidate up to $17 billion of bad debt from failed
thrifts1.
Gaining traction in the 1990s and subsequently exploding over the last 5-years,
commercial real estate has undergone another tectonic shift in the capital markets
landscape—Sovereign Wealth Fund Equity Investment.
With Sovereign Wealth Funds representing approximately $6.3 Trillion globally2, an
increase in allocation of only a few percentage points toward commercial real estate
would result in a new equity stream like nothing we have seen in 30 years.
Additionally, it has been observed that Sovereign Wealth Fund investors are often able to
out bid and pay more for assets than other institutional buyers. In an era of record low
global yields, Sovereign Wealth Funds are beginning to flock to real estate investments
with initial yields as low as 3%.
Today many investors are eager to understand how sovereign investors can invest in such
a low yield world, how they often pay more than traditional investors, and how to
position their funds to compete. The following outlines the focal points of this thesis.
1 “The Past, Present, and Future of CMBS,” Wharton Spring Review, Spring 2012, at [http://realestate.wharton.upenn.edu/research/papers/full/730.pdf] 2 “Sovereign Wealth Funds Investing in Real Estate”, Real Estate Spotlight, November, 2013 (Preqin); https://www.preqin.com/docs/newsletters/RE/Preqin_Real_Estate_Spotlight_November_2013.pdf
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PurposeandThesis
The purpose of this thesis is three-fold:
1) InvestigatetheimpactofSovereignWealthInvestmentoncommercialreal
estatepricingandtheassociatedriskpremium(Spread)
2) ExplorepotentialreasonsthatSovereignWealthFundscanoperateasan
intramarginalinvestor
3) DiscussopportunitiesandconstraintsprovidedbySovereignWealthInvestment
consideringtheresultsoftheanalysisportionofthisthisthesis
This thesis will employ consolidated data from the past 14 years to investigate the
correlation and the impact magnitude of Sovereign Wealth Investment in various US
markets. The analysis will consider the following three scenarios:
• TheimpactofInternationalSovereignWealthInvestmentintotheUnitedStates
ontheUnitedStates’officemarket
• TheimpactofInternationalSovereignWealthInvestmentintoUSMajorMarkets
onthesameMajorMarket’sofficemarket
• TheimpactofInternationalSovereignWealthInvestmentintotheMajor
MarketsontheremainingNon-MajorMarket’sofficemarket
Although there is a general sense in the market that these Sovereign Investors are able to
“pay more,” there has been little research to quantify the impact and magnitude of their
participation or offer potential reasons why. McAllister and Nanda (2014) explored
foreign investment in 30 US MSAs and its associated impact on Office cap rates. This
thesis is different in that it; (i) isolates Sovereign Wealth Funds apart from other foreign
investors, (ii) focuses on risk premium, (iii) strategically looks at particular economic
market scenarios, above, rather than MSA data, (iv) looks at spillover affects, and (v)
offers potential reasons (qualitative and quantitative) to explain the lower risk premium
for these investors.
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Similar to McAllister and Nanda, this thesis will measure Sovereign Wealth Investment
as a percent of total investment rather than use absolute investment dollars. This method
provides a clearer view into the impact of the relative share of total investment that
comes from Sovereign Wealth Funds.
To isolate an investor’s willingness to pay for risk, we will delve deeper into “price” by
looking at its underlying yield spread. For our purposes, “yield spread” equals the risk
premium less expected growth rate (see Equation 5 on page 27). While an investor’s
assumption about growth can vary, the fundamental drivers of growth are independent of
the investor’s perspective and will balance out in an efficient market. Therefore,
expected growth should not lead to a long-term premium or discount paid by a particular
investment group. The benefit of focusing on yield spread is that it is directly observable
from the market – cap rate less the risk free rate – and provides a consistent foundation
for analysis over time. For these reasons, the thesis will utilize yield spread to
approximate an investor’s ability to pay for risk.
In short, the impact magnitude to the yield spread will be in terms of basis point
change per 1% increase in the Sovereign Wealth Investor’s share of total investment
volume.
After identifying a statically significant model, the thesis will attempt to identify why
sovereign wealth investors may be able to pay more for risk than other institutional
investors. There are three intrinsic factors identified in this thesis as to how Sovereign
Wealth Funds have such a low risk premium. Sovereign Wealth Funds are typically large
enough to benefit from global diversification of their portfolio—providing an overall
lower portfolio risk premium, open to non-economic investment drivers, and are naturally
very long-term investors—indeed often with an indefinite investment horizon.
As a long-term investor, this thesis will further explore the following time related
advantages; (i) the impact on yield change on the total return over time. (ii) Sovereign
Wealth Fund’s ability to exit their holdings at the most opportune time—not an ability
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shared by most institutional equity investors that have a specific hold period. (iii) Time’s
dampening affect on volatility.
Diving deeper, we will will look at the magnitude of “spillover” effects that Sovereign
Wealth Investors have on other investor’s willingness to pay for risk, if any.
Theoretically, risk premium is unique to each investor and should not be influenced by
another investor’s risk premium. With that said, investment funds often have an
obligation or invested interest to activate its funds and therefore may be forced to invest
outside of their natural risk-return spectrum. Essentially, this thesis will explore whether
Sovereign Wealth Fund participation is bending the Security Market Line (SML) rather
than just investing below it.
Finally, the thesis will summarize the findings of the analysis and discussions through the
body of work. Then it will provide some thoughts on how to compete with sovereign
wealth funds from the investor and fund manger’s perspective. The genuine hope is that
this thesis will be employed as an actionable tool rather than a simply theoretical
exercise.
Methodology
This thesis will utilize both a qualitative and quantitative approach. Qualitative will
investigate history, character, and trends. The quantitative methods, highlighted by
multiple linear regression analysis, will add rigor and provide information about the
impact to yield spread from the participation of Sovereign Wealth Fund’s investment.
Since the goal of this thesis is to understand the impact of Sovereign Wealth Investment
on the the relative pricing of risk, the dependent variable will be “spread.” Spread is
widely available data that approximates risk premium. More on the use of spread as a
proxy for risk premium in the following chapter.
The analysis will utilize as many independent variables as possible. Capturing many
statistically significant independent variables will help isolate the impact of Sovereign
Wealth participation from other forces affecting spread— notably total investment
volume. Since total investment volume can impact yield spread through a mechanism
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similar to supply and demand3, using investment volume as an independent variable will
isolate market fluctuations that otherwise mute or artificially augment the affects of
Sovereign Wealth investment.
For example, if sovereign wealth investment increased from 0.5% share of total
investment volume to 2% share of the total investment volume you would expect the
yield spread to decrease (assuming they have a lower risk premium). But if at the same
time total investment shrank by 10%, that would put upward pressure on yield spread and
could have a net increase between the two forces. Without controlling for total volume,
using percent share of total volume becomes unintelligible.
Lastly, in addition to in-market analysis, this analysis will cross markets to investigate
market “spillover effects.” Specifically, the thesis will look at what happens in non-
major markets when Sovereign Wealth Investment increases proportionally in Major
Markets. The theory is that traditional investors in Major Markets may seek to deploy
investment dollars in Non-Major markets when Sovereign Wealth Funds participate in
top markets. It is practical to expect a decrease in risk premium due to higher prices as
an increasing number of larger and better diversified investors get forced into secondary
and tertiary markets. This pricing mechanism is akin to Merton’s Investor Recognition
Theory and is discussed further in chapter 3 of this thesis.
3 “Does Foreign Investment Affect US Office Real Estate Prices?” McAllister and Nanda, 2014
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CHAPTER2:DEFINITIONANDHISTORYOFSOVEREIGNWEALTH
FUNDS
History
Sovereign Wealth Funds are government owned and backed investment vehicles. The
broadest definition of Sovereign Wealth Fund is from the US treasury which describes a
Sovereign Wealth Fund as “a government investment vehicle which is funded by foreign
exchange assets, and which manages those assets separately from the official reserves of
the monetary authorities (the Central Bank and reserve-related functions of the Finance
Ministry).” 4 These vehicles by definition are funded by foreign exchange reserves,
which in recent years have seen significant expansion driven by either current account
surpluses or commodity trade surpluses such as oil and gas. The former is commonly
found in Asian countries such as China, and Singapore, whereas the latter is a typical
driver of Middle Eastern, American, and European Sovereign Wealth Funds.
Based on the broad definition set forth by the U.S. Treasury has, the first Sovereign
Wealth Fund was created in 1854 with the Texas Permanent School Fund. While this
fund was created from the appropriation of government surplus dollars, it does not meet
the general understood definition for modern Sovereign Wealth Funds. Sovereign
Wealth Funds, as we know them today, were essentially created in 1951 with the
formation of the Kuwait Investment Board. The Kuwait Investment Board was
developed to add stability to their fluctuating reserves that were highly dependent upon
the volatile price of oil. Following Kuwait, in what is now Kiribati, the Revenue
Equalization Reserve was created in 1956. The Revenue Equalization Reserve was
primarily developed to diversify profits from their phosphate mine. Although these two
examples meet today’s understanding of what a Sovereign Wealth Funds is, the term
itself was not coined until a 2005 research article by Andrew Rozanov.5
4 “Thesis to Congress on International Economic and Exchange Rate Policies,” Department of the Treasury, at [http://www.treas.gov/offices/international-affairs/ economic-exchange-rates/]. 5 “Who Holds the Wealth of Nations,” State Street Global Advisors, at [http://web.archive.org/web/20080529122341/http://www.ssga.com/library/esps/Who_Holds_Wealth_of_Nations_Andrew_Rozanov_8.15.05REVCCRI1145995576.pdf]
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Sovereign Wealth Fund creation went quiet for a number of years until the 1970s when
the world went through the oil crisis of 1973, when the Organization of Arab Petroleum
Exporting Countries (OAPEC) announced an embargo and caused the price of oil to raise
from $3 a barrel to over $12. Sovereign nations and governments started slowly adding
various versions of a Sovereign Wealth Fund through the 1970s and 1980s, but didn’t
gain widespread adoption until the 1990s.
Function
Sovereign Wealth Funds were initially created as “stabilization funds” for countries
where volatile assets backed their foreign exchange account. The idea was to use profits
from the cross boarder sales of their commodities to invest in other stable and diversified
asset types. Since the primary purpose for a stabilization based Sovereign Wealth Fund
was the stability of its current accounts, liquidity and safety were important features in its
mandate. As a result, low risk fixed income investments were often the vehicle of choice.
Classifications
Later, as commodity prices increased in the 1990s, Sovereign Wealth Funds were used
for a expanding array of purposes including; passing wealth to subsequent generations,
asset diversification, a search for higher returns on government current account surpluses,
and non-economic motivations.
Although Sovereign Wealth Funds were created to manage excess foreign exchange
reserves above the amount required by the country’s central bank to balance accounts and
to add diversity to volatile commodity based assets, today we see many different types of
Sovereign Wealth Funds with different objectives. Indeed, even the classification of
Sovereign Wealth Funds is fungible and continues to evolve.
The International Monetary Fund adds some structure to the US Treasury’s definition of
Sovereign Wealth Funds. According to the International Monetary Fund, there are three
primary groups of Sovereign Wealth Funds.
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The IMF categorized these three groups as follows:
• StabilizationFunds
• SavingsFunds
• ReserveInvestmentCorporations
In reality, Sovereign Wealth Funds are a blend of these. Additionally, State Capitalism
(the use of a SWF for non-economic purposes) may be a hidden driver of the investment
decision, but operate under one of the three fund types mentioned above. This is
important, because when this thesis explores potential reasons Sovereign Wealth Funds
can pay more for a given asset, you cannot ignore the possibility that there is a
government related strategic purpose driving the decision.
Until this point, this thesis has focused on stabilization funds because they were at the
heart of Sovereign Wealth Fund’s origins. However, the remainder of the thesis will
focus on the latter two categories—Savings Funds and Reserve Investment Corporations.
Saving Funds began to appear around 1990 when commodity prices and foreign trade
surpluses drove up emerging market’s foreign exchange balance above the required level
to balance accounts and to establish balance for a volatile assets base. Eventually, once
these two initial monetary needs were met, these cash rich developing counties focused
on transforming this short term explosion in wealth into long term sovereign wealth for
subsequent generations. This transformation to a savings focus marked a significant
change in investment profile—from short-term and high liquidity to long-term and low
liquidity. This shift has a significant impact on Sovereign Wealth Fund’s investment
strategy and risk premium.
As foreign exchange surplus continued to rise, some countries created multiple tiers of
Sovereign Wealth Funds with different investment mandates. While most countries went
from traditional foreign reserve investment to stabilization to savings, some countries
with extreme gains in surplus created pure investment funds dubbed by the IMF as
Reserve Investment Corporations. These were very long-term, or indefinite term,
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vehicles that focused on lowering opportunity costs by deploying cash into higher return
investments.
Figure 1 illustrates how foreign exchange surplus affects the development of Sovereign
Wealth Funds. It is important to note that there is often overlap for savings and pure
investment focused funds. In this stage a country may have multiple Sovereign Wealth
Funds with varying mandates or one with a wide scope to approach both structures.
