Royal Institute of Technology Department of Infrastructure Building and Real Estate Economics

Master of Science Thesis, no 292

Patterns in foreign real estate investments in Sweden

Author Anders Blomkvist

Supervisors Hans Lind Jan Wejdmark Stockholm 2005

Master of Science Thesis Title

Patterns in foreign real estate investments in Sweden

Author

Anders Blomkvist

Department

Royal Institute of Technology Department of Infrastructure Building and Real Estate Economics

Master Thesis number

292

Supervisors

Hans Lind, Professor, Building and Real Estate Economics and Jan Wejdmark, Director, Newsec Investor Services

Keywords

Real estate, Sweden, foreign investment, transactions, patterns

Abstract Sweden has in the last ten years experienced a large increase in foreign real estate investment. This capital has come from various foreign investors, including real estate funds and private equity investors. Sellers have almost exclusively been Swedish and the properties sold have had varied features. This thesis is an attempt to categorize and find patterns in transactions between foreign investors, Swedish sellers and properties involved in the transactions. The patterns found can be divided into four categories. The first is patterns within the investor and seller groups and the second is patterns between investor and property. The third group contains patterns between seller and property and finally, there is a fourth group with patterns between investor, seller, and property. In the first group investors can be categorized differently depending on their approach to leverage, return demands and investment horizon. The amount of management they are willing to put into their properties also differentiates them. The categorization of the sellers was based the business they were in. The only clear pattern is that core business focusing companies enter in sale-leaseback transactions. The results from the second group are that core investors want new or newly refurbished properties with good geographic location, long lease contracts, reliable tenants and low vacancy. Opportunists look for portfolio transactions and renting investors demand very long lease contracts with a credit worthy tenant and strategically important properties. In the third group, sellers involved in sale-leaseback transactions are interested in selling their entire property stock, and the last group showed no patterns except for renting investors that bought portfolios from industry and service companies. Other interesting issues such as promissory notes and various guarantees (given by the seller to the investor) and how they affect the sale price are also discussed in the thesis. When looking towards the future, it is concluded that core and renting investors will stay in Sweden since their way of doing business will not be that affected by changes on the rental and financial markets. For opportunistic investors however, the outlook is not as bright and they will probably shift their attention to other countries.

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Examensarbete Titel

Mönster i utländska fastighetsinvesteringar i Sverige

Författare

Anders Blomkvist

Institution

Kungliga Tekniska Högskolan Institutionen för infrastruktur Enheten för Bygg- och Fastighetsekonomi

Examensarbete nummer 292 Handledare

Hans Lind, Enheten för Bygg- och Fastighetsekonomi och Jan Wejdmark, VD, Newsec Investor Services

Nyckelord

Fastigheter, utländska investerare, transaktioner, mönster

Sammanfattning Sverige har under de senaste tio åren blivit en allt mer intressant marknad för olika typer av utländska fastighetsinvesterare, så väl för fastighetsfonder som för investerare av privat kapital. Säljarna har i de flesta transaktioner varit svenska och fastigheterna som sålts har haft olika utmärkande egenskaper. Examensarbetet är ett försök att kategorisera och finna mönster i transaktioner mellan utländska investerare, svenska säljare och de fastigheter som varit inblandade i transaktionerna. De mönster som påträffades kan delas in i fyra grupper. Den första gruppen innehåller mönster inom olika investerar- och säljarkategorier och den andra visar mönster mellan investerare och fastighet. Den tredje gruppen innehåller mönster mellan säljare och fastighet och slutligen i den fjärde gruppen finns mönster mellan investerare, säljare och fastighet. I den första gruppen är investerare kategoriserade beroende på deras inställning till hävstångseffekten, avkastningskrav, investeringens livslängd och hur mycket management de är villiga att lägga på fastigheten. Kategoriseringen av säljarna baseras på vilken typ av verksamhet de bedriver. Det enda tydliga mönstret som påträffades var att företag som fokuserar på sin kärnverksamhet gör sale-leaseback-transaktioner. Resultatet från den andra gruppen visade att investerare av typen core försöker finna nybyggda alternativt nyrenoverade byggnader med bra geografiskt läge, långa hyreskontrakt, pålitliga hyresgäster och låg vakans. Opportunistiska investerare söker portföljtransaktioner och investerare av typen renting kräver mycket långa hyreskontrakt med en ekonomiskt stabil hyresgäst samt att fastigheterna i transaktionen har ett strategiskt värde för säljaren. Den tredje gruppen innehåller mönster där säljaren i sale-leaseback-transaktioner säljer hela sitt fastighetsbestånd. Den sista gruppen uppvisade inga direkta mönster utom investerare av typen renting som har köpt fastigheter från industri- och servicebolag. Examensarbetet tar även upp intressanta frågor kring reverser och hyresgarantier och för en diskussion om hur de kan påverka försäljningspriset. När man tittar mot framtiden görs bedömningen att investerare av typerna core och renting kommer att stanna på den svenska fastighetsmarknaden. Opportunisterna däremot kommer förmodligen att flytta sin verksamhet till andra länder.

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Acknowledgements In writing this paper, I have been fortunate to have Associate professor Hans Lind as my supervisor. He has throughout the whole process contributed with valuable opinions and constructive criticism. I would also like to thank Jan Wejdmark, Director at Newsec Investor Services where much of this paper was written, for the hospitality and for providing the outer means for me to do my work. He has also contributed with important thoughts on various issues. I am also grateful to Fastighetsakademin (the Real Estate Academy) for funding my travels to Germany and England. I would also like to thank all the interviewees for putting their valuable time at my disposal. Without their participation this paper could not have been written. Finally, a big thank you to Angela Hill for proof reading.

Stockholm, April 2005 Anders Blomkvist [email protected]

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Table of contents 1 Introduction .........................................................................................................................6 1.1 Background .....................................................................................................................6 1.2 Objectives .......................................................................................................................6 1.3 Method ............................................................................................................................7 1.4 Limitation.........................................................................................................................7 1.5 Disposition ......................................................................................................................8 2 The value of real estate.......................................................................................................9 2.1 Return .............................................................................................................................9 2.2 Risk .................................................................................................................................9 2.3 Real options ..................................................................................................................10 2.4 Management skills and optimistic outlooks ...................................................................10 2.5 Pricing inaccuracies ......................................................................................................10 3 Overview of transactions..................................................................................................12 3.1 Recent market activities ................................................................................................12 3.2 Selected transactions....................................................................................................14 3.3 Investors .......................................................................................................................15 3.4 Sellers ...........................................................................................................................18 4 Transactions from the investors’ perspective................................................................20 4.1 Core investors ...............................................................................................................20 4.2 Opportunistic investors .................................................................................................22 4.3 Renting..........................................................................................................................25 5 Transactions from the sellers’ perspective ....................................................................29 5.1 Real estate companies .................................................................................................29 5.2 Financial institutions......................................................................................................30 5.3 Developers ....................................................................................................................32 5.4 Industrial and service companies..................................................................................33 6 Special issues....................................................................................................................36 6.1 Promissory notes ..........................................................................................................36 6.2 Guarantees ...................................................................................................................36 6.3 Motives to use promissory notes and guarantees.........................................................37 7 Patterns in transactions ...................................................................................................39 8 Will the investors stay? ....................................................................................................43 8.1 Rental market................................................................................................................43 8.2 Interest rates .................................................................................................................44 8.3 Yield demands ..............................................................................................................45 8.4 Future outlook ...............................................................................................................45 9 Final thoughts....................................................................................................................46 References ............................................................................................................................47 Appendix 1 Interview questions

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1 Introduction 1.1 Background During the last ten years, Sweden has experienced a large increase in foreign real estate investments, peaking in 2003 with SEK 40 billion invested (SEK 50 billion including bids on Pandox and Tornet). This capital has come from many different categories of investors, including German open-ended public funds and British private equity investors. Also, American opportunistic closed-ended funds and single corporations have been very active as investors. This increased interest in Swedish real estate has contributed to making Sweden one of the most attractive real estate investment destinations in Europe, outranked only by the UK and France.1 In these transactions sellers have been mainly Swedish, spanning a vast spectrum of business areas from real estate and development corporations to insurance, pension and other financial institutions. The incentives for each seller have varied, but notable are focus on core business and portfolio allocation. The properties involved in transactions with foreign investors have had similarities as well as differences in their features. These features range from tenant related questions, type of lease contract, and vacancy rates to location and physical state of the property. With all this activity among foreign and Swedish players, one should be able to observe some trends or patterns that have been followed when carrying out transactions. This thesis is an attempt to identify these patterns.

1.2 Objectives The overall purpose of the paper is to map out and compare different real estate transactions made in Sweden during the last five years in order to discover patterns between foreign investors, Swedish sellers and the properties involved in these transactions. A categorization of which type of investor has bought what property from what seller and in what kind of transaction will be made to try to answer this question. To attain this purpose, it has been broken down into four objectives. First, a discussion on how the value of real estate can be viewed from different ownership perspectives will be presented in order to familiarize the reader with some of the research in this area. The next step is to take a closer look at eight selected transactions in order to find patterns in foreign investment or in the way foreign investors have conducted their investments. Also, spotting tendencies in the way sellers have acted and the importance of various property features in the deals concerned is of interest. Do patterns like “investor of type A makes real estate transaction of type B with seller of type C” exist? Are there other patterns? The third objective will be to investigate whether there were any specific features in the transactions, e.g. concerning sale price or investment risk, and to identify different strategies followed by the various types of foreign investors and Swedish sellers. The last objective is to make some predictions on how future changes on the Swedish financial and real estate markets might affect foreign investors.