FIGURE 1: SWF Development Stages
Figure 2 below shows actual reserve account balances for twelve relevant countries. It is
clear that Kuwait was among the first to have a significant surplus as a result of their
positive position in the oil crisis. Later on, China literally flies of the chart and now sits
around $4 trillion. Russia, Saudi Arabia, the United States, and Singapore are all above
$100 million in foreign exchange reserves. The country with the world’s largest
Sovereign Wealth Fund (Norges Bank Investment Management (NBIM)) only has an
exchange surplus of $43 million, which is extremely small compared to its peers. This
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could be because they have shifted the largest amount to their Sovereign Wealth Fund,
which has over $900 Billion in assets under management.
FIGURE 2: Foreign Exchange Reserve in Billion USD
Figure 3 shows the profound scale of developing counties in Asia and the Middle East.
With the exception of Norway’s mammoth fund in North Europe, no other region in the
world has the same weight as Asia and the Middle East. According to KPMG, total
assets under Sovereign Wealth Fund management was $5.86 Trillion in 2014,6 which is
currently estimated at $6.3 Trillion.7 Also from the Figure, you can see that there were 65
Sovereign Wealth Funds before 2010. Another 19 were added in the four years after
2010 with another 22 funds currently being planned. Many of these new funds are
located in Africa, Russia, and Central America.
6 KPMG Sovereign Wealth Fund 2014 at, [https://www.kpmg.com/ES/es/ActualidadyNovedades/ArticulosyPublicaciones/Documents/sovereign-weath-funds-v2.pdf] 7 “Sovereign Wealth Funds Investing in Real Estate”, Real Estate Spotlight, November, 2013 (Preqin); https://www.preqin.com/docs/newsletters/RE/Preqin_Real_Estate_Spotlight_November_2013.pdf
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The following chart shows the Sovereign Wealth Funds and their total asset value at the
end of 2013.
FIGURE 3: Global Sovereign Wealth Map
InvestmentProfile
As the purpose of this thesis is to look at the impact of Sovereign Wealth Funds’
investment into US commercial real estate, this thesis will focus only on the two
Sovereign Wealth Funds that typically invest in this asset class—Savings and Reserve
Investment corporations. Indeed, there are many investor profiles and programs within
each of the two categories. From hereinafter, this thesis will refer to this group simply as
Sovereign Wealth Funds.
Due to the nature of Savings and Reserve Investment Corporations’ mandate, multiple
degrees of separation from liquidity obligations, and their significant account balances,
Source: KPMG Sovereign Wealth Fund 2014
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Sovereign Wealth Funds tend to have an effective “indefinite” investment horizon. An
indefinite investment horizon model is supported by the fact that the Sovereign Wealth
Funds tend to draw well below the rate of growth and in some cases have zero obligation
to payout anything at all. An indefinite hold period is extremely rare and some would say
novel among investors. Typical investors, even most endowments, have an obligation to
return a specific amount of their invested capital at a roughly specific time or duration of
investment.
Another noteworthy attribute of Sovereign Wealth Funds investors is their specific target
market. They typically invest in developed countries to add stability, counter in-country
cyclicality, and diversify volatile assets. Basically, since Sovereign Wealth Funds are
really an extension of the country’s central bank, they need to balance the entire
country’s asset exposure. Few other investor groups have this issue. Typically, investors
only consider their own portfolio when considering diversification.
SovereignWealthInvestmentandLargestFunds
The following details the world’s largest government sponsored investment funds. This
list includes national/public pension funds to illustrate scale. However, these specific
investment groups tend to have a very different investment profile and will not be
analyzed within this thesis.
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TABLE 1: Top Government Sponsored Investment Funds8
Fund Country Type SizeinbillionSocialSecurityTrust USA NationalPension 2789
GovernmentPensionInvestmentFund Japan NationalPension 1150
GovernPensionFund-Global Norway SovereignWealthFund 882
AbuDhabiInvestmentAuthority(ADIA) UAE SovereignWealthFund 773
ChinaInvestmentCorporation(CIC) China SovereignWealthFund 746
SAMAForeignHoldings SaudiArabia SovereignWealthFund 671
KuwaitInvestmentAuthority(KIA) Kuwait SovereignWealthFund 592
SAFEInvestmentCompany China SovereignWealthFund 567
NationalPensionServiceofRepublicofKorea Korea NationalPension 455
StichtingPensioenfondsABP Netherlands PublicPension 440
FederalRetirementThrift UnitedStates PublicPension 422
GICPrivate-Limited Singapore SovereignWealthFund 344
QatarInvestmentAuthority Qatar SovereignWealthFund 256
FIGURE 4: Top Government Sponsored Funds
8SWFI – Fund Rankings at, [https:www.swfinstitute.org/fund-ranking/]
0
500
1000
1500
2000
2500
3000
Sovereign Wealth Funds
Other
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CHAPTER3:HistoryofSovereignWealthFundInvestmentinUS
CommercialRealEstate
History
Sovereign Wealth Fund investment into commercial real estate is a relatively new
occurrence. As commercial real estate continues to evolve and mature, so does visibility
and its access as an investment class. Additionally, statistics surrounding this maturing
asset class is starting to accumulate sufficient data (deal flow data over time) to draw
inferences about investment characteristics (market beta, risk premium, annual return,
etc.).
At the same time, sovereign coffers began to explode as commodity prices soared
globally. In search for diversification and higher returns, sovereign investment groups
began to look at commercial real estate as a realistic alternative to traditional stocks and
bonds.
Another significant innovation was the investment manager (sponsor), which entered into
a joint venture with the foreign group. This person acts as a local expert to invest the
Sovereign Wealth Fund’s investment dollars.
Over 60% of all Sovereign Wealth Funds have at least 5% of their portfolio invested in
commercial real estate.9 Figure 5 shows that Sovereign Wealth Funds grew aggregate
annual investment in commercial real estate from nearly zero in 2004 to over 3% of all
US investment (6% in the six major US markets) by 2008. Note: The Major six markets
are defined by Real Capital Analytics (RCA) as Boston, New York, D.C., Chicago, Los
Angeles, San Francisco.
9 “Sovereign Wealth Funds Investing in Real Estate”, Real Estate Spotlight, November, 2013 (Preqin); https://www.preqin.com/docs/newsletters/RE/Preqin_Real_Estate_Spotlight_November_2013.pdf
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FIGURE 5: SWF Investment History – Major Markets
FIGURE 6: SWF Investment History – US Total
As Sovereign Wealth Funds allocated more toward US commercial real estate, they
primarily targeted large global markets such as Boston, New York, D.C., Chicago, Los
Angeles, San Francisco. These 6 markets typically attract around 80-90% of all US
Sovereign Wealth Fund investment volume. Figure 7 illustrates the highly concentrated
0%
1%
2%
3%
4%
5%
6%
7%
$0
$1,000,000,000
$2,000,000,000
$3,000,000,000
$4,000,000,000
$5,000,000,000
$6,000,000,000
$7,000,000,000
$8,000,000,000
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
SWFInvestmen
tas
%ottatalCRE
Investmen
t
SWFInvestmen
t
0%
1%
2%
3%
4%
$-
$1,000,000,000
$2,000,000,000
$3,000,000,000
$4,000,000,000
$5,000,000,000
$6,000,000,000
$7,000,000,000
$8,000,000,000
$9,000,000,000
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
SWFInvestmen
tas
%ottatalCRE
Investmen
t
SWFInvestmen
t
20
nature of the group’s investments. In fact, only three times since 2004 have these 6
markets failed to attract less then 90% of Sovereign Wealth Fund’s US allocation.
FIGURE 7: Sovereign Wealth Fund Major Markets Vs. Sovereign Wealth Fund US total
A potential reason behind the concentration in large international cities that foreign
investors tend to invest in markets they know and are familiar with. As global
destinations for business and pleasure, they have likely been visited by these investors.
Significant research has shown a similar tendency to invest in known assets when
investing in stocks. Beginning with Robert Merton’s Investor Recognition Hypothesis
(Merton, 1987), which, in relevant parts, essentially states that (i) a security’s value
increases with investor recognition and (ii) security’s expected return decreases with
investor recognition. Less known equities also increase in idiosyncratic risk and are more
sensitive to news (Lehavey and Sloan, 2008). The mechanics behind this turn on investor
pool size, information flow, and diversification. In short, the more an equity is known,
the greater the information and more diverse the investor pool is. Better information
allows for lower risk, while a large and diversified investor base allows for a lower cost
of capital and therefore lower required return. Alternatively, an equity with little
0%
20%
40%
60%
80%
100%
120%
$0
$1,000,000,000
$2,000,000,000
$3,000,000,000
$4,000,000,000
$5,000,000,000
$6,000,000,000
$7,000,000,000
$8,000,000,000
$9,000,000,000
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
SWFMajorM
arketV
sUSTotal
USSW
FInvestmen
t
SWFMajorMarket SWFUSTotal SWFMajorMarket%ofUSTotal Average
21
recognition will require fewer investors to take less diversified positions and therefore
require a higher expected return to compensate, thereby driving pricing down.
This fits what we see in commercial real estate in the United States. Markets high in
recognition seem to receive more globally diverse investors, benefit from better global
information, and tend to have lower expected returns (higher prices). On the other hand,
secondary and tertiary markets offer less global information and fewer and less diverse
investors. As a result, investors in these markets require greater expected returns to offset
their over-weighted and a less diversified position in these markets.
When comparing total Sovereign Wealth Fund investment to total cross boarder
investment dollars, an interesting trend appears. Sovereign Wealth Funds started
investing in US commercial real estate in the early 2000s. Since that time they have
disproportionally invested in these top 6 markets when compared to their cross boarder
peer investors. Sovereign Wealth Funds make up about 10% of all investment into the
top 6 US markets, while they only average around 8% of the US total cross boarder
investment pool. This consistent over-weighting on the top 6 markets compared to other
foreign investors appear to occur because much of Sovereign Wealth investment comes
predominately form Asia and the Middle East. In the alternate, private foreign
investment includes more proximal sources such as Canada and Mexico, which are more
likely to invest in secondary markets due to increased familiarity.
Another potential reason that Sovereign Wealth Funds invest primarily in the largest
markets is that Sovereign Wealth Funds have an outsized amount of capital to deploy, yet
due to taxation benefits, typically invest in less than 50% interest in an investment. As a
result, Sovereign Wealth Funds prefer large transactions.
RecentTrendsandNews
In a discussion panel hosted by Bloomberg, CBRE, and EY, Erh Fei Liu from Cindat
Capital Management, said that China's sovereign wealth fund, Chinese Investment
Corporation (“CIC”), has "a trillion" to invest in commercial real estate around the
world. The CIC, which, according the WSJ, already has accumulated about $220 billion
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in overseas assets since 2007 and is backed by China's $3.44 trillion in foreign reserves,
has the ability to produce a flood of equity capital into global real estate. In a discussion
concerning the future management of its newly created capital, CIC chairman Ding
Zuedone stated that he was his intent to increase its allocation to real estate in developed
countries, particularly the US due to its economic strength and political safety.
Moreover, the CIC is taking a more "hands on" approach, directly investing alongside
strategic private equity partners.
Singapore's sovereign wealth fund (SIG), controlling around $320 billion in assets
(according to research firms in the US), is aggressively targeting real estate in search of a
"fair return" for its aging population of 3.3 million. The Chief Investment Officer of SIG
told Bloomberg that they are "overhauling" their traditional endowment model to jump
on opportunities that may represent an "idiosyncratic" situation. Real estate seems to be
at the center of the overhaul with the acquisition of NYC's Time Warner Center.
Norges Bank Investment Management (NBIM), started investing in commercial real
estate in 2011 with the purchase of a 25% interest in The Crown Estate's Regent Street,
London. Since that time it has become ever more aggressive with its direct investment in
real estate. NBIC has stated a target allocation of 5% of total fund value10. At the end of
2014 the allocation was 2.2%. As of December 2015 the fund has reached 3.0% of the
total value of the portfolio, falling slightly behind their target of 1% increase per year.
While 2015 did see a fair amount of investment activity with over $160 million in a 50%
partnership with Prologis, $152 million in a 49.9% stake in a San Francisco office tower
alongside TIAA – CREF, and £240 million for 100% of a 95-year lease in West One
Shopping Centre and adjacent building at 75 Davis in London, part of the increased
allocation is also due to the poor performance of the two other asset classes—Equities
and Fixed Income. In Q3 2015 Equities returned -8.6%, Fixed Income returned 0.9%,
while Real Estate returned 3.0%.
10 “Q3 2015 Government Pension Fund Global, Quarterly Report” — Norges Bank Investment Management; http://www.nbim.no/contentassets/c241d687f06c4dc498a50407f80f04ca/3q_15_eng_web.pdf
23
At the end of 2014, NBIM had about $9 billion in 360 assets around Europe and about $5
billion in 83 assets in Northern America11. In total, this represents around $14 billion in
real estate (about 2% of the funds total). Pursuing the target allocation of 5% of total
value (~$35 billion) in real estate with a target increase of about 1% of the fund per year
would mean about $7 billion entering the commercial real estate equity market each year
from one fund. In a recent presentation to the Minister of Finance NBIM Chief
Executive Officer, Yngve Slyngstad, hinted that their target allocation may actually be
10% (+/- 5%).
A study by Cornell shows that target allocations for government funded investment funds
are aiming on average around 10%. These figures are corroborated by research done by
Preqin. In Figure 8 shows that 93% of all Sovereign Wealth Funds target between 5%
and 15%, with 53% targeting between 5% and 10% allocations.12 It is also clear that the
current allocation is lagging far behind the target allocation. This supports the idea that
Sovereign Wealth Funds will continue to be an increasing player in the global real estate
market.
FIGURE 8: Distribution of Sovereign Wealth Funds by Allocation
11 Norges Bank Investment Management – Holdings; http://www.nbim.no/en/the-fund/holdings/ 12“Sovereign Wealth Funds Investing in Real Estate”, Real Estate Spotlight, November, 2013 (Preqin)
45%
32%
14%9%
0%
57%
36%
7%
0%
10%
20%
30%
40%
50%
60%
Lessthan4.9% 5-9.9% 10-14.9% 15orMore
CurrentAllocation TargetAllocation
24
With around $6.3 trillion worth of funds under management, it is possible to estimate the
targeted volume entering the market over the next few years. For example, assume that
25% of the “less than 4.9%” group goes to “5-5.9%” (filling its 57% target) and the
remaining 20% goes to the “10-14.9%” group (nearly filling its 36% target for that
group). Further, to be conservative, use the low end of each bucket (5% for the “5-5.9%”
group and 10% for “10-14.9%” group). This would yield the following calculation;
Total Targeted Equity Increase = 0.05 * 0.25 * 6.3 + 0.1 * 0.2 * 6.3 = $204 Billion
Preqin also found that 100% of Sovereign Funds over $100 Billion are invested in real
estate via direct, listed, or private vehicles. This means that the shift of the 45% of all
funds not invested in real estate will come entirely from funds smaller than $100 Bn.
This shift may be made possible by an increase in the outsourcing of fund management
operations and the efficiencies surrounding that shift. Historically, a fund needed to be
sufficiently large to afford a global real estate investment operation and the property
diversification that comes with one. The trend described by NBIM in its December 2015
presentation to the Finance Minister of Norway, recreated in Figure 9, best illustrates
how smaller funds may be able to increasingly access this market.
FIGURE 9: NBIM Cost of Investment Management (bps)
bps
MillionUSD
0246810121416
0
20
40
60
80
100
120
140
2011 2012 2013 2014
InternalManagementCosts ExternalManagementCosts
Tax CREAssestsUnderManagment(billion)
25
Indeed, part of the reduction in costs are due to economies of scale (fixed costs are
allocated across a broader base). However, there is a clear trend toward outsourcing
investment management and one can assume that efficiencies correlate to cost savings.
Figure 9 shows that Norges Bank Investment Management allocated around 2% of total
costs toward external management in 2011 when they had around $2 Billion under
management. That proportion grew to around 40% outsourced in 2014. This increased
maturity of the Sovereign Wealth investment structure, increased outsourcing, and
economies of scale have driven down costs to where the smaller Sovereign Wealth Funds
can economically participate.
26
CHAPTER5:DATAANDMETHODOLOGY
Approach
As previously stated, the purpose of this analysis is to understand the impact of Sovereign
Wealth Investment on relative pricing and to apply economic and business principles to
explain potential reasons for any correlations.
To understand the heart of pricing variations, one cannot only look at absolute values
such as price per foot since rent density varies largely by location, vintage, and market.
Likewise, you cannot simply use traditional pricing metrics like price per earnings (PE)
or the more common metric in commercial real estate, Cap Rate – the inverse of price to
earnings. This is because a cap rates float like a buoy on the tidal fluctuations of the risk
free rate.
To understand the impact on commercial real estate pricing we will drill down to risk
premium. Risk premium is traditionally defined as the amount of “premium” that an
investor is willing to pay above the prevailing “riskless” investment. Given that the
argument of this thesis is that Sovereign Wealth Investors are willing to pay more than
their peers in the same market, time, and location, you could assume that Sovereign
Wealth Funds are willing to accept a lower risk premium. In short this thesis will attempt
to understand their unique pricing of risk.
Unfortunately, data on market derived risk premia is not readily available, and therefore
we are unable to analyze for trends. What is available is what Real Capital Analytics
(RCA) calls “spread.” Spread is defined as the difference between transactional cap rate
and the 10-year bond rate. Assuming that the 10-year bond rate is a proxy for a risk free
rate, we can use the following two definitions (Equation 1 and 2) of total return as a
proxy for risk premium. Geltner points out that the 10-year bond rate is not entirely
riskless due to market fluctuations that can alter the investor’s Opportunity Cost of
Capital, which changes the present value of the bond. Also given that the delta between a
27
true riskless rate and the 10-year bond rate (around 100-200 bps)13 is independent of
location, vintage, and market, we can employ this assumption without fear of altering the
results).
Equation 1 is derived from a constant growth perpetuity model while equation 2 is
derived from the capital asset pricing model (CAPM). Both are backed by sound
financial theory. Taken together these equations allow this analysis to approximate risk
premium with RCA’s definition of spread.
The following are two basic definitions of total return;
(1) E(r)=E(y)+E(g) where,
E(r)=expectedreturn
E(y)=expectedinitialyield
E(g)=expectedgrowth
(2) E(r)=Rf+RP where,
E(r)=expectedreturn
Rf=riskfreerate
RP=riskpremium
By taking equation 1 and 2 together, you get the following equality;
(3) E(y)+E(g)=Rf+RP
Noting that the data provides “spread” as defined by RCA as the difference between cap
rate and the risk free rate we memorialize the definition here;
(4) SpreadRCA=cap-Rf
13 “Commercial Real Estate Analysis & Investment” 2e Gletner, Miller, Clayton, Eichholtz, page 251
28
While Cap Rate is related to NOI and E(y) is related to the Property Before Tax Cash
Flow (PBTCF), the difference is small and we can say, E(y) ≈ Cap Rate. By substituting
Cap Rate for E(y) in Equation 3, it can then be rearranged to see the relationship between
risk premium and spread;
(5) Cap+E(g)=Rf+RPHIJKLM
Cap-Rf+RP–E(g)
Substituting the RCA definition of spread into equation 5;
(6) SpreadRCA=RP–E(g)
Equation 6 shows that in an effort to analyze the affects of Sovereign Wealth Investment
on risk premium the analysis will have to consider that growth is baked into the data set.
If expected growth, E(g), was known, then it could be added to the “spread” data provide
by RCA to calculate quarterly risk premia. It can be argued that CPI growth, rental
growth, or another metric might make sense for E(g), but E(g) is, by definition, an
expectation of growth not actual growth and therefore has no econometric approximation.
Expected growth is tied to investor sentiment and there is little data for investor
expectation of growth (although some economists are attempting to do this with survey
data). It has been shown that E(g) is “stickier” than actual growth.14 Indeed, expected
growth may be a reason for pricing discrepancies on a one off basis, but this tends to
normalize over an efficient market. Therefore, this thesis will continue to focus on
systemic drivers of variation.
DataSource
Real Capital Analytics (RCA) was highly utilized for sourcing data to support this thesis.
RCA was able to provide consistent quarterly data from 2001 – Q3 2015. As a result,
RCA provided almost 14 years of quarterly data on the following metrics: Spread, Cap
14 “Commercial Real Estate Analysis & Investment” 2e Gletner, Miller, Clayton, Eichholtz, page 254
29
Rates, Rent Revenue, Office Investment Volume, Cross Boarder (foreign investment)
Office Investment Volume, and Sovereign Wealth Office Investment Volume.
For each of these metrics, data was collected for three statistical groups
1) UStotalMarket
2) SixMajorMarkets
3) Non-MajorMarkets
The six Major Metros, for this analysis, are defined by Real Capital Analytics (RCA) as
the following six markets; Boston, New York, Los Angeles, Chicago, D.C., and San
Francisco.
Only US Office over $2.5 million was considered for the analysis when pulling data from
RCA. It is well known that Sovereign Wealth Funds invest across all major asset classes,
but it is more revealing to look at the affects on one product type as apposed to all asset
classes lumped together. Office seemed the most interesting and provided the richest
data set. The same analysis performed within this thesis can be done for each product
type to understand the impact of Sovereign Wealth Investment on other real estate
products.
Another source of data was the St Louis Federal Reserve, which supplied 10-year
treasury constant maturity rate, CPI data and GDP growth rates. For all three, we used a
quarterly average for aggregating the data.
CPI data was used to create an independent variable called “Real Rent Ratio.” This was
adopted from previous work from Chervachidze and Wheaton (2013). The real rent ratio
is defined as the relative real rent when compared to the average for the research period.
In this case nominal rents provided by RCA are transformed into real rents using 2001 as
the base year, CPI01.
30
The following equations are used to calculate the periodic Real Rent Ratio;
(7) QRSTQRUVW = XYZI[\K]J[W^
_`a^_`abc
(8) QRSTQRUVQSVefW =]J\K]J[W^
cg ]J\K]J[W^g
bc
Finally, data on Sovereign Wealth Fund activity and cross boarder investment activity
was sourced from Preqin, an alternative asset data source, the Sovereign Wealth Fund
Institute (Sovereign Wealth FundI), CBRE, US Governmental White Papers, and KPMG.
Analysis
This thesis leverages the use of multiple linear regression to understand the marginal
impact of Sovereign Wealth Fund investment on US commercial real estate pricing (as
defined above), holding other factors constant. The coefficient to the independent
variable related to sovereign wealth fund investment will identify the impact of one unit
change in Sovereign Wealth Investment on the investment spread.
It is important to note that the analysis will not use absolute investment dollars for
Sovereign Wealth Investment. This is a crucial point. The operating thesis, as stated
before, is that a fundamental difference in investor profile allows the investor to pay more
for each unit of risk, and therefore reduces risk premium (or proximally - spread).
Simply stating that Sovereign Wealth Funds invested $1 Billion would not achieve
sufficient clarity as it could be argued that the sheer size of investment into the markets
will alter the price of risk that an investor is willing to pay. To guard against this
concern, the analysis uses Sovereign Wealth Fund investment as a percent of total
investment in its regression modelling. The resulting regression coefficient will then
describe the impact of the relative mix of investor as it becomes more or less Sovereign
Wealth Fund (versus other institutional sources).
31
The analysis seeks to identify a statistically sound model over the 14 years of quarterly
data that best describes/predicts the risk spread for each of the three markets identified
above. It will begin by considering a broad range of independent variables that might
influence the risk spread and then identify those that are statically significant. An alpha
level of 0.05 will be used as the threshed for statistical significance. This means that the
null hypothesis has a 5% probability of being true. As a result, the analysis will require a
P values less than 0.05. Also the analysis will attempt to get a good “fit” and achieve as
high as possible R2 value. By doing this, other variables are fixed and the resulting
regression better isolates the impact Sovereign Wealth Fund participation in the market.
The list of potential independent variables are as follows;
• NominalGrossDomesticProductGrowth(GDPGrowth)
• 10-yearTreasuryConstantMaturityRate
• RealRentRatio(definedabove)*15
• CapRate*
• TotalVolume
• CrossBoarderInvestment(allforeigninvestmentincludingSWF)
• SWFVolumeasaPercentofTotalInvestmentVolume
Dependent Variable;
• Spread(RCA)*
In addition to the above independent variables, this thesis will explore “time lagging”16
when it has a sound economic reason. For example, the analysis will investigate whether
an investment made by a SWF last quarter impacts the spread in the current quarter.
15 * Metrics are relative to office over $2.5 million.
16 “Time lagging” is the process of lagging time series data in a regression model. By regressing data as an independent variable that has been lagged by a specific amount of time, you can see the associated affect from an earlier period on the current period’s dependent variable.
32
When looking at markets the analysis will typically look at data from that market.
Spread, Rent Revenue, Total investment, Cross Boarder investment, and Sovereign
Wealth Investment all are in-market data points. GDP growth, CPI, and 10-year bond
rates are all examples of cross market variables and will apply to all analyses.
With that said, there is one analytical approach where the thesis looks at cross market
interactions and therefore the data will be crossed. The idea is that there may be a
“trickle down” effect, where an investment in the 6 major markets affects the spread in
non-major markets. In this case the analysis will also look closely at time lagging to
understand any time delayed interactions between markets.