1

Invest in Sweden Agency (2004)

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1.3 Method The method used in this thesis is a combination of interviews and articles collected from various business newspapers and real estate related journals, together with some recent research performed at the Division of Building and Real Estate Economics at the Royal Institute of Technology in Stockholm, Sweden. To get an overview of recent trends in foreign real estate investment and how the market has reacted to this activity, articles in the Swedish press were collected. These articles also contained information about investors, sellers and properties involved in transactions. Furthermore, each company’s home page has been used for additional information. To gain insight into specific questions of interest, and to better understand what strategies drive the different parties when performing transactions, an interview study was made with both sellers and buyers in every transaction studied. Also, the perspectives of some real estate advisors involved in these transactions were collected. A total of 22 interviews were made in Stockholm, Wiesbaden, Frankfurt and London, each one lasting approximately one hour. All interviewees are found in the reference list and the interview questions in Appendix 1. The process of selecting transactions involved three steps. The first selection was to pick out the 40 largest transactions on the Swedish real estate market the last five years that involved foreign investors. Then these investors were categorized into core, opportunistic, or renting and the sellers into real estate companies, developers, financial institutions, or industry and service companies. This was made to try to cover as many of the different investors and sellers as possible in the scope of this thesis. The final selection of investors and sellers was made by finding those transactions where they had been involved that had the highest sale price.

1.4 Limitation This paper is by no means a complete review of the kinds of transactions that have been made by foreign investors in Sweden since 2000. It is an attempt to highlight certain investors and sellers as well as some specific issues related to their transactions. The starting point in the paper is that foreign investments have increased in recent years. Questions raised by other researchers concerning general features on the Swedish real estate market that make it attractive are left out. They have been well documented in other papers such as Axelsson & Victorin, “Foreign investors on the Swedish property market”, 1999 and in Arntell & Olofsson, “What factors attract foreign real estate investors to Sweden from a portfolio perspective”, 2004. Due to the comparatively small scope of the paper, the interview study is limited to parties involved in eight transactions that took place 2001-2004. These transactions are direct investment in real estate. All other forms of real estate related investment activities such as indirect investments in real estate stock are left out. Corporate takeovers will be mentioned only briefly since the actual effect of these investments on the market is relatively small, and in many of these deals management and strategies remain the same after completion. In some interviews, it was difficult to obtain the specific transaction information requested since the information was considered business secrets by nature. In these cases more general information about the companies has been used in the analysis.

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Unfortunately the Vital – JM transaction could not be thoroughly studied due to a late cancellation of the interview with Vital.

1.5 Disposition In chapter 2 some recent research on how different ownership perspectives affect the assessment of real estate value is discussed. This is followed by the chapter 3 overview of all transactions studied in the paper, including a presentation of the categorization of sellers and investors involved in these transactions. The chapter also contains a review of newspaper articles about how the Swedish real estate market has been affected by the heavy inflow of foreign capital in the last four to five years. Short presentations of all sellers and investors involved in studied transactions are also included. Presentation and analysis of interviews is made in chapters 4 and 5. Some special issues such as promissory notes and rental guarantees that arose during the process of writing this paper are discussed in chapter 6. The patterns found between investors, sellers and properties are presented in chapter 7. Finally, a discussion about whether the foreign investors will stay in Sweden or not and some concluding comments are found in the closing chapter.

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2 The value of real estate What is real estate worth to different players? The fact that a property might hold different values for different owners is not surprising. But how is this value created? This chapter will discuss several reasons for value creation from an ownership perspective. The discussion is based on an article by Ragnar Lindgren2 and a Royal Institute of Technology research project by Hans Lind3. These two authors have a somewhat different view on the value of real estate. Ragnar Lindgren uses modern financial theory as a starting point for his research on real estate ownership, whereas Hans Lind has a real estate valuation based view.

2.1 Return When investing in a property with the intention of holding it for a longer period it is crucial to understand how to run it in order to maximize returns. The investor who can make best use of and perform maintenance most effectively should own the property. This ought to lead to more specialization and professionalism in real estate ownership. One example is retail focused companies that have superior knowledge of how to design shopping centers, know how to put together a functional tenant mix, and have competence in negotiating with tenants. Another example is companies that focus on ownership in a certain geographic region, which gives great knowledge about the local submarket and could lead to higher rents. A more traditional perspective on generating returns is to maximize net operating income, which is total rent income less maintenance costs. When looking at a possible investment, an investor might believe he can raise the rents and/or run the property more rationally than the current owner, hence generating a greater return. This is related to the discussion above that the most professional owner should hold the property. A more financial way to generate returns is when the investor has access to superior loan conditions which might enable him to get higher leverage or lower interest costs. This can correlate with a lower estimation of risk by the investor with lower loan costs as a result. Other arguments could be that the investor has great knowledge about financial markets and the structuring of real estate transactions or simply has a financially solid reputation and is trusted by banks that in turn provide advantageous loans. In all of the examples above the assumption is that the investor will maximize the returns by being a superior owner compared to the seller. A different situation appears when the investor demands a lower return than the seller and is interested in buying properties that the seller might view as non profitable. A reason to the lower return demand could be that the investor has lower estimations of return in other investments. In other words, the investor’s opportunity cost is lower.

2.2 Risk When talking about return it is hard to leave out risk. How is risk treated by the investor? From an appraisal perspective, one assumption is that the investor views the risks differently than the seller. This could involve assumptions about the investor’s own competence in leasing the property more effectively than the seller, or higher belief in the tenant’s credit 2 3

Lindgren (1998) Lind (2004) Lind (2000)

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worthiness, which lowers the estimated risk of rent losses. Additional assumptions could be a belief in a stronger future rental market or that the investor’s own management skills will allow for a future increase in rents. All these assumptions indicate that the investor has lower risk estimation. Of course, the opposite is possible. It is then likely that this higher risk estimation will be incorporated in the transaction, thus bringing sale price down. The classic argument about risk is that it can be diversified. In the real estate world this means that, if all the assumptions in the CAPM (Capital Asset Pricing Model) were satisfied, everybody should own a small piece of every property, made possible by indirect ownership in stocks and funds. Of course, this is impossible and companies might choose to diversify risk by investing in different kinds of property. However, diversification is not prioritized when foreign investors make investment decisions.4

2.3 Real options Often there exists some kind of uncertainty when investing in real estate about what the future performance of the investment will be. The investor might want to wait and see how the market develops before making additional investments in the property (such as renovation). Having this ability to renovate but also the possibility of waiting can be viewed as having a real option. Consideration of real options will have an impact on how investors evaluate the investment and might differ depending on investors’ strategy for the property. The investor most likely to invest, and in turn determine the highest and best use of the property, will be the one that recognizes the value of this option.5

2.4 Management skills and optimistic outlooks As has been mentioned briefly above, skills and knowledge of management can affect how an investor values a property. With superior management an investor might observe potential values that are hidden for the seller or less informed investors. This means that the property will be worth the most to the investor that has access to the highest skilled management, which with their superior knowledge predicts the highest possible future net operating incomes. This optimism about the future should imply that the investor is willing to pay more for the property than others and that properties will be sold by pessimists to optimists. However, a theory called “Winner’s curse” creates an interesting contradiction to the argument above. The theory states that “some buyers will underestimate the value of an item and others will overestimate it… [and] …the high bidder will usually be one of the people that overestimated. Therefore there is a good chance that the “winner” paid too much for the item.”6 This could happen in a property transaction and the investor should ask himself why the seller values the property lower. Are there objective reasons behind it, such as portfolio optimization and management strategies, or has the investor overestimated future net operating incomes?

2.5 Pricing inaccuracies One way for an investor to enter the real estate market is if pricing inaccuracies exist on this market or other financial markets. The market prices the property inaccurately and this is spotted and used by the new entrant.

4

Axelsson & Victorin (1999) Brueggeman & Fisher (2005) 6 InvestorWords.com (2005) 5

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Is this entrant interested or capable of running the property? One possibility is that the entrant will buy to the lower and inaccurate price and then sell the property to a higher and more correct price. This new buyer would pay a higher price not only because the market now has adjusted to the correct price but also since he is more capable of running the property compared to the investor who spotted the pricing inaccuracy and therefore is capable of generating operating profits. If the scenario is reversed and the property was originally over priced, the only difference would be that the property would be sold at a loss for the new entrant. The outcome would be the same. The investor most capable of performing effective maintenance would, in the end, own the property.

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3 Overview of transactions This chapter begins with a quick review of what has happened on the Swedish real estate market in the last few years, discussing foreign investors and domestic sellers. Also, corporate takeovers are briefly mentioned. This is followed by a look at the transactions that have been selected for further studies, including short presentations of all companies involved.

3.1 Recent market activities Investors The interest in Swedish real estate has had an enormous upswing during the last eight years, increasing from about SEK 8.5 billion in 19977 to an all time high of SEK 40 billion in 2003. These investors pursue different investment strategies and can roughly be classified into core, core plus, opportunistic and renting investors depending on their investment horizon and return requirements. Although originating from all over Europe and the US, some investors in each investment segment stand out as major owners. These investors include investment bank Goldman Sachs’ Whitehall Street Real Estate Funds (Whitehall), conglomerate General Electric Real Estate, and German fund manager CGI.8 They have combined investments of SEK 14.4 billion since 20029. Most notable are Whitehall’s 2003 acquisition of 31 office properties in the Stockholm region from the Swedish real estate firm formerly known as Drott for SEK 5.2 billion, and CGI’s purchase of the single Stockholm CBD (Central Business District) property Klara Zenit from Wihlborgs for SEK 3.2 billion, also in 2003.10 100 90 80 70 Percent

60 50 40 30 20 10 0 2000

2001

2002

2003

2004

Year

Figure 3.1 Foreign investments in percent of total investment on the Swedish real estate market 2000-2004

11

Many reasons for foreign interest in Swedish real estate have been discussed in earlier work by others (see for example Axelsson and Victorin, 1999 and Arntell and Olofsson, 2004). The major influences on foreign investments appear to be: •

High supply of properties, with Stockholm being one of Europe’s ten largest real estate markets with 10.5 million square meters of office space. The Göteborg and Öresund regions also provide large retail and office areas.