33
CHAPTER6:ANALYSISANDRESULTS
AnalysisOverview
From the process described above, the analysis identified five independent variables that
create a good economic model for the various test scenarios. The three scenarios are
repeated here;
• ImpacttospreadinthesixMajorMarketsfromSovereignWealthInvestment
madeintothesamesixmajormarkets
• ImpacttospreadintheNon-majorMarketsfromSovereignWealthInvestment
madeintothesixMajorMarkets
• ImpacttospreadintheUSfromSovereignWealthInvestmentmadeintotheUS
The following comprise a list of independent variables that were identified as statistically
significant;
• 10-YearBondRate
• RealRentRatio(asdefinedabove)
• TotalInvestmentVolume
• LaggedTotalInvestmentVolume(onequarterlag)
• PercentSovereignWealthInvestmentVolume
As noted in the “method” chapter, the analysis started with a large array of potential
independent variables. Subsequently the analysis found the above list to produce the best
model and also allowed the analysis to isolate the affects of the share investment volume
that comes from Sovereign Wealth Investors. In particular, by looking at total
investment, the thesis holds constant the affects that total investment volume can have on
the price of risk. Also, by lagging it, the regression can isolate the affect of last quarter’s
influx of capital. Interestingly, the analysis found that lagging Sovereign Wealth
Investment produced less significant results and therefore was not considered in the final
34
model. It appears that this is due to the three factors; (i) Sovereign Wealth Investment is
still a small portion of the overall investment pool, (ii) Sovereign Wealth Investment is
somewhat sporadic and the market does not price in an overpriced purchase from a
Sovereign Wealth Investor in the previous quarter as they do total volume and (iii) Not
enough data.
Point (ii) above is highlighted by the volatility of Sovereign Wealth Investment compared
to Total Investment. Total investment volume has a relative standard deviation of +/-
30% of its average, meaning that 68% of the time, total investment volume in US Office
falls within +/- 30% of its average. On the other hand, the same metric for Sovereign
Wealth Investment is 54% and 155%, Major Metros and Non-Major Metros respectively
(see table 2). While both skewness and heteroskedasticity are a concern while looking at
Sovereign Wealth Investment (investments occur more often and are a larger share of
total investment toward the end of our analysis period), the broad picture can still be seen
from this application of standard deviation.
In addition to the analyses, interpretation and discussion is found in the following
chapter.
TABLE 2: Volatility by Investment Market
SovereignWealthInvestmentintoSixMajorMetroMarkets
As seen above in Figure 7 above, 70% of all Sovereign Wealth Investment dollars finds
its home in one of the six Major Markets. In fact, if the analysis removes the somewhat
MARKET STDEV AVERAGE HALFSTDEV/AV.
TOTALINVESTMENTVOLUME-US 40,400,681,267 68,253,544,195 30%
TOTALINVESTMENTVOLUME-MAJORMETRO 18,321,890,936 30,222,581,572 30%
SWFINVESTMENTVOLUME-US 934,998,559 851,860,881 55%
SWFINVESTMENTVOLUME-MAJORMETRO 773,417,790 716,024,691 54%
SWFINVESTMENTVOLUME-NON-MAJORMETRO 413,765,004 133,729,454 155%
35
anomalous year of 2007, when there was a very large investment outside the six major
markets, then the average is over 74% with a median of 89%. This reflects the previous
assertion that Sovereign Wealth Investors, in general, tend to invest in markets they know
or are at least familiar with. In this section, the analysis investigates the impact of
Sovereign Wealth Investment in the six major markets from investments made in these
same six markets.
Below is the data that was regressed for the six major metros. Note that Q1 2001 is
missing. This is due to the lagged variable. The dataset from RCA did not provide
information before 2001 so Q1 2001 was truncated from these regressions.
DATA TABLE 1: Sovereign Wealth Investment into Six Major Metros
PERIOD
MAJORMETROS
OFFICEYIELDSPREAD
10YRBONDRATE
REALRENTRATIO
TOTAL VOLUME
(BILLION $)
LAGGED TOTAL
VOLUME (BILLION $)
SWF AS % OF TOTAL VOLUME
01Q2 3.16 5.28 1.08 $12.84 $8.90 0.1101Q3 4.46 5.00 1.08 $9.01 $12.84 -01Q4 3.77 4.76 1.09 $9.70 $9.01 -02Q1 3.67 5.08 1.09 $9.08 $9.70 -02Q2 3.81 5.11 1.08 $10.58 $9.08 0.0302Q3 4.69 4.27 1.07 $12.57 $10.58 -02Q4 4.50 4.00 1.06 $14.49 $12.57 -03Q1 4.84 3.92 1.05 $11.17 $14.49 -03Q2 4.92 3.62 1.04 $12.0288 $11.17 -03Q3 4.03 4.23 1.02 $16.75 $12.03 -03Q4 4.01 4.29 1.01 $18.63 $16.75 -04Q1 4.26 4.01 0.99 $17.1466 $18.63 0.1504Q2 3.20 4.60 0.98 $19.42 $17.15 -04Q3 3.47 4.30 0.98 $26.14 $19.42 -04Q4 3.20 4.18 0.97 $30.87 $26.14 0.2705Q1 2.82 4.30 0.97 $30.32 $30.87 -05Q2 3.18 4.16 0.98 $42.28 $30.32 0.0805Q3 2.55 4.22 0.98 $38.67 $42.28 0.0305Q4 2.40 4.49 0.98 $40.54 $38.67 1.7606Q1 1.89 4.58 0.98 $38.14 $40.54 -06Q2 1.31 5.07 0.99 $46.57 $38.14 3.6306Q3 1.90 4.89 0.99 $42.06 $46.57 1.6106Q4 1.56 4.63 1.01 $63.35 $42.06 0.6407Q1 1.42 4.68 1.02 $79.28 $63.35 0.7307Q2 0.91 4.85 1.02 $68.82 $79.28 0.2107Q3 1.31 4.74 1.02 $52.73 $68.82 -07Q4 1.83 4.27 1.01 $57.97 $52.73 -08Q1 2.93 3.67 1.01 $24.37 $57.97 -08Q2 2.45 3.88 0.99 $21.85 $24.37 13.0808Q3 2.72 3.86 0.98 $18.36 $21.85 10.61
36
08Q4 4.32 3.23 1.00 $10.52 $18.36 -09Q1 4.25 2.74 1.00 $6.74 $10.52 -09Q2 4.09 3.32 0.99 $5.70 $6.74 -09Q3 4.81 3.52 0.98 $7.33 $5.70 -09Q4 4.83 3.46 0.97 $9.71 $7.33 -10Q1 3.65 3.72 0.96 $9.06 $9.71 -10Q2 4.34 3.49 0.95 $13.36 $9.06 1.4510Q3 4.82 2.78 0.95 $17.90 $13.36 1.0510Q4 3.41 2.88 0.94 $29.82 $17.90 0.0811Q1 3.59 3.46 0.94 $19.06 $29.82 -11Q2 3.56 3.20 0.93 $32.50 $19.06 1.4911Q3 4.85 2.41 0.94 $28.36 $32.50 0.6311Q4 4.58 2.05 0.94 $32.80 $28.36 0.4712Q1 4.09 2.04 0.95 $24.37 $32.80 0.5912Q2 4.68 1.83 0.95 $27.25 $24.37 -12Q3 5.06 1.64 0.95 $34.18 $27.25 0.6312Q4 4.72 1.71 0.96 $53.97 $34.18 1.7913Q1 4.47 1.95 0.96 $38.73 $53.97 3.3413Q2 3.48 1.99 0.97 $32.68 $38.73 0.9113Q3 3.51 2.71 0.97 $34.96 $32.68 -13Q4 3.20 2.74 0.97 $54.80 $34.96 2.5314Q1 3.58 2.77 0.99 $36.94 $54.80 6.1214Q2 3.47 2.62 0.99 $45.97 $36.94 3.6614Q3 3.66 2.50 1.01 $51.46 $45.97 2.1314Q4 3.95 2.28 1.04 $55.72 $51.46 3.9815Q1 4.00 1.97 1.07 $62.89 $55.72 1.6015Q2 3.79 2.16 1.07 $53.15 $62.89 0.6515Q3 3.70 2.22 1.08 $48.60 $53.15 0.64
Regressing the above variables yields the following regression:
SUMMARYOUTPUT1 RegressionStatistics
MultipleR 0.93 RSquare 0.86
AdjustedRSquare 0.85 StandardError 0.41 Observations 58.00
ANOVA
df SS MS F Regression 5.00 54.65 10.93 64.45
Residual 52.00 8.82 0.17 Total 57.00 63.46
Coefficients StandardError tStat P-value Lower95%Upper95%
Intercept 2.05 1.26 1.63 0.11 (0.47) 4.5810YRBondRate (0.77) 0.06 (13.5) 0.00 (0.89) (0.66)RealRentRatio 5.59 1.32 4.23 0.00 2.94 8.24
TotalVolume(Bn$) (0.02) 0.01 (3.02) 0.00 (0.03) (0.01)LaggedTotalVolume(Bn$) (0.02) 0.01 (3.87) 0.00 (0.04) (0.01)SWFas%ofTotalVolume (0.068) 0.02 (2.94) 0.00 (0.11) (0.02)
37
SovereignWealthInvestmentEffectsonNon-MajorMetros
In this next section the analysis considers the effects on Non-Major Metro risk spread
from SWF Investment into Major Metros. This assumption is testing the “trickle down”
affect from an investment into major metros. The theory is that when SWF Investors
enter a major market and push up prices via a reduced risk spread, other investors exit
these markets and invest in secondary markets. It is important to note that the analysis
did consider investment into non-major markets and the associated effect on the risk
spread in the same market, but due to very little investment into these markets there are
no statistically significant results to be observed.
Data Table 2: Sovereign Wealth Investment effects on Non-Major Metros
PERIOD
NON-MAJORMETROS
OFFICEYIELDSPREAD(%)
10YRBONDRATE
REALRENTRATIO
NON MAJOR
MARKET TOTAL
VOLUME (BILLION $)
LAGGED TOTAL
VOLUME (BILLION $)
SWF AS % OF TOTAL VOLUME
01Q2 3.51 5.28 1.09 $12.84 $8.90 0.1101Q3 4.90 5.00 1.11 $9.01 $12.84 -01Q4 4.32 4.76 1.12 $9.70 $9.01 -02Q1 3.97 5.08 1.11 $9.08 $9.70 -02Q2 4.24 5.11 1.10 $10.58 $9.08 0.0302Q3 5.24 4.27 1.09 $12.57 $10.58 -02Q4 5.03 4.00 1.07 $14.49 $12.57 -03Q1 5.26 3.92 1.05 $11.17 $14.49 -03Q2 5.13 3.62 1.04 $12.03 $11.17 -03Q3 4.74 4.23 1.02 $16.75 $12.03 -03Q4 4.16 4.29 1.02 $18.63 $16.75 -04Q1 4.50 4.01 1.00 $17.15 $18.63 0.1504Q2 3.61 4.60 1.00 $19.42 $17.15 -04Q3 4.21 4.30 0.99 $26.14 $19.42 -04Q4 3.70 4.18 0.98 $30.87 $26.14 0.2705Q1 3.38 4.30 0.98 $30.32 $30.87 -05Q2 3.64 4.16 0.98 $42.28 $30.32 0.0805Q3 3.18 4.22 0.96 $38.67 $42.28 0.0305Q4 2.86 4.49 0.96 $40.54 $38.67 1.7606Q1 2.35 4.58 0.96 $38.14 $40.54 -06Q2 2.04 5.07 0.97 $46.57 $38.14 3.6306Q3 2.52 4.89 0.97 $42.06 $46.57 1.6106Q4 2.26 4.63 1.00 $63.35 $42.06 0.6407Q1 2.27 4.68 1.01 $79.28 $63.35 0.7307Q2 1.87 4.85 1.02 $68.82 $79.28 0.2107Q3 2.50 4.74 1.03 $52.73 $68.82 -07Q4 3.18 4.27 1.02 $57.97 $52.73 -08Q1 4.03 3.67 1.02 $24.37 $57.97 -08Q2 3.47 3.88 1.01 $21.85 $24.37 13.0808Q3 3.60 3.86 1.00 $18.36 $21.85 10.6108Q4 5.46 3.23 1.02 $10.52 $18.36 -
38
09Q1 5.60 2.74 1.02 $6.74 $10.52 -09Q2 4.21 3.32 1.01 $5.70 $6.74 -09Q3 4.49 3.52 1.00 $7.33 $5.70 -09Q4 4.97 3.46 0.98 $9.71 $7.33 -10Q1 4.90 3.72 0.97 $9.06 $9.71 -10Q2 5.90 3.49 0.95 $13.36 $9.06 1.4510Q3 5.51 2.78 0.95 $17.90 $13.36 1.0510Q4 5.00 2.88 0.94 $29.82 $17.90 0.0811Q1 4.55 3.46 0.94 $19.06 $29.82 -11Q2 4.79 3.20 0.93 $32.50 $19.06 1.4911Q3 5.82 2.41 0.93 $28.36 $32.50 0.6311Q4 5.99 2.05 0.94 $32.80 $28.36 0.4712Q1 5.75 2.04 0.94 $24.37 $32.80 0.5912Q2 6.05 1.83 0.94 $27.25 $24.37 -12Q3 6.02 1.64 0.94 $34.18 $27.25 0.6312Q4 5.78 1.71 0.95 $53.97 $34.18 1.7913Q1 5.79 1.95 0.95 $38.73 $53.97 3.3413Q2 4.97 1.99 0.96 $32.68 $38.73 0.9113Q3 5.03 2.71 0.97 $34.96 $32.68 -13Q4 4.50 2.74 0.97 $54.80 $34.96 2.5314Q1 4.60 2.77 0.98 $36.94 $54.80 6.1214Q2 5.06 2.62 0.98 $45.97 $36.94 3.6614Q3 4.84 2.50 0.99 $51.46 $45.97 2.1314Q4 4.96 2.28 1.01 $55.72 $51.46 3.9815Q1 5.22 1.97 1.03 $62.89 $55.72 1.6015Q2 4.85 2.16 1.03 $53.15 $62.89 0.6515Q3 5.27 2.22 1.03 $48.60 $53.15 0.64
Regressing the above variables yields the following regression:
SUMMARYOUTPUT2
RegressionStatistics MultipleR 0.95 RSquare 0.90
AdjustedRSquare 0.89 StandardError 0.38 Observations 58.00
ANOVA
df SS MS F Regression 5.00 64.68 12.94 89.33
Residual 52.00 7.53 0.14 Total 57.00 72.21
CoefficientsStandardError tStat P-value
Lower95%
Upper95%
Intercept 4.07 1.20 3.40 0.00 1.67 6.4710YRBondRate (1.03) 0.06 (18.22) 0.00 (1.14) (0.92)RealRentRatio 4.99 1.26 3.95 0.00 2.45 7.53
TotalVolume(Billion$) (0.01) 0.01 (2.55) 0.01 (0.03) (0.00)LaggedTotalVolume(Billion
$) (0.02) 0.01 (2.85) 0.01 (0.03) (0.00)SWFas%ofTotalVolume (0.057) 0.02 (2.66) 0.01 (0.10) (0.01)
39
SovereignWealthInvestmentintoUSTotal
The final regression focused on the impact that total Sovereign Wealth Investment in the
US Office market on US Office risk spread. While the percent participation in this
market is less than in the six major metros, it is worthwhile to learn what relative impact
there is for every 1% increase in the share of total investment made. See the results
below.
Data Table 3: Sovereign Wealth Investment into United States
PERIOD
USOFFICEYIELDSPREAD
10YRBONDRATE
REALRENTRATIO
US TOTAL
VOLUME (BILLION $)
LAGGED TOTAL
VOLUME (BILLION $)
SWF AS % OF TOTAL VOLUME
01Q2 3.36 5.28 1.09 $27.945 $20.16 0.0501Q3 4.69 5.00 1.10 $20.25 $27.95 -01Q4 4.05 4.76 1.11 $23.67 $20.25 -02Q1 3.83 5.08 1.11 $20.95 $23.67 0.2802Q2 4.03 5.11 1.09 $24.87 $20.95 0.0102Q3 4.99 4.27 1.09 $28.66 $24.87 -02Q4 4.80 4.00 1.07 $34.51 $28.66 -03Q1 5.04 3.92 1.05 $27.91 $34.51 -03Q2 5.03 3.62 1.04 $28.98 $27.91 -03Q3 4.38 4.23 1.03 $32.68 $28.98 -03Q4 4.09 4.29 1.02 $46.59 $32.68 -04Q1 4.39 4.01 1.00 $39.54 $46.59 0.3404Q2 3.43 4.60 0.99 $47.09 $39.54 -04Q3 3.85 4.30 0.99 $58.68 $47.09 -04Q4 3.47 4.18 0.98 $83.07 $58.68 0.1605Q1 3.14 4.30 0.98 $72.29 $83.07 -05Q2 3.43 4.16 0.98 $91.73 $72.29 0.1405Q3 2.95 4.22 0.98 $103.89 $91.73 0.0105Q4 2.68 4.49 0.98 $100.14 $103.89 0.7306Q1 2.17 4.58 0.99 $97.95 $100.14 0.0306Q2 1.75 5.07 0.99 $103.44 $97.95 1.6606Q3 2.28 4.89 1.00 $99.05 $103.44 0.7106Q4 1.99 4.63 1.01 $129.25 $99.05 0.3207Q1 1.92 4.68 1.02 $157.91 $129.25 0.3807Q2 1.50 4.85 1.02 $156.24 $157.91 0.3507Q3 2.02 4.74 1.02 $127.54 $156.24 2.1207Q4 2.61 4.27 1.01 $132.87 $127.54 -08Q1 3.71 3.67 1.01 $59.57 $132.87 -08Q2 3.03 3.88 1.00 $48.23 $59.57 6.7908Q3 3.31 3.86 0.98 $41.39 $48.23 4.7108Q4 5.05 3.23 1.01 $25.65 $41.39 -09Q1 5.04 2.74 1.01 $13.72 $25.65 -09Q2 4.15 3.32 1.00 $14.32 $13.72 -09Q3 4.66 3.52 0.99 $17.17 $14.32 -09Q4 4.91 3.46 0.98 $23.47 $17.17 -10Q1 4.50 3.72 0.97 $19.90 $23.47 -
40
10Q2 5.03 3.49 0.96 $27.23 $19.90 0.9310Q3 5.13 2.78 0.95 $38.20 $27.23 0.4910Q4 4.27 2.88 0.95 $63.41 $38.20 0.1811Q1 4.10 3.46 0.94 $36.94 $63.41 -11Q2 4.30 3.20 0.93 $70.78 $36.94 0.6911Q3 5.43 2.41 0.93 $57.53 $70.78 0.4011Q4 5.44 2.05 0.94 $69.01 $57.53 0.2212Q1 5.08 2.04 0.94 $53.10 $69.01 0.3112Q2 5.54 1.83 0.94 $63.07 $53.10 0.1712Q3 5.63 1.64 0.94 $70.96 $63.07 0.3012Q4 5.34 1.71 0.95 $110.59 $70.96 0.8713Q1 5.28 1.95 0.95 $75.42 $110.59 3.7013Q2 4.28 1.99 0.96 $75.28 $75.42 0.3913Q3 4.47 2.71 0.96 $91.75 $75.28 -13Q4 3.96 2.74 0.97 $118.07 $91.75 1.1714Q1 4.16 2.77 0.97 $92.84 $118.07 2.9214Q2 4.42 2.62 0.98 $95.50 $92.84 1.9814Q3 4.38 2.50 0.99 $111.17 $95.50 0.9914Q4 4.58 2.28 1.00 $130.62 $111.17 1.7015Q1 4.80 1.97 1.03 $136.89 $130.62 1.3215Q2 4.45 2.16 1.03 $121.72 $136.89 0.7715Q3 4.65 2.22 1.03 $115.61 $121.72 0.34
Regressing the above variables yields the following regression:
SUMMARYOUTPUT3
RegressionStatistics MultipleR 0.95 RSquare 0.91 AdjustedRSquare 0.90 StandardError 0.34 Observations 58 ANOVA
df SS MS F Regression 5 58.78 11.7 99.87 Residual 52 6.12 0.10 Total 57 64.90
Coefficients StandardError tStat P-value Lower95% Upper95%Intercept 2.60 1.18 2.20 0.03 0.23 4.9710YRBondRate (0.95) 0.05 (17.60) 0.00 (1.06) (0.84)RealRentRatio 5.93 1.27 4.68 0.00 3.39 8.48TotalVolume(Billion$) (0.01) 0.00 (3.55) 0.00 (0.01) (0.00)LaggedTotalVolume(Billion$) (0.01) 0.00 (2.14) 0.04 (0.01) (0.00)SWFas%ofTotalVolume (0.098) 0.04 (2.54) 0.01 (0.18) (0.02)
41
CHAPTER7:DISCUSSIONANDCONCLUSION
RegressionFindings
The following summarizes the Sovereign Wealth Fund Participation coefficient for each
of the three regression models outlined in the previous section.
TABLE 3: Summary of Regression Models (SWF as a Percent of Total Volume)
INVESTMENTMARKET YIELDSPREADMARKET COEFFICIENT17 R2UNITEDSTATES(ALLMARKETS) UnitedStates(allmarkets) (0.098)** 0.916MAJORMETROS 6MajorMetros (0.068)** 0.866MAJORMETROS Non-MajorMetros (0.056)** 0.90
This means that for all investment in the United States, for every one percent increase in
share of total investment form Sovereign Wealth Investment you should see a reduction
in yield spread of 9.6 basis points or 0.096 percent – and so on for the other two
scenarios. You can also see that all three coefficients are statically significant at alpha
equals 0.01, which means that the probably of the null hypothesis is around 1%.
One of the most interesting findings in these results is the “spill over” affect into other
markets. It was noted previously in Figure 7 that more than 80% of all Sovereign Wealth
Fund investment is made in six major metros. In an attempt to understand if there is any
spill over into the non-major markets, a regression was set up where the investment into
the six major metros was the independent variables and the spread from non-major
markets was the dependent variable. As noted in table 3 above, there was a statically
significant impact to yield spread in non-major markets from investment into the six
major metros. In fact, with every 1% increase in the share of investment from Sovereign
17Statistical significance is based on the traditional scale:
* P ≤ 0.05 ** P ≤ 0.01 *** P ≤ 0.001 **** P ≤ 0.0001
42
Wealth Funds in the six major metros, you see 5.6 basis points decrease in yield spread.
Interestingly this is fairly close to the yield spread contraction you see in its same market.
This may be explained by two ways.
1) Comparable crossover
2) Forcing investors out of major markets into non-major markets
For the “comparable crossover” theory, one would assume that investors in an adjacent
secondary and tertiary markets witness yield spread compression and adjust their own
yield spreads to follow the “trend.” There is often a “follow the leader” mentality
between major and non-major markets, where major markets are perceived to house the
aggregation of more information and sophistication. Whether this is true or not is beyond
the scope of this thesis.
Secondly, you may see a movement of investors from major markets into non-major
markets. These investors are typically more diversified due to scale and are more
accustomed to paying the lower risk spreads found in larger markets.
You can see from Figure 8 and 9 below that there is approximately 85 bps risk premium
paid in non-major markets over major markets. If these same investors that are familiar
with paying a specific premium in major markets move to non-major markets as a result
of Sovereign Wealth Fund investors entering major markets, it is plausible that they
would be willing to pay a slightly lower spread.
Interestingly, there isn’t a strongly significant impact from lagging Sovereign Wealth
Fund investment. This could be either because there isn’t enough data to produce the
significance needed (when you lag Sovereign Wealth Fund investment you loose a data
point in 2001 which could cause the degradation of significance), or investors are quick
to respond and typically act within the same quarter that the Sovereign Wealth Fund
invests into the major market.
43
FIGURE 10: Yield Spread Major Market Vs Non-Major Market
FIGURE 11: Yield Spread Premium Paid in Non-Major Markets
Another interesting finding is that the impact of a 1% increase in Sovereign Wealth
Funds participation yields a larger reduction in yield spread in the entire US Market
versus the 6 Major Metros. Since more than 80% of all Sovereign Wealth Investment is
-50.0
0.0
50.0
100.0
150.0
200.0
3/1/01
10/1/01
5/1/02
12/1/02
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2/1/11
9/1/11
4/1/12
11/1/12
6/1/13
1/1/14
8/1/14
3/1/15
YieldSpreadPremium(bps)
Delta Average
0
100
200
300
400
500
600
7003/1/01
10/1/01
5/1/02
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3/1/15
6MajorMetrosOfficeYieldSpread Non-MajorMetrosOfficeYieldSpread
44
allocated into the six major metros (see Figure 7 above), you would expect that the
greater coordinated impact to spread would be in those markets. The increased impact to
spread within only 20% addition allocation of investment is likely due to the spillover or
“echo” effect into Non-Major Markets discussed above. The spill over affect from
investment into the six major markets into the non-major markets enhances the overall
impact to the spread in the US.
PremiumPaidfromSovereignWealthFundParticipation
With it established that there is an inverse correlation with Sovereign Wealth Investment
and yield spread, it is logical to quantify the premium paid due to their participation.
While 5.8 bps in all Non-Major markets or 9.8 bps in the entire US may sound small, the
scale of these markets make these very large in absolute terms. By calculating the
estimated risk premium as if the Sovereign Wealth Fund participation was zero (holding
total investment constant), you could estimate the premium the market paid due
Sovereign Wealth Fund participation in each quarter. The analysis approaches this by
multiplying the Sovereign Wealth Fund regression coefficient by a particular quarter’s
percent Sovereign Wealth participation, which produces the yield spread impact from its
participation. If you subtract this from the cap rate for that market and multiply by the
implied net income, you can approximate the total volume assuming there was zero
sovereign wealth investment participation (same total volume). The difference between
this and the actual volume is the premium paid in that quarter from the Sovereign Wealth
Fund’s participation.
Below is a summary of the premium paid by the market due to Sovereign Wealth Fund
participation (0% participation from Sovereign Wealth Fund, same total investment).