7

Axelsson & Victorin (1999) Invest in Sweden Agency (2004) 9 Newsec Analys (2005) 10 Newsec (2004) 11 Newsec Analys (2005) 8

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• • •

Acceptable yields (lease revenues minus costs) make investments in real estate more attractive than those in government bonds. Simplicity and transparency through little bureaucracy and access to public and other data banks makes the acquisition process easy. Market liquidity is high through continuous transaction activity. This also makes exits available for investors wanting to leave the market.12

This large interest has helped keep the market strong and prices high when facing increasing vacancies in the wake of the IT crash in 2000. Sellers Many Swedish firms have used the increasing foreign investment interest to divest their real estate portfolios. The most prominent reasons for this action have been summarized below into four different incentives for firms to divest. • • • •

Financial and pension institutions that are over weighted in real estate following the downturn of the stock market sell real estate to achieve a better balance in their portfolio. Corporations that have core businesses other than real estate ownership sell to invest in these businesses and strengthen their balance sheets. Construction corporations and developers that suffer from a declining business cycle with little construction sell real estate to make money on markets other than their core markets.13 Real estate companies sell fully developed properties with no further additional profitability.14

Power and automation giant ABB sold its entire Swedish portfolio to London & Regional Properties and airline operator SAS sold its Stockholm headquarters to Nordisk Renting for some of these reasons.15 However, not all industrial companies have had the desire or need to remove real estate from their books. At Volvo Trucks’ headquarters outside of Göteborg, one has chosen to keep not just Volvo Truck’s properties but also Volvo Cars’ real estate in the company. “It’s one thing if you are located in central Stockholm. This entire area that we operate has developed because of our needs. There’s no other obvious tenant”, says Mårten Wikfors, Head of Media Relations at Volvo. “Also, we have not had cash flow problems so there has been no need to sell”, he adds.16 Corporate takeovers During the last four years some major foreign investments have been made as corporate takeovers of both listed and unlisted Swedish real estate companies. Royal Bank of Scotland acquired the largest unlisted company, Nordisk Renting (with a real estate portfolio worth about SEK 17 billion), from Nordea in 2003.17 Another large transaction was GE Capital’s SEK 5 billion takeover of Stenvalvet, a real estate company created to hold properties sold by Vasakronan, in 2001. Sellers were companies in a consortium of Credit Suisse First Boston, Femte AP-fonden and Crown North Corp.18

12

Veckans affärer (2003-04-14) Veckans affärer (2003-04-14) 14 Dagens Industri (2003-07-14) 15 Dagens Industri (2003-11-02) 16 Dagens Nyheter (2004-01-02) 17 Newsec (2003) 18 Dagens Industri (1997-06-25) 13

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Listed companies that have been sold include Tornet, sold in 2003 to LRT Acquisition, a special purpose vehicle formed by American investment bank Lehman Brothers Real Estate Partners (60%) and listed Swedish venture capitalist Ratos (40%), for SEK 9 billion.19 In the same year, the hotel specialized company Pandox was acquired for SEK 5.66 billion by Apes Holding, a cooperation between Norwegian real estate company Eiendomsspar and investment company Sundt.20 From an investment point of view many listed real estate companies have been traded with a discount. This means that a company’s value on the stock market is lower than the combined value of the company’s properties, adjusted for debt. In a survey performed by Swedish real estate advisor Leimdörfer, the average discount in 2002 was 28 percent.21 This could well have contributed to the foreign interest in taking over Swedish real estate companies.

3.2 Selected transactions In order to cover as many of the different kinds of investors and sellers as possible in the scope of this paper, a selection of eight transactions was made. These transactions cover a variety of interesting investment forms, spanning from single property transactions via portfolio transactions to sale-leaseback deals. All transactions studied are found in Table 3.1. Year

Seller

Country

2001

SAS

2002

Buyer

2

Country

Object

Sweden/Norway/ GE Capital Denmark (together with Nordisk Renting)

USA/UK

Airport properties

ABB

Sweden

London & Regional Properties

UK

Portfolio

2 760

1 100 000

The ABB portfolio

2002

JM

Sweden

Vital Forsikring Norway ASA

Office

977

21 240

Office and hotel property in Stockholm. The Mercedes house.

2003

Wihlborgs Sweden

CGI

Germany Mixed use

3 200

65 000

The Klara Zenit block. Mainly office and retail space.

2003

Drott

Sweden

USA

5 186

280 000

31 properties in the Stockholm region.

2003

AMF Pension

Sweden

Goldman Sachs' Whitehall Street Real Estate Funds Deka Immobilien

Germany Office

770

24 500

Office property in Stockholm.

2003

Skanska

Sweden

Blackstone Group

USA

Portfolio

2 060

140 000

10 properties in Stockholm and Öresund. Mostly office space.

2004

Nordea

Sweden

Cardinal Capital Partners

USA

Office

4 900

88 000

Nordea's head quarter in Stockholm. Subset of total portfolio sold.

Table 3.1 Overview of studied transactions

Portfolio

Price Area (m ) SEK (million) 3 000 285 000

Comment

11 airport related properties in Sweden, Denmark and Norway.

22

19

Invest in Sweden Agency (2004) Invest in Sweden Agency (2004) 21 Dagens Industri (2002-09-19) 22 Newsec (2003 & 2004); CB Richard Ellis (2004); Catella Property Group (2004); Jones Lang LaSalle (2004); Invest in Sweden Agency (2004) 20

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To find patterns in these transactions, a categorization of the players involved is described in Table 3.2. The investors are categorized into core, opportunistic, and renting, and the sellers are categorized into real estate companies, financial institutions, developers, and industrial and service companies. All sellers and investors involved in studied transactions are briefly described in the following subchapters. Sellers Real estate companies

Financial institutions

Developers

Wihlborgs

Nordea

Skanska

Industrial and service companies ABB

Drott

AMF Pension

JM

SAS

Core investors

Opportunistic investors

Renting

CGI

Goldman Sachs' Whitehall Cardinal Capital Partners Street Real Estate Funds Blackstone Real Estate Group GE Real Estate

Investors

Deka Immobilien

London & Regional Properties Table 3.2 Categorization of sellers and investors

3.3 Investors Core investors Investors focusing on stable income streams and low volatility are said to be low risk or core investors. Investments in mature and liquid markets with a steady risk/return profile are trademarks of this strategy. These investments normally generate returns ranging from 810% and involve low leverage.23 Most prominent core investors on the Swedish real estate market in later years have been German open ended funds, including hausInvest europa managed by CGI (Commerz Grundbesitz Investmentgesellschaft), grundbesitz-global by Deutsche Bank Real Estate and Deka-ImmobilienGlobal and Deka-ImmobilienEuropa by Deka Immobilien. Together, these funds have invested close to SEK 11.5 billion in Sweden during the last three years24. In addition to investment incentives described above, German open ended funds have seen a large inflow of money during the last few years. This is probably an effect of German savers’ hesitation to invest their money in stocks, with an increasing popularity of open real estate fund placements as a result. Naturally, fund managers want to invest this money as wisely as possible and Sweden has proved to be a good destination.25 Also, a change in German tax legislation in 2002 made it more favorable to invest abroad and helped boost real estate acquisitions in Sweden.26 CGI German open ended real estate fund hausInvest europa, on the market since 1972 and managed by CGI, was one of the first funds of its kind to make pan-European investments. Of the real estate assets worth some EUR 12 billion, about 75% are investments outside Germany, spread across 60 cities in 10 European countries.27

23

ING Real Estate Investment Management (2004) Newsec Analys (2005) 25 Veckans affärer (2004-05-17) 26 Byggindustrin (2004) 27 CGI’s homepage (2005) 24