45
FIGURE 12: Estimated Office Market Premium Paid as a Result of Sovereign Wealth
Fund Participation – United States18
FIGURE 13: Estimated Office Market Premium Paid as a Result of Sovereign Wealth
Fund Participation – Six Major Metros
18 US Office premium does not equal the sum of the Major Metros and Non-Major Metros. This is because the regression considers all product types, while the premium paid analysis only looks at Office. Office investment is not uniform across different market. On average office makes up the following share of total volume; 44% Major Metros, 24% non Major Metros, and 33% US total.
0%
10%
20%
30%
40%
50%
60%
70%
-
500
1,000
1,500
2,000
2,500
3,000
3,500
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
MarketPremiumPaidduetoSWFparticipationPremiumPercentofSWFInvestment
0%
10%
20%
30%
40%
50%
60%
70%
80%
-
500
1,000
1,500
2,000
2,500
3,000
3,500
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
MarketPremiumPaidduetoSWFparticipation(million)PremiumPercentofSWFInvestment
MillionUSD
MillionUSD
46
FIGURE 14: Estimated Office Market Premium Paid as a result of Sovereign Wealth
Fund Participation – Non-Major Metros
What the above charts highlight is that the premium paid in a market is significant
compared to the Sovereign Wealth Fund investment on absolute terms. Recall, the
regression uses total Sovereign Wealth Fund investment (all products) dollars against
office cap rates and spread. As a result, the above premium is only for office product
while the Sovereign Wealth Fund investment is for all product types. If you limit
Sovereign Wealth Fund investment in these markets to only Office, the total market
premium would be well in excess of the Sovereign Wealth Fund’s actual investment (in
absolute terms).
Moreover, since the entire Sovereign Wealth Fund’s investment is not a “premium”19
most of the market premium is actually being paid by others in the market. This can be
called “market pricing spillover.” Simply put, by Sovereign Wealth Funds participating
in the market, other investors in the market will pay more.
Consider the following example;
19 If the market price is $10 million for an office property and a Sovereign Wealth Fund pays $10.1 million, only $100k of that volume is “premium.”
0%
5%
10%
15%
20%
25%
30%
-
200
400
600
800
1,000
1,200
1,400
1,600
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
MarketPremiumPaidduetoSWFparticipation(million)
PremiumPercentofSWFInvestment
MillionUSD
47
In 2014 the six major markets experienced an estimated $3.01 billion premium paid in
the Office market alone as a result of Sovereign Wealth Fund participation (Figure 13).
At the same time, there was around $7.3 billion invested by Sovereign Wealth Funds (all
product types). Since data on Sovereign Wealth Fund investment does not breakout
investment by product type we can not say for sure how much volume is allocated for
office, but to illustrate the point we will assume that for the six major markets Sovereign
Wealth Funds invest 80% of their volume in Office. Following this assumption, that
would mean that Sovereign Wealth Investment into Office for the six major metros
would equal around $5.84 million and the total office market premium would be a little
more than half that size (3.01/5.84 = 0.51).
Now, assume that the premium paid per transaction is 10% above market. That would
mean that for a $10 million (market rate) office, a Sovereign Wealth Funds would pay
$11 million (one million over what the market would otherwise pay). Following this
assumption, apply that 10% transactional premium to the $5.84 million invested by
Sovereign Wealth Funds in the office market for the six major metros during 2014. This
would imply that their share of the premium was around $584,000 or that the market paid
the remaining “market premium” at $2.46 million ($3.01 million less $584,000). Put
another way, Sovereign Wealth Funds would be paying only 19.5% of the market
premium that they created simply by participating.
While this example leverages multiple assumptions, the point is apt. Unfortunately, exact
cap rate data for each Sovereign Wealth Fund transaction is needed to accurately estimate
the actual participation of the market premium. Regardless, it is clear that when SWFs
invest in a market, the rest of the market pays more than they otherwise would have.
ReasonsforIntramarginalInvestmentProfile
HoldPeriod
It has been mentioned in passing that one of the key reasons Sovereign Wealth Funds
may be able to pay more than private investors is that many of them effectively operate
48
under an indefinite time horizon. Indeed, other institutional investors can claim to have
an “indefinite hold period.” Many pension funds and endowments operate under a policy
that attempts to not draw down their investment pool to meet current obligations. With
that said, financial obligations of pension funds and even endowments have significant
fixed obligations. Meaning that in bad times, the fund may have to liquidate long term
assets to meet current liabilities. The pension fund has to pay its pensioners, and
endowments have to fulfill short and medium term obligations otherwise loose significant
credibility.
Sovereign Wealth Funds on the other hand typically have near zero obligations. Since
most are set up only after the central bank has built up a strong financial base to
accommodate fluctuations in the economy and market, Sovereign Wealth Funds are
typically a second or third degree away from financial obligations. Typically, there is a
second tier, mentioned above, with a “savings” structure that may act as the initial
backstop should the central banks need liquidity20. For these reasons, most Sovereign
Wealth Funds as applied to this analysis are essentially operating with an indefinite
investment horizon. This implication should not be understated.
An indefinite investment horizon allows a sovereign Wealth Fund to select when to buy
and when to sell. They are not constrained by fund liquidation dates, investor return of
capital, or other factors that may require an inopportune liquidation. In addition to
enhanced market timing, there are two other factors that play a direct role in reducing
Sovereign Wealth Fund’s risk premium; (i) the diminishing impact of yield change over
time and (ii) time’s ability to mute volatility21. The following two sub-sections will focus
20 NBIM is an outlier here. It is largest Sovereign Wealth Fund globally, but it is Norway’s only Reserve Investment Corporation (as the IMF would define it) and, as seen in Figure 2, Norway keeps only around $100 billion (7% of total assets) in its foreign reserve account compared to its peers that have 6-10 times this. As a result, has less protection from negative shocks. As a result, NBIM has been rumored be considering liquidating some of its assets to backfill its small foreign exchange account. [Presentation of investment performance in compliance with Global Investment Performance Standards (GIPS) 2010] 21 Interestingly Sovereign Wealth Funds have not leveraged their indefinite time horizon by targeting highly volatile markets. Sovereign Wealth Investors tend to invest heavily in well known, stable, and less risky markets, which is why the six major markets comprising over 80% of all US Sovereign Wealth Investment targets. With an infinite investment horizon, they may be able to mute highly volatile secondary markets (Miami, Las Vegas, Phoenix, etc.), and earn outsized returns over time.
49
on these two topics. They are more analytically rigorous than market timing and may be
more difficult for the reader to grasp without explanation.
YieldChangeImpact
This thesis has discovered that as Sovereign Wealth Funds enter the largest markets in the
world they employ their lower risk premium and increase overall prices around them. An
indefinite investment horizon is central to their decreased risk premium. In this section,
the impact of yield change will be investigated to understand advantages gained from a
longer hold period.
Over time the impact of yield change (higher exit cap rate than entrance cap rate)
becomes deminimus. To illustrate this example, one can turn to the various components
of the total IRR.
Total Internal Rate of Return (IRR Total) can be thought of as a function of three primary
factors: Initial Yield, Cash Flow Growth, and Yield Change. The following illustrates
the applicable composite IRR formula.
IRR Total = IRR Initial Yield + IRR Cash Flow Growth + IRR Yield Change + IRR Interaction Effects
This type of analysis allows a focused exploration of the impact of a potential yield
change on the total IRR through time. The following graph shows how a 2% change in
cap rate impacts an investment’s total IRR over time. The chart is expressed as a percent
of total IRR. So, for example, in year nine the Yield Change IRR is approximately -52%
in magnitude of the total IRR. Since the total IRR at year nine, for example, is around
3.9%, the IRR of just the Yield Change component is approximately -2.1%.
The following illustrates the technique used to parse out the components of the IRR as
mentioned above.
50
TABLE 4: IRR Parsing Technique (5 year hold example)
IRR=InitialYield+CashFlowChange+YieldChange+InteractionEffect
Year 0 1 2 3 4 5 6ACTUALCASHFLOW 1 2 3 4 5 6OperationalCashFlow 4 4.1 4.2 4.2 4.3 4.4CapitalCashFlow -100 88.3 TotalFlow TotalIRR 1.91% -100.0 4.0 4.1 4.2 4.2 92.7 INITIALYIELDCOMPNOENT OperationalCashFlow 0 4 4 4 4 4 4CapitalCashFlow -100 100 TotalFlow IYIRR 4.0% -100.0 4.0 4.0 4.0 4.0 104.0 CASHFLOWCHANGECOMPONENT (Actualcashflowwith“initialcap”onexityear.Isolatesthecashfloweffects) OperationalCashFlow 0.0 4.0 4.1 4.2 4.2 4.3 4.4CapitalCashFlow -100 110.4 TotalFlow -100.0 4.0 4.1 4.2 4.2 114.7 CFCIRR 2.0% YIELDCHANGECOMPONENT OperationalCashFlow 0 4 4 4 4 4 4CapitalCashFlow -100 80.0 TotalFlow -100.0 4.0 4.0 4.0 4.0 84.0 YCIRR -4.0% INTERACTIONEFFECT IE -0.09% ComponentIRRasaPercentofTotalIRR IYasa%oftotalIRR 209% YCasa%oftotalIRR -209% Growthasa%ofIRR 105%
Running the above analysis through a data table (changing only the exit year variable)
yields the following;
ASSUMPTIONS
GROWTH 2%
INITIALYIELD 4%
CAPINCREASE 1%
HOLDPERIOD 9
51
TABLE 5: IRR Parsing Example Results by Exit Year
YR TOTALIRR IY% YC% CFGROWTH%
4 0.81% 493.91% -627.50% 246.95%5 1.91% 209.09% -209.09% 104.55%6 2.65% 150.71% -123.33% 75.36%7 3.19% 125.56% -86.38% 62.78%8 3.59% 111.56% -65.82% 55.78%9 3.90% 102.65% -52.73% 51.32%10 4.15% 96.48% -43.68% 48.24%11 4.35% 91.97% -37.05% 45.98%12 4.52% 88.52% -31.98% 44.26%13 4.66% 85.81% -28.00% 42.90%14 4.78% 83.61% -24.78% 41.81%15 4.89% 81.81% -22.12% 40.90%16 4.98% 80.29% -19.90% 40.15%17 5.06% 79.01% -18.02% 39.50%18 5.13% 77.90% -16.40% 38.95%19 5.20% 76.95% -15.00% 38.47%20 5.26% 76.11% -13.77% 38.06%21 5.31% 75.37% -12.69% 37.69%22 5.35% 74.72% -11.73% 37.36%23 5.40% 74.13% -10.87% 37.07%24 5.43% 73.61% -10.10% 36.80%25 5.47% 73.13% -9.41% 36.57%26 5.50% 72.71% -8.78% 36.35%27 5.53% 72.32% -8.21% 36.16%28 5.56% 71.96% -7.69% 35.98%29 5.58% 71.64% -7.21% 35.82%30 5.61% 71.34% -6.77% 35.67%31 5.63% 71.06% -6.37% 35.53%32 5.65% 70.81% -6.00% 35.40%33 5.67% 70.57% -5.66% 35.29%34 5.69% 70.36% -5.34% 35.18%35 5.70% 70.15% -5.04% 35.08%36 5.72% 69.97% -4.77% 34.98%37 5.73% 69.79% -4.51% 34.90%38 5.74% 69.63% -4.27% 34.81%39 5.76% 69.47% -4.05% 34.74%40 5.77% 69.33% -3.84% 34.67%
52
FIGURE 15: Yield Change component IRR as a percent of Total IRR
With all else being equal, Figure 15 shows that a 2% increase in cap rate is severely more
damming to the total IRR during the initial years than after a longer hold. While in year
5, for example, a 2% increase in cap rate would crush the Total IRR, but in year year 40 a
2% increase in cap rate produces a -0.22% IRR, which is only 3.84% of the Total IRR.
This means that over the long term, growth and initial yield account for nearly 98% of the
Total Return IRR. This is inline with the constant growth perpetuity model represented
by Equation (1), as stated earlier as [E(r) = E(y) + E(g)]. Therefore, an investor with an
indefinite term horizon (or very long-term horizon) does not price in yield change when
calculating risk. They are free to focus on initial yield and growth to support their return.
Since the marginal investor models total return over a 10 year hold, natural market
pricing considers the risk of yield change when pricing risk premium. As this risk is
substantially reduced in the case of most Sovereign Wealth Investors they are effectively
intramarginal with respect to yield change.
ASSUMPTIONS
GROWTH 2%
INITIALYIELD 4%
CAPINCREASE 1%
HOLDPERIOD 9
0%
1%
2%
3%
4%
5%
6%
7%
-250%
-150%
-50%
50%
150%
250%
5 9 13 17 21 25 29 33 37
YC%
IRR(secondaxes)YCCompo
nentIRRasape
rcen
tofTotalIRR
TotalIRR
53
TimeMitigationofRisk
The following section describes the affects of time on an investment’s risk adjusted
return. Since Sovereign Wealth Funds have a very long-term investment horizon, the
following is material in understanding how they operate under a lower risk premium than
their peer investors.