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Deka Immobilien Belonging to the Sparkasse Financial Group, Germany’s largest financial organization, Deka Immobilien Investment GmbH was established in 1966. It is owned by Deka Bank Deutsche Girozentrale, which in turn is held by the German State Banks (50%) and German Savings Banks (50%). The company specializes in open-ended property funds, where it is one of Germany’s largest management companies, and runs both public and special funds for private and institutional investors respectively. With an outspoken strategy of internationalization and diversification, Deka Immobilien has acquired over 356 properties in 20 countries.28 Vital Forsikring Following its 2004 merge with Gjensidige NOR Spareforsikring ASA, Vital Fosrikring ASA is the largest privately owned life- and pension insurance company in Norway, with total assets of NOK 168 billion. Vital Eiendomsforvaltning ASA is responsible for real estate placements, managing a portfolio worth approximately NOK 1 billion. Its focus is on office-, retail- and hotel properties, and investments have been made in Norway, Sweden and England with a total lease area of 1.8 million square meters.29 Opportunistic investors These investors have a strategy that focuses on capital growth by investing in properties that need to undergo some structural improvements on mature markets or in high-quality properties in emerging markets. The clear emphasis on capital appreciation and a return in excess of 16% requires higher risk and leverage.30 Some of the largest direct property investments ever made in Sweden have been performed by opportunistic investors such as Whitehall Street Real Estate Funds managed by American investment bank Goldman Sachs and American investment and advisory firm Blackstone Group. The former acquired a portfolio consisting of mainly office properties from property developer NCC in 2002 worth SEK 3.95 billion, and another portfolio from life insurance company Länsförsäkringar Liv and real estate company Humlegården for SEK 2.035 billion later that year. In 2003 investments continued with the acquisition of 31 properties in the Stockholm region from real estate firm Drott for SEK 5.2 billion. Blackstone made a 2003 acquisition of ten properties from developer Skanska for SEK 2.060 billion.31 Altogether Goldman Sachs and Blackstone have invested SEK 13.245 billion the last three years. Goldman Sachs Whitehall Street Real Estate Funds Goldman Sachs' Whitehall Street Real Estate Funds (Whitehall) have been a very active investor with transactions in Sweden worth some SEK 11 billion the last two years. Whitehall invests in real estate and real estate related investments all over the world and has acquired assets with a gross value of over USD 60 billion since inception (1991). Investment horizon depends on the local market but is usually five to seven years.32 Blackstone Real Estate Group Being a part of Blackstone Group, the Blackstone Real Estate Group was formed in 1992 and focuses on real estate private equity investments. Operating primarily in North America and Europe, the company has raised nearly USD 6 billion for real estate investments through its Blackstone Real Estate Partners I-IV and Blackstone Real Estate Partners International funds. Investments have been made in office buildings, the lodging sector, distribution and warehousing centers, retail and a variety of real estate operating companies.33 28

Deka Immobilien Investment (2004) Vital Forsikring’s homepage (2005) 30 ING Real Estate Investment Management (2004) 31 Newsec (2003 & 2004) 32 Dagens Nyheter (2003-07-15) 33 Blackstone Group’s homepage (2005) 29

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Renting Investors interested in financial stability and a long term inflow of money with little real estate risk or full responsibility for maintenance of the properties can enter into renting or saleleaseback deals. Usually investors’ requirement of the property is that it has a strategic value for the seller and that the seller thereby is willing to sign 10-25 year lease contracts.34 Two investors with recent activities in this segment are Cardinal Capital Partners and GE Real Estate. The former made its first entry on the Swedish market in 2004 when it bought office properties from the Nordic bank Nordea for SEK 4.9 billion in a sale-leaseback transaction.35 The latter made its first appearance on the Swedish real estate market in 1995, and its first major investment was the 1997 joint acquisition with Morgan Stanley of nearly 130 properties spread out over the country for about SEK 3 billion.36 The total amount invested by these two companies since 2003 is SEK 6.14 billion37. Another very active investor in the last three years has been UK based London & Regional Properties. The company’s first investment outside the UK was made in Sweden in June 2002 when acquiring ABB’s real estate portfolio in a sale-leaseback deal for a price of SEK 2.3 billion. In August 2003 Ica-Ahold’s 14 distribution centers were bought together with GE Real Estate in another sale-leaseback deal worth SEK 2.5 billion. This investment was followed by the SEK 1.9 billion acquisition of a portfolio consisting of six office properties in the greater Stockholm area from Vasakronan in December 2003. Like the transactions before, this was also a sale-leaseback deal.38 Cardinal Capital Partners Founded in 1988 and focusing exclusively on acquisitions of net leased (meaning that all operating expenses are paid by the tenant39) corporate real estate, Cardinal Capital Partners has invested approximately USD 4 billion since startup. Acquisition and leaseback, acquisition of existing single tenant real estate, and acquisition of build-to-suit transactions via “pre-sale” purchase commitments are the three primary areas of business.40 GE Real Estate Being part of global conglomerate General Electric’s business portfolio, GE Real Estate in the Nordic region focuses on property-related transaction, management, sale-leaseback, and financing solutions. The company has made transactions with an underlying property value of approximately SEK 17.5 billion, and its properties are located in Sweden, Norway and Denmark.41 London & Regional Properties This privately owned real estate company, founded about ten years ago, is (with its portfolio) worth over GBP 3.5 billion one of the largest private property companies in the UK. Its focus is on long-term property investment, outsourcing, commercial property development, and hotel investment and development. As mentioned above, its business in Sweden has been centered on corporate outsourcing in several sale-leaseback deals. The 2002 entry in Sweden also opened the Scandinavian market for expansion into Denmark and Finland.42

34

Newsec (2005) Newsec (2004) 36 Axelsson & Victorin (1999) 37 Newsec Analys (2005) 38 Dagens industri (2004-02-20); London & Regional Properties (2004) 39 Brueggeman & Fisher (2005) 40 Cardinal Capital Partners’ homepage (2005) 41 GE Real Estate in the Nordic region’s homepage (2005) 42 London & Regional Properties’ homepage (2005) 35

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3.4 Sellers Wihlborgs Wihlborgs is a real estate company that works in the Stockholm- and Öresund regions in Sweden. Its main focus is on effective maintenance of existing property stock and development of profitable projects. These projects are chosen on future growth expectation and will be sold when an opportunity arises to cash in on built up values. Enhancement of the property portfolio, which consists of 70% commercial properties, 20% development properties, and 10% housing properties, is done through sales, purchases and development. Book value of the 500 properties making up the stock was SEK 37.1 billion on September 30, 2004.43 Drott Drott, the company involved in the transaction analyzed in this paper, is today a completely different company from the time when this transaction took place only a few years ago. By the end of 2002, Drott had properties with a book value of SEK 40 billion. Through aggressive divestments worth SEK 12.1 billion and a split of the company in two parts, the part keeping the name Drott became focused on housing in expanding Swedish regions, while the other part, Fabege, became more commercially and Stockholm oriented. Later Fabege was acquired by Wihlborgs and Drott by Stena Fastighetsförvaltning. When Drott is mentioned below, it’s the Drott as of December 2002 that is referred to.44 Nordea Nordea was created between 1997 and 2000 when Swedish bank Nordbanken and Finnish bank Merita merged to form MeritaNordbanken. In 2000 two additional banks were integrated with MeritaNordbanken: Unidanmark from Denmark through a merger, and Norwegian bank Christiania Bank og Kreditkasse through an acquisition. These four banks went on to form Nordea in October 2000 and focuses on three business areas: retail banking, corporate and institutional banking, and asset management and life. In 2004 Nordea had a net profit of about EUR 1.9 billion.45 AMF Pension Founded in 1973 and owned jointly by Svenskt Näringsliv (the Confederation of Swedish Enterprise) and LO (the Swedish Trade Union Confederation), AMF Pension is one of Sweden’s better known pension companies. With assets under management of approximately SEK 210 billion, the company focuses on traditional insurance, unit-linked insurance, premium pensions, non-pension related mutual fund savings, and corporate pension solutions. 5.7% of the portfolio is invested in real estate, 37.5% in equities and 56.8% in fixed-income investments.46 Skanska Skanska was founded in 1887 and has been a major international construction company since the mid-1950s. Currently its focus lies on construction related services and project development; net sales were SEK 121 billion in 2004.47 Being one of 15 business units within the Skanska Group, Skanska Project Development Sweden is responsible for developing properties in Sweden and Denmark. The unit manages, develops, and sells properties out of Skanska’s development portfolio and focuses on offices, industrial and retail parks, warehousing and logistic facilities. This business unit acted as seller in the transaction with Blackstone. 43

Wihlborgs’ homepage (2005) Drott’s homepage (2005) 45 Nordea’s homepage (2005) 46 AMF Pension’s homepage (2005) 47 Skanska’s homepage (2005) 44

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In January 2004 Skanska Project Development Sweden’s portfolio included 97,000 square meters of ongoing projects, of which 83% was already leased. A total of 558,000 square meters has been completed in the three key areas Stockholm, Göteborg and the Öresund region.48 49 JM Founded in 1945 by contractor John Mattson, JM is a project developer of residential properties and (to a certain degree) commercial properties, mainly in the Stockholm area. Business is focused on regions with high expected growth such as metropolitan and university areas located in Sweden, Norway and Denmark. Turnover in 2004 was SEK 8.4 billion.50 ABB Global power and automation technology company ABB focuses on improving customers’ operations by supplying products, systems, solutions and services. Revenues in 2004 were about USD 20.7 billion.51 SAS Formed in 1946 from the three Scandinavian countries’ national airlines, SAS is today the leading Nordic listed airline operator with 32.4 million passengers transported in 2004. The company provides air transport and related services and also has some hotel operations with Rezidor SAS Hospitality.52

48

Skanska Project Development’s homepage (2005) Skanska Project Development (2004) 50 JM’s homepage (2005) 51 ABB’s homepage (2005) 52 SAS’ homepage (2005) 49

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4 Transactions from the investors’ perspective In this chapter, facts from interviews with investors and advisors on the eight transactions studied will be presented and analyzed. The presentation highlights the most important questions discussed.

4.1 Core investors Listed in the table below are the three transactions studied that involved core investors. Year

Seller

2003

2003

Country

Buyer

Country

Wihlborgs Sweden

CGI

Germany Mixed use

AMF Pension

Deka Immobilien

Germany Office

Sweden

Object

2

Price SEK (million) 3 200

Area (m )

Comment

Advisors

65 000

The Klara Zenit block. Mainly office and retail space.

770

24 500

Office property in Stockholm.

Catella, Citigroup, Nordea Securities Jones Lang LaSalle

Table 4.1 Transaction involving core investors

Initiation of transactions Transactions have been initiated in two different ways. In the first scenario, the investor has been looking for investment opportunities for some time and already has made a thorough analysis of the market and local submarkets. The second scenario occurs when the investor has been contacted by an advisory firm. The advisory firm can act on its own and try to work out a deal with both seller and investor, but in this paper’s selection of companies the advisor was most commonly given a sale assignment from the seller. Sellers often perform “beauty contests” to promote the property in open market bidding. In these biddings investors are welcome to leave bids on what they think the property is worth. Another way for the investor to approach a deal is to negotiate exclusively with the seller. For this opportunity, the investor usually pays a premium that will raise the final sale price. When an investor considers what approach to use, time and money are both important. Open market bidding involves more competition, is more time consuming, and the investor is not sure to get to buy in the end. This costs money, and many German core investors believe that the premium for exclusive negotiation is a reasonable one. In the transactions studied here, both Deka and CGI were negotiating exclusively. At the time of the investments both CGI and Deka were working on several parallel deals. Altogether six properties were bought buy the two investors. Financially related questions The form of investment used by CGI and Deka were open ended funds including significant private investments. Deka mentions that they set up Swedish companies that buy the properties. Return requirements are adjustable depending on the market, the competition, and the property. Normally properties located in CBD generate lower returns but with lower risk involved. Both investors have experienced a large inflow of money in recent years. CGI, for example, has raised EUR 2-3 billion per year. This has enabled the companies to use low leverage, never more than 50%. When deciding on what leverage ratio to use, the cost of financing the _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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transaction with loans is compared to alternative investments. The interest cost depends on the competition from other investors, meaning that the more buyers that want to invest, the higher the property price will be, resulting in more loans and higher costs. Another side of interest rates is that if they are low and one can borrow money easily and cheaply, one can pay more for the property (but according to Deka, never above market price). Also, a low leverage ratio gives less exposure to interest rates. CGI used a German bank and Deka used a Swedish bank for their loans. When looking at risks, CGI’s two main considerations were the fact that the property wasn’t fully renovated, together with tenant credit risk (meaning the risk that tenant goes bankrupt and cannot pay rent). For Deka, the biggest risk was the possible failure of the merge between HP and Compaq, since these companies were leasing a major part of the property (this is the author’s opinion). These risks were incorporated in the price and Wihlborgs also gave rental guarantees to CGI. Rental guarantees will be more thoroughly discussed in chapter 6. Strategies involved CGI constantly scans different markets throughout the world in search for new investment opportunities by following three methods; go to a new country, a new sector, or a new structure. When an attractive market suitable for their investment prerequisites is found, a more thorough analysis containing information about advisors, tax legislation, development market, etc., is made. Then more detailed investment profiles on interesting properties are created. Ideally, investments are made in markets that have bottomed out to reap future benefits. However, this is not always possible. When the inflow of money is heavy, investments must be. However, the keywords here are long term benefits and sustainability. At the time of the investment, Sweden had a stable market that seemed to be giving good returns and that contained properties that fit CGI’s investment profile. Deka employs a somewhat similar strategy. Office buildings are the main focus, but investments are also made in retail and logistic properties to spread risk. When entering a new market, only investments in properties with no vacancy are considered. As Deka learns about the market, more risky investments with some vacancy might be carried out. As with CGI, investments are preferred when the market is anticipated to pick up. Both CGI and Deka show signs of herd behavior. The influence of other players is heavy when considering what markets to enter. This is seen as useful in finding hot markets, and with many players on the market, more exit opportunities exist. However, market entry always depends on the fit between properties, investment profile, and expected yields. Property criteria When investing in properties, the German funds studied look for the following attributes: 1. 2. 3. 4. 5.

Favorable physical state of object New building or newly refurbished Good location Solid tenants with long term lease contract Low vacancy rate

Deka mentions that they look beyond the property and focus on the lease contracts, taking into account the probabilities of tenants to remain in the property, length of expected stay,

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financial status, etc. The demand for new buildings can have something to do with this as the tenant is more likely to stay in a well kept property. Another reason for investing in new buildings is that the buyers are not interested in property management, where they usually team up with a local company. Their expertise lies in asset management, such as finding the right tenant mix.

4.2 Opportunistic investors Listed in the table below are the two studied transactions involving opportunistic investors. Year

Seller

Country

Buyer

Country Object

2003

Drott

Sweden

USA

2003

Skanska Sweden

Goldman Sachs' Whitehall Street Real Estate Funds Blackstone Group

USA

2

Area (m )

Comment

Advisors

Portfolio

Price SEK (million) 5 186

280 000

31 properties in the Stockholm region.

Catella

Portfolio

2 060

140 000

10 properties in Stockholm and Öresund. Mostly office space.

Jones Lang LaSalle

Table 4.2 Transactions involving opportunistic investors

Initiation of transactions Both Goldman Sachs’ Whitehall Street Real Estate Funds (Whitehall) and Blackstone Real Estate Group (Blackstone) had previously been active on the market before settling their deals. For example, they both participated in the bidding on the NCC portfolio in 2002, with Whitehall as the final buyer. This made Blackstone look for other similar investment opportunities, and the company found one when Skanska wanted to sell a portfolio. In this deal, Blackstone took no chances with competition and exclusive negotiations were arranged. The objects acquired in both transactions were property portfolios. These transactions allow the seller to mix high quality properties with some lesser properties that would have been very difficult (or impossible) to sell piecewise. In return, the investor can get a portfolio discount, which means that the price of the portfolio is lower than buying the properties piece by piece. If the investor has knowledge about the market in advance, he might have identified potential buyers of the different properties in the portfolio depending on their preferences in type of property, location, tenant, lease contract, etc. By selling the acquired properties piecewise, the investment is likely to be profitable. See Figure 4.1.

Figure 4.1 The effect of portfolio discounts

The shifting quality of the properties in the portfolios made the actual portfolios sold differ from the original ones in the transactions studied. They both evolved into a subset of the original portfolio during negotiations, probably due to disagreements in price. Financially related questions _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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The investment vehicles used by Whitehall and Blackstone are private equity funds, open to both private and institutional investors. These funds look for investments in niche markets that are a good alternative to bigger markets. The internal rate of return (IRR) demanded is well over 20% and depends on the property, credit availability on the market, leverage ratio, and interest rates. Since interest rates in Sweden have been low the last few years, highly leveraged transactions have not been so costly to finance. Leverage of 80-90% is frequently used by both Whitehall and Blackstone but they are not restricted to these ratios. With the right prerequisites they go as high as possible. When using highly leveraged financing, the exposure to interest rates and loan amortization increases. This is counteracted by arranging interest-only loans with no amortization in the first years with both foreign and Swedish banks. By focusing on a high IRR and high leverage, the investment is largely affected by its duration. Consider the following example. A property portfolio is bought with high IRR and high leverage. If some properties are sold shortly after the acquisition, the return from this sale might cover equity used in the original financing. This means that the investor has, in a short amount of time, created an investment with return generating properties without risking any equity. This example together with the discussion above about favorable portfolio discounts implies that opportunistic investments in property portfolios can be very profitable. The Drott transaction had some interesting features in terms of factors affecting the sale price (beyond the traditional cash flow analysis valuation). Early access to net operating income, promissory notes, and rental guarantees given to Whitehall by Drott gave the sale price a push upward. Promissory notes will be more thoroughly discussed in chapter 6. Strategies involved When asked what kind of investment strategies they follow, the two investors showed that they have somewhat similar approaches. Whitehall uses a specific strategy for every investment depending on type of property, market and business cycle to generate IRR’s above 20%. These individual deal strategies are supported by asset-by-asset underwriting. Blackstone has an aggressive approach and is highly focused on getting an above 20% IRR with minimum risk. How this is achieved is of less importance and the transaction is structured around this requirement. How, then, are Whitehall and Blackstone affected by other real estate investors? Competition has more of an influence than herd behavior. Whitehall brings up that all core and core plus investors on the market make it harder to find good investments. However, since Whitehall currently holds quite a bit of real estate, they can act as sellers when these other investors realize that there are other properties to invest in than those that are newly built, perfectly located, etc. Whitehall believes that in the long run there will be an upward trend in the submarkets where they have invested. Both investors are constantly monitoring world markets to find new investment opportunities. New market entry is preferred when the market is believed to have bottomed out and future profits then are as high as possible. This, together with acceptable yields, market transparency, and exit opportunities were some of the reasons for Whitehall’s and Blackstone’s entries in Sweden. Once a market is entered, it is easier to find profitable deals since access to market information is better. This detail was expressed by both investors. Another interesting effect of this increased foreign interest is the contradiction between sellers’ and buyers’ estimations concerning the state of the future market. Drott, for example, _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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thought that the falling rental market would cause the real estate market to go down, something that did not occur. Whitehall, on the other hand, anticipated a recovery in the market during their holding period. Property criteria When asked whether the investor and seller appreciated the value of the portfolio differently, Blackstone’s straight answer was no. The transaction was favorable since 95% of total space was leased on an average of 7-8 years (a very long time for Sweden). Also, some larger tenants (Electrolux, Ericsson and the Swedish government) made up for the weaker ones. However, and much more interesting, Whitehall presented a list of three points why they had a different opinion of the portfolio’s value than Drott did. Whitehall viewed the transaction as an opportunity to satisfy its return requirements by acquiring a substantial portfolio with good interim cash flow with upside from: 1.

Potential asset repositioning by employing asset management strategies different from Drott.

2.

Potential for cap rate compression driven by increased demand/capital flows during the holding period.

3.