Risk is typically tied to volatility of a return around an average, or the probability of
making a certain return at any particular moment. In most cases, this is the probability of
achieving the expected return (Er) or greater. Some might argue that downside risk is
more important. In this case, “risk” would be the probability of getting a return below
zero or similarly, the probability of getting a return below the expected return (Er). Risk
can be expressed with the following equalities;
P(R<0) or P(R<Er)
If you neglect to consider hold period, then you are missing a significant part of the
mechanics. The probability of making a specific return in the next 5 minutes is
drastically different than making a certain return over 20 years.
“I never had the faintest idea what the stock market is going to do in the
next six months, or the next year, or the next two. But I think it is very easy
to see what is likely to happen over the long term.” ~ Warren Buffet
Similar to Warren Buffet’s point on volatility and time, when thinking about commercial
real estate we may not know if rents will go up or down in the next 6 months, but we can
be reasonably sure that they will grow approximately with CPI over the long-term.
Time dampens volatility over time, but does not affect expected return. Whereas Figure
16 shows how volatility for the return on Stocks, Bonds, and Cash diminishes with time
in real terms, the same mechanism applies to returns on commercial real estate
investments.
54
The Following is a chart from “Winning the Loser’s Game” by Charles Ellis.
FIGURE 16: Range of Returns Adjusted for Inflation over Different Hold Periods
Figure 16 shows that a 1-year investment in Stocks is highly volatile with returns from
nearly -40% to over 50%. Therefore, assuming a normal distribution of returns, the
probability of achieving the benchmark (Er, zero, or other) is not great. At the same time
as hold period increases, volatility of returns is greatly reduced and continues to center
around the expected long-term return (Er). After a 25 year hold period, the data used in
this analysis produced a zero probability of negative real returns for Stocks, while Bonds
and Cash both had a probability greater than zero of achieving a negative real return.
Another example of time’s ability to mute volatility (and by extension, risk) comes from
Javier Estrada at IESE Business School. In the following example, Professor Estrada
utilizes US equity market return data from 1900 to 2010 to illustrate the dampening
effects of time on total returns in the stock market.
55
FIGURE 17: Total Return and Hold Period (Prof. Estrada, IESE Business School)
With a 1-year hold period, there are 110 return events from 1900 to 2010. As you can
see, the return profile is very volatile. The range of possible outcomes is from 55% to
negative 60% return. Also, there are 39 events where returns are below zero which is a
P(r < 0) = 35%. You could do a similar metric around the expected return, but from these
charts, it is easy to identify negative return events.
Looking at the 10-year hold scenario (upper right). The chart displays annual returns
after a 10-year hold. For example, an investment made in 1900 if divested at the end of
1909 would have returned 8% compounded annual growth. A 10-year hold period
mitigates the fact that in year four and eight there were nearly 20% annual loses and still
maintains a return above zero. From the charts above, it is clear that volatility is muted
as hold period increases. With a 10-year hold returns range from 18% to negative 8%
with a probability of a negative return of 15%. Continuing with this trend, the 20 year
30-Year Hold 20-Year Hold
1-Year Hold 10-Year Hold
56
and 30-year hold periods, volatility is further dampened. The probability of a negative
return is 3% and zero percent respectively.
Table 6 shows an estimated summary of the data in Figure 17. The E(r) is an estimate
but since it would not change with hold period, 9% will serve as an example to calculate
a modified Treynor ratio. You can see that with an increasing hold period, the
probability of a negative return diminishes, E(r) does not change, and the risk adjusted
measure for return increases. Treynor Ratio is basically a measure of return for every
unit of risk. The actual number is not important, just its trend of increasing return for unit
of risk.
TABLE 6: Summary of Data from Figure 17 (estimates)
HoldPeriod(yr) Max Min Range P(R<0) E(r) TreynorRatio22
1 50% -59% 109% 35% 9% 0.0710 18% -8.0% 26% 15% 9% 0.2920 15% -0.5% 16% 3% 9% 0.4830 11% 1.2% 10% 0% 9% 0.77
The risk dampening affect of time in the equities market is the same as in the commercial
real estate market. And indeed, the same analysis could be performed on total return for
US Office greater than $2.5 million. One benefit of using equity market data to illustrate
the point is the robustness of data going back over 100 years. Commercial real estate is
still catching up to the stock market in terms of data. It is safe to say that commercial real
estate is generally less volatile than equities, but the concept of time dampening volatility
and centering around the long-term expected return is the same.
As a very long-term investor, Sovereign Wealth Funds are able to increase the certainty
of achieving a specific return. This increase in certainty is a decrease in risk and further
allows Sovereign Wealth Funds to have a lower risk premium than the marginal investor.
22 This modified Treynor ratio is based on Jack Treynor’s ratio hijkl
mnop. In this case, we use return range rather than beta in the
denominator and assume 1.5% for an average RP. This term is simply a risk adjusted measure based on systemic risk used for comparing various investment scenarios.
57
StateCapitalism
Some argue that a subtle undercurrent to the Sovereign Wealth Fund investment strategy
is state capitalism. There are three primary factors that leave investors and policy makers
worried and that have a direct impact on SWF competitiveness as an investor.
1. Non-commercial factors impacting the investment decision
2. General secrecy and lack of transparency and regulation
3. Taxation benefits
As government entities, some argue that Sovereign Wealth Funds may not be solely
focused on return maximization. Some SWFs are open about their non-commercial
investment motivations. For example, they may admit to investing in an asset simply to
learn best practices or gain technical exposure—benign, but non-commercial. On the
other hand, some Sovereign Wealth Funds are less open about their non-commercial
motivations but are still somewhat innocent in nature. An example of this could be the
acquisition of an iconic building in the US as an example of strength and wealth—a
beacon of country pride. The SWF may claim that this is purely for economic reasons,
when in fact the country needed a symbol of strength and was willing to pay wild prices
to secure the symbol. Others are more nefarious and engage to control strategic
geopolitical real estate assets in energy, telecom, and infrastructure. An example of this
is from 2006 when Singapore’s Sovereign Wealth Fund (Temasek) purchased a
controlling interest in a Thai telecom (Shin Corporation) that, among other controversial
aspects, controlled military satellites.23
Whatever the reason, nefarious or benign, these non-economic investment factors allow
Sovereign Wealth Funds to be more aggressive in pricing and may allow them to take on
additional monetary risk for non-monetary returns.
The second concern about Sovereign Wealth Fund’s lack of transparency and regulation
23 Wikipedia, [https://en.wikipedia.org/wiki/Sale_of_Shin_Corporation_to_Temasek_Holdings] Financial Times, [http://www.ft.com/intl/cms/s/0/6d6e3658-9836-11e3-8c0e-00144feab7de.html#axzz3wBmaxWUz] and Forbes, [http://www.forbes.com/sites/simonmontlake/2011/08/19/temasek-sells-down-thai-telecom-asset-at-loss/]
58
exacerbates the first point of non-economic investment factors. Sovereign Wealth Funds
have no shareholders or stakeholders to answer to. Also, it is extremely sensitive and
challenging for a government to regulate Sovereign Wealth Funds as they are part of a
much larger geopolitical economic system. Governments routinely buy and sell foreign
financial instruments for various reasons. For example, foreign governments will issue
private debt to firms or publicly via US treasury bonds. It is a sensitive ecosystem that,
as a byproduct, infuses developed markets with liquidity and consequently can reduce the
cost of debt for the US debtor.So, without shareholders to report to and a political
system not equipped to manage aggressive financial investment from sovereign entities,
Sovereign Wealth Funds are free to operate behind a cloak—and have.
With that said, some Sovereign Wealth Funds have made significant improvements in
their transparency through self regulation and reporting. In 2008, led by the International
Monetary Fund (IMF) the International Working Group (IWG), a consortium of vanguard
Sovereign Wealth Funds, was created to establish best practices for transparency and
regulation. These best practices became known as the “Santiago Principles” and are now
a requirement for admittance into the International Federation of Sovereign Wealth Funds
(IFSWF). Resulting from the 2008 meeting, 23 countries agreed to a set of Generally
Accepted Practices and Principles (GAPP) to increase the transparency of their industry.
The 23 countries ranged form US to Norway, to Libya and Qatar. See Appendix B for a
full list.
Later the Global Investment Performance Standards (GIPS) were created to formalize
how SWFs report their performance. Since SWFs operate under a complex and novel
structure, a consist reporting standard is crucial to true transparency.
To quantify transparency, in 2009 the Peterson Institute and for International Economics
(IIE) created a system which investigates 33 categories of transparency and scores each
fund on a weighted scale. A perfect score is 100. This ranking was updated in 2012 and
is summarized in Figure 18 below.
59
0102030405060708090100
0
100
200
300
400
500
600
700Norway
UAE(Abu
Dhabi)
China
HongKon
gKu
wait
Singapore
Singapore
Russia
Qatar
Australia
Kazakhstan
UAE(Dub
ai)
UAE(Abu
Dhabi)
Korea
Libya
Algeria
UAE(Abu
Dhabi)
Iran
Unite
dStates
Malaysia
Azerbaijan
Brun
eiUn
itedStates
New
Zealand
Chile
Kazakhstan
Canada
Ireland
Timor-Leste
UAE(Dub
ai)
UAE(Dub
ai)
Bahrain
Oman
Chile
Mexico
FIGURE 18: SWF Foreign Investment Vs IIE Transparency Score
Norway is the clear leader and also the largest fund. Some of the larger low-transparency
funds include; Qatar (QIA), UAE (Investment Corp of Dubai), Libya (Libyan Investment
Authority), and Algeria (Revenue Regulation Fund). Interestingly, members of the
IFSWF represent both ends of the spectrum calling into question the effectiveness of
program. Regardless, many of the most transparent countries are members of the IFSWF.
A full list and methodology of the ranking are attached in Appendix A.
Finally, the topic of taxation. While investing abroad, Sovereign Wealth Funds enjoy
advantages compared to private investment funds (domestic and foreign). Regarding
taxation, there are three buckets of investments that a Sovereign Wealth Fund would
participate: (i) Debt Obligations, (i) Equities, and (iii) Real Estate.24 For each case there
are certain tax advantages over domestic investors, while in some cases Sovereign
Wealth Funds even have an advantage over private foreign investors. Although this
thesis focuses on impacts related to real estate, it is interesting to note that both private
and sovereign foreign investors are completely exempt from paying taxes on interest paid
by US holders of foreign debt. This debt can be either a privately or publicly issued
24 This thesis only goes into taxation implications regarding real estate. For further reading on the topic, turn to the following excellent source: “Taxation and the Competitiveness of Sovereign Wealth Funds: Do Taxes Encourage Sovereign Wealth Funds to Invest in the United State?” Michael S. Knoll. Southern California Law Review 2009 Vol. 82:703 Page 710.
ForeignAssets(B
illionUSD
)
IIETranspa
rencyScore
2012 2009
60
obligation. This thesis discussed this tangentially in the previous section entitled: “State
Capitalism.” In this case, they are exempt from taxation that would otherwise be up to
35%. While this is a benefit to US debtors, it is clearly an advantage to Sovereign
Wealth Funds that issue debt.
Turning back to real estate. In the US, real estate enjoys significant tax benefits
including interest deductions and accumulated depreciation over either 27.5 of 39 years
depending on property type. These deductions typically yield a net loss, thereby
completely covering the operating income from taxation until a liquidation event. These
standard tax rules apply to all investors (foreign, domestic, sovereign, or private).
Prior to 1980, foreign investors would escape tax on capital gains (at liquidation) by
holding interest in a corporation that owned real estate. Rather than sell the real estate
which would provide taxable income, the foreign investor would sell shares in the
corporation, which would be treated as capital gains from a foreign source and was not
taxable.
In 1980, congress enacted the Foreign Investment into Real Property Tax Act (FIRPTA).
FIRPTA essentially stated that any disposition of a real property was “effectively
connected income” and therefore subject to US capital gains tax.25 There are two
relevant caveats to this rule: (i) foreign (private and sovereign) investment into non-
controlling interests of a REIT is not subject to FIRPTA and (ii) Sovereign Wealth
Funds (not private foreign investors) are still allowed to sell shares of a corporation that
owns commercial real estate without enacting FIRPTA.
What does control Sovereign Wealth Fund’s taxation is section 892 of the Internal
Revenue Code. Section 892 first came into affect with the introduction of the income tax
in 1917. Section 892 describes how foreign governments are to be taxed on domestic
investments. In short, it says that foreign governments, including Sovereign Wealth
Funds, are exempt from taxation on investment income (or Non-commercial income).
25 Wikipedia [https://en.wikipedia.org/wiki/Foreign_Investment_in_Real_Property_Tax_Act]
61
In 2008, the Joint Committee on Taxation led by Senators Max Baucus and Chuck
Grassley tasked the committee to “analyze the history, current rules, and policy
underpinnings of the US tax rules applicable to US investment by foreign governments,
including investments made by Sovereign Wealth Funds.”26 What the committee found
is that Sovereign Wealth Funds enjoy an advantage over not only domestic investors, but
also private foreign investors. Here is a short excerpt from their report that points to
three important advantages over domestic and private foreign investors.
“Inpractice,someofthemostimportantstatutoryUSincometax
advantagesthataforeignsovereigninvestorenjoysoveraforeignprivate
investorare:
1. ExemptionfromUSwithholdingtaxonallUSsourcedividendspaid
bynon-controlledcorporations
2. ExemptionfromUSwithholdingtaxoninterestpaidbya
corporationwheretheforeignsovereignownsatleast10%(sothe
general“portfoliointerest”exemptionisnotavailable)butlessthan
50%(sothepayorisnot“controlled”bytheforeignsovereign)of
thepayor
3. ExemptionfromUStaxoncertaingainsfromrealestate
transactions.”27
Sovereign Wealth Funds have benefited from not only being foreign, but also from being
sovereign. Due to their links to a sovereign nation, these funds can side step FIRPTA.
And thanks to inclusionary rulings over the past 15 years, SWFs fall under the protection
of a century old tax code, Section 892.
From this, it is clear to see that there are significant US tax advantages that make
Sovereign Wealth Funds intramarginal investors. In addition to US tax benefits,
Sovereign Wealth Funds also enjoy home country tax advantages as well. As sovereign
26 “Baucus, Grassley Seek JCT Analysis of US Taxation of Sovereign Wealth Funds,” United States Senate Committee on Finance, March 13, 2008. 27 Joint Committee on Taxation, Economic and US Income Tax Issues Raised by Sovereign Wealth Fund Investment in the United States (JCX-49-08), June 17, 2008
62
entities, taxing a SWF at home would be like taking money from one pocket and putting
it in another.
Sovereign Wealth Funds effectively have zero global taxation on US real estate
investments. This is both an advantage over domestic investors and private foreign
investors alike. Some propose to repeal these rules to provide a “fair” taxation on
Sovereign Wealth Funds,28 but splitting the bark off the tree may be more difficult than
one would think.
Summary-FromtheInvestor’sPerspective
This thesis has identified that there is a statistically significant interaction between
Sovereign Wealth Fund participation in US commercial real estate investment and Office
risk premia. In the six major markets, for example, this results in a 6.8 bps decrease in
market wide “spread” with every 1% increase in SWF participation in the market’s total
real estate volume. For a complete list of findings, see Chapter 7. This thesis also
showed that not only are SWFs able to pay more, but they bend the market’s risk return
line by motivating other’s to reduce their risk premium as well. One interesting insight is
that SWFs only pay about a quarter of the premium paid by the total market.
With market share in the six major metros reaching 6% in 2008 and back up to 4% in
2014, SWFs are increasingly become an integral part of the total investment volume in
the US. The analysis also revealed that up to $208 billion is projected to enter the global
commercial real estate market in the coming years. Considering these results we can
expect to see Sovereign Wealth Funds becoming an increasingly fraction of the total real
estate market, resulting in further downward pressure on market risk premia.
In addition to the regression analysis, this thesis has identified and discussed the
following contributing factors that make Sovereign Wealth Funds an intramarginal
investor:
28 “Tax, Sovereign Wealth Funds, and Pension Funds: A new approach for a new environment, KPMG [https://www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/Documents/Tax-Sovereign-Wealth-Funds-and-Pension-Funds-Report.pdf]
63
1) Long(Indefinite)InvestmentHorizona. OptionalMarketTimingb. YieldChangeImmunityc. VolatilityDampening
2) Strategic(non-economic)InvestmentMotivations
3) UniqueTaxationAdvantages
Through various analyses, this thesis illustrated how a very long-term investment horizon
can impact risk premium. It turns out that over the very long-term, yield change becomes
a deminimus factor, volatility dampens out, and returns center around a long run expected
return. Further, non-economic or strategic investment factors and preferential taxation
decrease the SWFs risk premium. Taken together, these factors create a very real
competitive advantage that is Bourne out in the data.
As an institutional investor, your investment horizon is likely much less than 30 years.
Even if you don’t have an obligation to return funds on a date certain, you are likely
obligated to somesort of liquidation rights. Similarly, you are likely not driven by non-
economic factors for investing and stake holders ensure that your fund seeks profit
maximization. Finally, your fund essentially plays under the same taxation rules as
everyone else—other than Sovereign Wealth Funds.
So how to compete with an intramarginal investor operating below the security market
line? One way is to get in their way. SWFs are projected to increase their investment
into commercial real estate by $208 billion. One investment strategy is to invest in assets
that are most appealing to Sovereign Wealth Funds and wait for them to join the party.
Even if a Sovereign Wealth Fund doesn’t directly purchase your asest, their participation
will lower overall spreads anyway.
Another strategy, is invest in secondary markets before they do. So far, Sovereign
Wealth Funds have predominately invested in the top six markets (as shown in Figure 7).
Eventually with the increase in Sovereign Wealth Funds interested and able to invest in
real estate you will likely see penetration into secondary and tertiary market. Further, this
64
analysis shows that secondary markets are a natural target as they smartly leverage the
strengths inherent to Sovereign Wealth Funds.
As of the time of this writing this trend is beginning. Portland, Oregon recently broke a
record high sale for the city with a multifamily asset sold to a Singapore Sovereign
Wealth Fund.29 The Janey sold for $45 million, or $647 per square foot. This is $147 per
square foot more than the previous multifamily record according to Greg Frick of HFO
Investment Real Estate. This transaction represents what Sovereign Wealth Funds target
and what others should position themselves with – well positioned top of market assets in
high growth secondary and tertiary markets.
Further analysis can be performed around time lagging as new data becomes available.
Since meaningful SWF investment in the US began in 2004 there was not enough data to
lag SWF investment and yield significant results. In three years from today there will be
more complete time series data around SWF investment, which will allow a better
understanding of the market reaction one or two quarters after Sovereign Wealth Fund
involvement.
This thesis was designed to be an actionable tool for investment and fund managers. To
be help them better understand this new investor type and how to best position
themselves alongside them. It is exciting that this new source of equity is enhancing and
deepening the real estate investment industry.
29 Foreign investors pay record-setting price for Northwest Portland building [http://www.oregonlive.com/business/index.ssf/2015/12/foreign_investors_pay_record-s.html]
65
BIBLIOGRAPHY
“ReporttoCongressonInternationalEconomicandExchangeRatePolicies.”[http://www.treas.gov/offices/international-affairs/economic-exchange-rates/]DepartmentoftheTreasury.(2007).“DoesForeignInvestmentAffectUSOfficeRealEstatePrices?”PatMcAllisterandAnupamNanda.“ProgressonSovereignWealthFundTransparencyandAccountability:AnUpdatedSWFScoreboard”AllieE.BagnallandEdwinTrumanAugust2013NumberPB13-19“Investorrecognitionandstockreturns”ReuvenLehavyandRichardG.Sloan.[http://webuser.bus.umich.edu/rlehavy/ir.pdf]RevAccStud(2008)13:327–361DOI10.1007/s11142-007-9063-y.
“ASimpleModelofCapitalMarketEquilibriumwithIncompleteInformation”RobertMerton[http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1987.tb04565.x/full].
“InvescoGlobalSovereignAssetManagementStudy2014”NickTolchardandAlexProut[http://igsams.invesco.com/downloads/IGSAMS_2014_en.pdf]
“SovereignWealthFundsInvestinginRealEstate”VariousAuthors[https://www.preqin.com/docs/newsletters/re/Preqin-RESL-May-2015-Sovereign-Wealth-Funds-Investing-in-Real-Estate.pdf].
“IRSreleasesproposedguidanceaddressingincomeofforeigngovernmentsunderSection892”VariousAuthors[http://www.pwc.com/us/en/tax-services-multinationals/newsletters/us-inbound-tax/guidance-under-section-892.html].
“SovereignWealthFunds”KPMG2014JavierSantiso,PhD[https://www.kpmg.com/ES/es/ActualidadyNovedades/ArticulosyPublicaciones/Documents/sovereign-weath-funds-v2.pdf].
"9eRegulationofSovereignWealthFunds:9eVirtuesofGoingSlow,"RichardA.Epstein&AmandaM.Rose,76UniversityofChicagoLawReview111(2009).
“WhoholdstheWealthofNations?”AndrewRozanov,2008OfficialInstitutionsGroup[http://web.archive.org/web/20080529122341/http://www.ssga.com/library/esps/Who_Holds_Wealth_of_Nations_Andrew_Rozanov_8.15.05REVCCRI1145995576.pdf]
66
“SovereignWealthFunds:BackgroundandPolicyIssuesforCongress”MartinA.Weiss,CRSReportforConfess2008
“SovereignWealthFundsGenerallyAcceptedPrincipalsandpractices“SantiagoPrinciples””VariousAuthors,InternationalWorkingGroup(IWG)
“TaxationandthecompetitivenessofSovereignWealthFunds”DoTaxesEncourageSovereignWealthFundstoInvestintheUnitedStates?”MichaelS.Knoll,2009SouthernCaliforniaLawReview[Vol.82:703]
67
Appendix
AppendixA:IIEScoreMethodology
Source: IIE Policy Brief 2013 NUMBER PB13-19
For each of the 33 elements, posed as questions, if the answer is an unqualified yes, we score it as 1. If the answer is no, we score it as 0. However, partial scores of 0.25, 0.50, and 0.75 are recorded for many elements, indicated by (p) in the descriptions below.
The four categories in the scoreboard are listed below with subcategories where relevant.
STRUCTURE
1. Is the SWF’s objective clearly stated? (p)
2. Is there a clear legal framework for the SWF? This element was incorporated into the 2008 scoreboard from the Santiago Principles.
3. Is the procedure for changing the structure of the SWF clear? (p)
4. Is the overall investment strategy clearly stated? (p) Fiscal Treatment
5. Is the source of the SWF’s funding clearly specified? (p)�6. Is the nature of the subsequent use of the principal and earnings of the fund clearly specified? (p)�7. Are the SWF’s operations appropriately integrated with fiscal and monetary policies? (p)��
8. Is the SWF separate from the country’s international reserves?
GOVERNANCE
9. Is the role of the government in setting the investment strategy of the SWF clearly established? (p)
10. Is the role of the governing body of the SWF clearly established? (p) This element was incorporated into the 2008 scoreboard from the Santiago Principles.
11. Is the role of the managers in executing the investment strategy clearly established? (p)
12. Are decisions on specific investments made by the managers? (p)
68
13. Does the SWF have internal ethical standards for its management and staff? (p)
14. Does the SWF have in place, and make publicly available, guidelines for corporate responsibility that it follows? (p)
15. Does the SWF have ethical investment guidelines that it follows? (p)
TRANSPARENCY AND ACCOUNTABILITY
Investment Strategy Implementation
16. Do regular reports on investments by the SWF include information on the categories of investments? (p)
17. Does the strategy use benchmarks? (p)��
18. Does the strategy use credit ratings? (p)��
19. Are the holders of investment mandates identified? (p)
Investment Activities
20. Do regular reports on the investments by the SWF include the size of the fund? (p)
21. Do regular reports on the investments by the SWF include information on its returns? (p)
22. Do regular reports on the investments by the SWF include information on the geographic location of investments? (p)
23. Do regular reports on the investments by the SWF include information on the specific investments? (p)
24. Do regular reports on the investments by the SWF include information on the currency composition of investments? (p)
Reports
25. Does the SWF provide at least an annual report on its activities and results? (p)
26. Does the SWF provide quarterly reports? (p)
69
Audits
27. Is the SWF subject to a regular annual audit? (p)��
28. Does the SWF publish promptly the audits of its
operations and accounts? (p)��
29. Are the audits independent? (p)
BEHAVIOR
30. Does the SWF have an operational risk management policy?
31. Does the SWF have a policy on the use of leverage? (p)
32. Does the SWF have a policy on the use of derivatives? (p)
33. Does the SWF have a guideline on the nature and speed of adjustment in its portfolio? (p)
70
AppendixB:Listof2008IWGCountries
Countries and Their SWFs
Australia: Australian Future Fund
Azerbaijan: State Oil Fund
Bahrain: Reserve Fund for Strategic Projects
Botswana: Pula Fund
Canada: Alberta Heritage Savings Trust Fund
Chile: Economic and Social Stabilization Fund / Pension Reserve Fund
China: China Investment Corporation
Equatorial Guinea: Fund for Future Generations
Islamic Republic of Iran: Oil Stabilization Fund
Ireland: National Pensions Reserve Fund
Korea: Korea Investment Corporation
Kuwait: Kuwait Investment Authority
Libya: Libyan Investment Authority
Mexico: Oil Stabilization Fund
New Zealand: Superannuation Fund
Norway: Government Pension Fund
Qatar: Qatar Investment Authority
Russia: Reserve Fund / National Wealth Fund
Singapore: Temasek Holdings Pte Ltd
Government of Singapore Investment Corporation Pte Ltd
Timor-Leste: Petroleum Fund of Timor-Leste
Trinidad and Tobago: Heritage and Stabilization Fund
United Arab Emirates: Abu Dhabi Investment Authority
United States: Alaska Permanent Fund