Enhanced returns through attractive leverage and structuring.

In the last point it’s important to understand that on the one side you have the actual property, which ultimately is not that important, and on the other you have the financial structure of the deal, which is very important. When it comes to what property attributes are important for Whitehall and Blackstone, they both mention a favorable physical state that isn’t too capital-demanding. Whitehall also lists solid tenants and Blackstone adds geographic location as important. Although they have separate views on differences in valuation, both Whitehall and Blackstone believe that they cannot run the property more efficiently than the sellers. The money is made on intelligent financial solutions and competence in asset management.

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4.3 Renting Listed in the table below are the three transactions studied that involved renting investors. Country

2001 SAS

Sweden/Norway/ GE Capital Denmark (together with Nordisk Renting)

USA/UK

Airport properties

2002 ABB

Sweden

London & Regional Properties

UK

Portfolio

2 760

1 100 000

Cardinal Capital Partners

USA

Office

4 900

88 000

2004 Nordea Sweden

Buyer

Country Object

2

Year Seller

Price Area (m ) SEK (million) 3 000 285 000

Comment

Advisors

11 airport related properties in Sweden, Denmark and Norway. The ABB portfolio

Newsec

Nordea's head quarter in Stockholm. Subset of total portfolio sold.

Leimdörfer, Credit Suisse First Boston Catella, Citigroup, Nordea Securities

Table 4.3 Transactions involving renting

Initiation of transactions All transactions started out with the seller wanting to focus on its core business and taking their real estate off the books. Together with advisors, they scanned the market for potential buyers and promoted the properties both in Sweden and internationally. The three investors entered the transactions for various reasons. For London & Regional Properties (LRP) and Cardinal Capital Partners (CCP), these were first time investments in Sweden. LRP considered its home market in the UK to be too crowded and started looking abroad for investments. In Sweden, they found higher yields on one of their business strategies of corporate outsourcing, and the ABB portfolio was a good match. As mentioned in chapter 3, LRP has remained in Sweden and has made additional investments. CCP was contacted by the advisor Catella since Nordea was interested in a triple net lease and CCP had previous experience with this contract form. An interesting aspect is that this long lease transaction is the only of its kind in Europe to this date. For GE, the situation was quite different, since it had been on the Swedish market for six years after its 1995 entry. This investment was estimated to be attractive with controllable risk and healthy return. Being one of the largest companies in the world, financing was not a problem for GE and this deal had the right prerequisites for investment. Even if the three investors had different objectives for entering, they all had somewhat the same financial requirements about the property and the seller involved in the transaction. These have been summarized below: 1. 2. 3. 4.

Tenant (seller) needs to have credit worthiness and be considered reliable. Long lease times, up to 25 years. Safe cash flows. Appropriate transaction volume.

The complexity in all these deals has been high. For Nordea, the triple net lease process demanded much attention. ABB had to satisfy USGAAP (United States Generally Accepted Accounting Principles) requirements and regulations and GE was involved in a transaction where three different jurisdictions (Sweden, Denmark and Norway) had to be satisfied. Initial _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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interest from investors was high, but many investors were eliminated during the process, due to their lack of understanding of key features in the contracts. GE made an interesting list of the types of problems that need attention in a sale-leaseback transaction of this kind: 1. 2. 3. 4. 5. 6.

Property related problems Financial questions Accounting Taxes Sales tax Legal questions

In the end, the investors who closed the deals were the most financially skillful, saleleaseback experienced investors that handled these questions most professionally. Financially related questions The three investors also used different methods to finance the transactions. GE teamed up with Nordisk Renting to form a 50-50 owned stock company that made the investment. The companies had similar demands on returns on equity over a longer period of time as investment objective. For LRP, which is a 100% private equity company, the focus of the investment is also to get a high return on equity. LRP’s investment process might look like this: They find an object they want to buy. Then they see what kinds of loans they can get. Finally they do the math to see what this loan gives them in return on equity, and determine whether this is enough. Leverage was high to extremely high in all three transactions, ranging from about 85-100%. This was made possible due to high competition between banks. One explanation to this competition could be that due to the increasing interest from foreign banks on the Swedish market, Swedish banks have become more aggressive and have changed their loan politics to lessen restraint. They now look beyond the bricks and mortar of the properties and take into consideration in what business the company performs, their credit rating, and the type of cash flow that is generated. With all three sellers having good credit ratings at the outset of the transactions, banks might have seen good business opportunities in financing loans, thus stretching the leverage to get the deal. Another reason for Swedish banks getting into the game of financing real estate more aggressively can be that when industry is not investing and the core business for banks is to lend money, they will lend it to segments that do invest, such as the property sector. Swedish banks seem to be preferred over international ones for financing sale-leaseback transactions. This could be based on their familiarity with the companies on the Swedish market, enabling them to appreciate Swedish companies’ business more accurately than foreign banks. When using high leverage, exposure to interest rates increases. Another factor that increases this exposure is that rents often are connected to STIBOR (Stockholm Interbank Offered Rate – the interest rate banks pay when borrowing from other banks at maturities other than overnight).53 With Swedish interest rates low in recent years, this exposure has not been high and has affected investors to a lesser extent. What kind of risk was involved? In sale-leaseback transactions, risk is closely connected to the financial state of the tenant and whether rents can be paid. When setting out, all three sellers were in good financial shape, but only Nordea remained this way. Initially, the risk for LRP was believed to lie in pricing the lease contract and sudden increases in maintenance 53

Riksbanken’s homepage (2005)

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costs. Later, when ABB experienced severe financial distress and its credit rating dropped by three points, with a desperate need of capital as a result, risk changed to a situation where LRP could lose all their money invested if ABB went bankrupt. This is somewhat counteracted with the use of nonrecourse loans, which is “a loan in which the borrower may have pledged collateral, but the borrower is not personally liable. The lender of a nonrecourse loan generally feels confident that the property used as collateral will be adequate for the loan”.54 For GE the initial risk involved whether SAS would be able to pay rent, but this was considered controllable since the properties were of strategic importance to SAS. Then, in the fall of 2001, SAS also experienced some hard times in the wake of the World Trade Center attack on September 11th and also the Linate airport accident in Milan, Italy in October. It probably would not have been possible to perform this transaction after these events, especially after the World Trade Center attack since GE is an American company. Strategies involved What is important when entering sale-leaseback deals is to ensure that the properties are of strategic importance to the seller. The investor brings a solution that makes it possible for the seller to focus capital on core competencies. The increasing popularity of sale-leaseback transactions in Sweden in recent years can be an effect of rising attention to specialization. The seller has no real competence in owning and running its properties and wants to focus on core business. However, the need for the properties for daily business is still there. In a situation like this, a professional real estate financing company could step in and buy the properties and lease them back to the seller. If the financing is right, the seller is likely to sign long term contracts. The long contracts are a way of bringing down investors’ risk. In all three transactions, the investors followed their predetermined investment strategies. The existing business cycle in Sweden with low interest rates, good possibilities of financing, and high yields made the investments look favorable. Also, the market has been such that the four prerequisites for transactions described above could be satisfied. Other investors’ interest for sale-leaseback on the Swedish market has not affected the three studied investors to a large extent. However, with competitors moving into the same market, one can feel safer knowing that others have made the same estimations about this market. The sellers are probably the winners here when an increasing number of interested investors make it easier to arrange a more attractive deal. An important difference in overall strategies between the investors is that LRP has found a niche of its own somewhere between real estate and renting companies, with their differing investment horizons. The big difference is that LRP is willing to take some property risk, meaning that the salvage value at the end of the contract is larger than zero. See Figure 4.2.

Figure 4.2 LRP has found a niche between real estate and renting companies 54

Dictionary of small business (2005)

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Property criteria Since they did not have a triple net lease contract, LRP became responsible for maintenance of the properties bought. This was seen as positive since LRP thought that they could be run more efficiently. First, cost awareness is likely to go up when an external company comes in to run the properties, and second, LRP is likely to enjoy synergy effects in owning the properties due to being a real estate focused company. On the question of whether the investors had appreciated the value differently than the sellers, the following issues came up. If the seller sees itself as a strong tenant with properties in good physical shape and the financing and the price are viewed as favorable, then the deal is good. The investor focuses more on stable cash flows and return on equity. If the two different approaches can be satisfied the transaction can take place. So, the difference is not so much about appreciating the value in different ways as about having different ways of satisfying internal financial demands. If the approaches to satisfying financial demands are too similar, the following event could take place. The seller observes what kind of financing is used by the investor, goes to the same bank, and requests the same loan conditions. If this loan is approved, the property stays within the company as well as the cash flows generated with the bank loan. Behavior like this has been observed. As already mentioned, solid tenants and properties that are strategically important to the tenant are central criteria when entering in sale-leaseback deals. As a complement to this, GE mentions geographic location of the property as having some importance.

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5 Transactions from the sellers’ perspective In this chapter, facts from interviews with sellers and advisors on the eight transactions studied will be presented and analyzed. The presentation highlights the most important questions discussed.

5.1 Real estate companies Listed in the table below are the two transactions studied that involved real estate companies. Year

Seller

Country

Buyer

Country

Object

2003

Drott

Sweden

USA

Portfolio

2003

Wihlborgs Sweden

Goldman Sachs' Whitehall Street Real Estate Funds CGI

Germany Mixed use

2

Price SEK (million) 5 186

Area (m )

Comment

Advisors

280 000

31 properties in the Stockholm region.

Catella

3 200

65 000

The Klara Zenit block. Mainly office and retail space.

Catella, Citigroup, Nordea Securities

Table 5.1 Transactions involving real estate companies

Initiation of transactions The reasons to sell and the objects sold differ greatly between the two real estate companies studied. Wihlborgs sold a single property in an exclusive negotiation and Drott a portfolio in an open market transaction. For Wihlborgs the driving force in sales is the strategy to sell fully developed properties. One of Wihlborgs’ main businesses is to acquire properties that have the potential to generate returns after refurbishment. An interesting point in this deal was that the property was not fully developed, which usually is a requirement for Wihlborgs to sell and for CGI to buy. The old Postgirot part of the property still needed to be refurbished and leased, and this was incorporated into the deal. Drott’s divestment was the result of a strategy to be better equipped to follow the fluctuations on the volatile Stockholm real estate market (meaning sell when peaking and buy when bottoming out). The portfolios sold represented an average of Drott’s property stock. Financially related questions Wihlborgs saw no future potential for the property and the divestment was in line with the strategy to buy, develop and sell. For Drott it was a complete change of strategy. The company wanted to raise turnover speed and this could only be done by slimming down the business to get lower solvency, which would enable faster action with market fluctuations. Both companies sold to free resources to invest elsewhere. During the time of the transaction, Wihlborgs bought a large amount of the Fabege stock. At this time prices were high on property in Stockholm, CBD and CGI offered Wihlborgs a good price. Without the profit from this deal they never would have been able to buy out Fabege. Drott, on its side, wanted to distribute the housing part of the new company as dividends to owners, and needed the capital from the sale to do so. _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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Strategies involved When asked about their strategies, both sellers followed the outlines described above without being too much affected by the increasing popularity of selling out real estate. Wihlborgs did what had been done for quite some time in selling a developed property. Drott, with its new strategy, needed to sell out real estate worth SEK 12 billion in 8.5 months to follow this strategy and a portfolio transaction was a good way to speed up the divestment process. At the time of these divestments, the Swedish rental market was considered by many to have peaked, and it was assumed that when it went down, it would bring the real estate market with it. This turned out to be incorrect due to low interest rates and the strong foreign interest that kept prices high. Of the two real estate companies studied, Drott was particularly of this opinion. Although markets were not going down, 2003 was a good time to sell to foreign investors. Wihlborgs mentioned that apart from high rents, the fact that their property was filled with long term tenants gave them a good price. Sale criteria The way the selection of investors was made differs in the two transactions due to their different structures. Wihlborgs received a generous offer and went through with the deal. For Drott it was not as easy. Few investors could handle the size of this portfolio. The volume of the transaction was important for Drott, since the timeframe for divestments was short. Also, the risk of not being able to sell certain properties is lower when selling a portfolio than selling the properties piecewise. When determining sale price, discounted cash flow analysis was used to make the appraisal. In addition and highly affecting the price, promissory notes were issued by Drott and rental guarantees were issued by both sellers. Drott also gave Whitehall early access to net operating incomes to bump up the price.

5.2 Financial institutions Listed in the table below are the two transactions studied that involved financial institutions. Year

Seller

2003

2004

Country

Buyer

Country

AMF Sweden Pension

Deka Immobilien

Nordea

Cardinal Capital Partners

Sweden

Object

2

Area (m )

Comment

Advisors

Germany Office

Price SEK (million) 770

24 500

Office property in Stockholm.

Jones Lang LaSalle

USA

4 900

88 000

Nordea's head quarter in Stockholm. Subset of total portfolio sold.

Catella, Citigroup, Nordea Securities

Office

Table 5.2 Transactions involving financial institutions

Initiation of transactions and financially related questions When making the decision to divest, Nordea was one of the largest real estate owners in the Nordic region, with properties at a book value of approximately EUR 1.6 billion. This was not in accordance with the strategy of focusing on core business and increasing capital efficiency. Investments in banking areas other than real estate were considered to have a higher long term return. Also, since it was not a real estate company with specific knowledge of this business, the cost awareness and efficiency of running the properties could have been _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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higher. By selling all of its real estate, Nordea made a net profit of approximately EUR 300 million. AMF had made the analysis that property values would decline on the local real estate market because of high vacancies and low rents. This analysis initiated a more sell-oriented phase in the constant allocation of funds within the asset portfolio. Even when the market turned out to decline less than anticipated, AMF Pension wanted to get a feel for the market by selling a property in Solna, north of Stockholm. The property was sold above book value, and the profit from the transaction went into paying interest on investments. In this category of sellers, there are also differences in the structuring of the transactions. Nordea went into a triple net lease contract on a portfolio of properties in an open market transaction. AMF Pension, on the other hand, sold a single property in exclusive negotiations. Strategies involved In addition to what has been stated above, increased foreign interest with high competition among investors made it favorable for Nordea and AMF Pension to sell at this point in time. However, Nordea claimed not to have been as affected by this as by the internal decision to sell out real estate. It is likely that the sale would have been followed through even if the market had not been as strong as it was. When looking at AMF Pension’s strategy to increase ownership in large, well located and modern properties in Stockholm and Göteborg, there is a close parallel to German pension funds. They also want to include properties with these features in their portfolios. This has increased competition for AMF Pension in recent years. Both sellers have followed their divestment strategies without being very affected by other players on the market. Nordea sold to focus on core business, and AMF Pension sold to collect profits on a market that was presumed to go down. Sale criteria Cardinal Capital Partners was the logical choice for Nordea when entering the triple net lease deal. CCP had previous experience of this kind of transaction and the know how to construct it. An external valuation was made, but the price was also affected by the portfolio’s market value. For AMF Pension, the condition for letting Deka negotiate exclusively was that a premium was paid that would have covered any bids if the property had been released on the market. Also, AMF Pension would never have sold if the price hadn’t been higher than book value.

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5.3 Developers Listed in the table below are the two transactions studied that involved developers. Year

Seller

Country

Buyer

Country Object

2002

JM

Sweden

Vital Forsikring ASA

Norway

2003

Skanska Sweden

Blackstone Group

USA

2

Area (m )

Comment

Advisors

Office

Price SEK (million) 977

21 240

Office and hotel property in Stockholm. The Mercedes house.

Catella

Portfolio

2 060

140 000

10 properties in Stockholm and Öresund. Mostly office space.

Jones Lang LaSalle

Table 5.3 Transactions involving developers

Initiation of transactions It was in Skanska’s interest to enter in this large portfolio transaction since it followed the overall capital strategy to bring down the volume of assets owned. The company wished to sell quickly and under controlled forms, and also to sell some less desirable properties. The only way to do this was to package them with good properties and sell the entire portfolio. This setup seems to be tailor-made for opportunistic investors (as described in chapter 4) and exclusive negotiations with Blackstone were initiated. JM also wanted to sell a large CBD portfolio, but this turned out to be impossible, and the properties were sold piecewise. According to the reasoning above, this might have made it more difficult to sell less desirable properties. Financially related questions The overall financial criterion to sell for both Skanska and JM was to focus on core business. Skanska divested to follow its capital strategy of bringing down employed capital, speeding up capital turnover, and to showing development profits. Also, properties sold were not considered value-adding assets. For JM, the sale was about materializing values built up in the developed properties. The profits from selling went into JM’s core business, which is project development. Strategies involved Skanska Project Development Sweden’s core business is planning the structure, constructing, and selling properties when they are fully developed. All divestments are outlined in an overall strategy and planned in accordance with this. The property does not have to be built for it to be considered fully developed. As long as it is filled with future tenants it can be sold virtually anywhere in the process. This also goes for JM, which wants to sell as early as possible in the development process. This behavior could be the effect of the companies’ considering themselves as having a higher degree of expertise in developing properties than in managing them. JM wanted to sell its entire stock of properties. As already mentioned, JM hoped to make some portfolio transactions but instead had to sell piecewise, starting in the Stockholm suburbs before going on to the CBD. The timing was good but selling six months earlier would have been even better, with rents at an all time high of SEK 4500 per square meter. For JM, the strategy of developing and selling is a long-established one. Skanska nowadays also follows a structure of planning, constructing, and selling, but used to employ a structure of focusing on certain business areas, project development, and transaction based activity. _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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Both sellers claim not to have been affected by the increasing popularity of focusing on core business since this has, in fact, been the overall strategy for some time. Sale criteria When looking at investors, Blackstone had knowledge about the Swedish market and was ready to do business. The company hadn’t closed any major deals before this one and was eager to invest. These criteria fit Skanska well. Internal property valuation and ordinary discounted cash flow analysis made up the foundation for the sale price. However, negotiations always play an important part in deciding the final price. On an overall basis, Skanska believes that the differences in return demanded make transactions like this one possible. JM made an analysis of which companies would be most likely to be interested in the transaction. Being a hotel and office building, the property was of mixed tenant use, which narrowed possible interested investors. JM searched for investors mainly in London and Norway and in the end Vital gave the best offer. Incorporated in the offer was some risk about the hotel’s future performance. It had just started its business, which increased return demands from the investor. To make rents more secure, JM gave Vital a rental guaranty and changed lease contracts from floating to fixed. When asked how properties were selected for the portfolio, Skanska had the following explanation. The strategy is to develop and sell. If the portfolio sold was divided into properties with different features, the following kinds of properties would be included: 1. Fully developed properties in good physical shape. 2. Properties in good shape but of the wrong type to match Skanska’s portfolio. 3. Properties in good shape but with the wrong geographic location. 4. Properties in less desirable physical shape and with little potential from Skanska’s perspective. On the same question, JM answered that properties weren’t specifically selected since the objective of the divestment was to sell the entire property stock.

5.4 Industrial and service companies Listed in the table below are the two transactions studied that involved industrial and service companies. Year

Seller

Country

Buyer

2001

SAS

Sweden/Norway/ GE Capital Denmark (together with Nordisk Renting)

USA/UK

Airport properties

2002

ABB

Sweden

UK

Portfolio

London & Regional Properties

Country Object

2

Price Area (m ) SEK (million) 3 000 285 000

2 760

1 100 000

Comment

Advisors

11 airport related Newsec properties in Sweden, Denmark and Norway. The ABB portfolio

Leimdörfer, Credit Suisse First Boston

Table 5.4 Transactions involving industrial and service companies

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Initiation of transactions In later years ABB has pursued a core business focused divestment strategy with the intention of streamlining the organization and putting more focus on current business units in power and automation technology. This strategy included a complete divestment of all properties held in Sweden. During the formation of ABB, aggressive acquisitions were made, and with these acquisitions came many new properties. To ensure an efficient and professional ownership, ABB Real Estate AB was created 1988. Its first assignment was to make an inventory of all properties and decide if they were to be renovated, sold or demolished. Later, when deciding to sell, all properties generating cash flow were sold. In 1999 SAS stood before an expansion of its core business which included renewal of the aircraft fleet. These investments were very capital intensive, and in order to raise capital, SAS decided to outsource all of its airport related properties in the Nordic region in a saleleaseback transaction. Another minor reason for the real estate divestment was the intention to slim down the balance sheet. Financially related questions Motivations other than freeing capital to focus on core business were also in play. ABB had previously made sale-leaseback buyback transactions to remove real estate from the books. However, the company still owned them and this was not allowed according to USGAAP. ABB, listed on the New York Stock Exchange, was required to follow these principles to avoid being delisted. Also, sometimes real estate has a tendency to weigh down the stock in non real estate companies.55 To counteract these tendencies and to meet with USGAAP regulations, ABB decided to sell all Swedish real estate in a true sale-leaseback transaction in 2002. Another related issue is that real estate departments can sometimes grow to become a burden for the company. To achieve more efficient usage of space with cost reductions as a result and also to be more flexible, ABB wanted to sell the properties. An additional factor that arose along the divestment process was increasing financial distress in the company. By selling real estate, positive cash flow was created that could be used to increase liquidity. For SAS, the financial motives were as mentioned: to release capital to invest in a renewal of the aircraft fleet. Strategies involved Neither ABB’s nor SAS’ divestment strategies were directly affected by the existing business cycle in Sweden. Initially, the timing with the business cycle was not that important for ABB. Over 10 years, the company had developed the properties into the portfolio that was finally sold. When the focus on core business increased, divestment of real estate followed. SAS uses five year investment plans to be in total control of the strategies it follows, and divestments of real estate in order to invest in core business was according to the plan. Of course, sellers were affected by trends to focus on core business. As sale-leaseback transactions became more popular, the market for these transactions grew accordingly. A greater number of companies means more competence and harder competition for existing deals, which drive prices up.

55

Liow & Ooi (2004)

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Sale criteria The sale process used by ABB was interesting in many ways. First, a short introduction to the transaction was sent to various investors to determine who was interested in buying. ABB sent a real prospect to seriously interested buyers. From here, virtual due diligence CDs containing all information available of every property in the portfolio were sent out. ABB received about 10 preliminary bids, of which four satisfied the demands from ABB and USGAAP. Finally, ABB selected the investor based not only on price, but also on who they thought would enable the best long term cooperation (meaning the fit between the organizations, attitudes, etc). Price was determined from property and environmental valuations, but most importantly, a USGAAP valuation was made. Flexibility is important for ABB in future renegotiation of the lease contracts. The company wants to be sure of that no one else gets to lease, but at the same time also wants to be able to leave properties if downsizing. Right now ABB leases back 70% of the portfolio. 30% is empty or sublet. SAS had different criteria when selecting investor. Not many investors were able to carry out a sale-leaseback transaction as complex as this one. Three jurisdictions in Sweden, Norway and Denmark and three different civil aviation authorities were involved. Also, only investors with financial focus were considered. SAS only wanted to release capital without losing control of the properties since they are dependant on these for their daily business. This made a triple net lease the perfect form of contract, where the buyer would focus only on collecting rents and leave maintenance to SAS. SAS had two important demands in this deal. First, a buy back option must exist; if there was future value in the properties, SAS wanted it. Second, SAS wanted to make sure that they could utilize the properties as they had always done, and thus wanted long term leases. The price was determined by an independent valuation of the properties. The price is also a function of this value (and indirectly sales price) and the rent paid (by SAS to buyers). If the valuation had turned out high, the sale price had been high, and in turn the rents paid would have been high. If the sale price had been low the rents would have been low. An interesting question that came up was the fact that the airport properties have no market value. Their value is in the importance of them in SAS’ daily operations. So SAS reasoned that there is no need to own these properties yourself if you are assured that you can use them anyway. In this case, a sale-leaseback transaction was the perfect contract form.

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6 Special issues This chapter touches some interesting aspects of the transactions that caught my attention during the process of writing this thesis. In an article in the Swedish daily business newspaper Dagens Industri there was a discussion of an outstanding debt from a real estate transaction in 1997 between Swedish developer NCC and American investors General Electric (GE) and Morgan Stanley (MS). NCC had sold 140 properties for about SEK 3 billion to a company called Brännkammaren that was jointly owned by GE and MS. The deal involved a promissory note worth SEK 700 million issued by NCC. However, for reasons not presented in the article, NCC had not gotten the final payment of SEK 70 million on the note.56 This sparked my interest and I decided to ask all interviewees if promissory notes had been involved in their transactions and if there were other forms of guarantees. The impact these issues might have on the sale price of properties is also discussed in this chapter.

6.1 Promissory notes A promissory note is “a legal document that obligates a borrower to repay a mortgage loan at a specified interest rate during a specified period of time or on demand.”57 When considering an investment, the return is, of course, of high interest. If the investor can get additional loans with a favorable interest rate in the form of a promissory note from the seller, less equity can be used, generating a higher return on equity. So, the use of promissory notes can be profitable for the investor. For the seller, lending money involves taking a risk. This risk should be included as an extra premium when deciding the interest rate. However, if the seller is eager to divest, a promissory note with relatively low interest rate might be a way to attract investors and bump up the sale price. Consider the following example. A property is for sale for SEK 100 million. The investor only wants to pay 85 million. The seller offers to issue a promissory note to the investor worth 10 million at a favorable interest rate. At these new terms, the investor is ready to borrow the remaining 5 million from a bank, and the transaction can be carried out. By issuing the promissory note, the seller has granted a loan which returns might not correspond to the risk taken. Another interesting fact is that issued promissory notes and interest rates used are not separately shown in the seller’s balance sheet but presented together with all other outstanding loans. This makes it hard to find out what kinds of notes were issued in separate transactions. The risk that was taken is also hard to detect. If the selling company is listed on a stock exchange, this means that investments in its stock carry higher risk than it appears. An even more drastic outcome would occur if the loan wasn’t paid back as described initially in this chapter. Of the transactions studied in this paper, one involved a promissory note.

6.2 Guarantees Rental guarantees are commonly used when the property sold has vacancies. Obviously, vacancies are something that the investors dislike since fewer rent paying tenants makes the investment less profitable. Nevertheless, investments could be made in properties with vacancies if the seller can guarantee that a certain cash flow will be received independently 56 57

Dagens Industri (2005-01-25) InvestorWords.com (2005)

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of how many tenants there are. This means that the seller will pay the amount remaining between the actual rents and the guarantied rental income for the investor. Let’s look at a simple example. A German pension fund looks at investing in a property that, when investigating it more closely, turns out to have some vacancy. As presented in earlier chapters, German pension funds only invest in properties with very little or no vacancy. To make the transaction possible, the Swedish seller guarantees to pay the rent for the vacant space for (for example) one year. The seller also takes on the responsibility to lease the vacant space for one year. This rental guaranty makes the German investor accept the transaction. One can argue that rental guarantees are a way to bring investment risk down. Other forms of guarantees to bring investment risk down involve environmental and technical guarantees. All investors, American in particular, want to make sure that the property is not polluted in any way, to bring the risk of future lawsuits down. Another concern is that the property, with its built-in technology (water and sewage treatment, ventilation, etc.) will start to malfunction. German investors are especially concerned with this question. Four transactions studied involved some of these guarantees.

6.3 Motives to use promissory notes and guarantees As explained above, the use of promissory notes is a way to boost the sale price. Various guarantees can also be used for this purpose. This subchapter will explore how a seller might reason when using these instruments. First, let’s look at promissory notes. They are, as already mentioned, a way for the seller to bump up the sale price. This is made not only because a higher price is always preferable. Promissory notes could also be used if the seller wants to avoid selling a property below book value. Let’s look at an example. Assume that the market is moving downwards and that properties are evaluated once a year. A seller evaluated his property to be worth SEK 100 million six months ago. When selling today, the seller is interested in getting paid this amount to avoid a loss. The problem is that the market now valuates the property to only 90 million. The seller decides to offer the buyer promissory notes and rental guarantees. When given these, the buyer might agree to buy the property for 100 million. See Figure 6.1 below. If the market is in an upward motion, the use of promissory notes and rental guarantees is no longer needed since market value will exceed property valuation.

Figure 6.1 Illustration of the use of promissory notes and rental guarantees

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Now, let’s look at some additional motives to use rental guarantees. As explained above, they can be used to close the transaction with a hesitating investor. They can also have other positive effects; consider the following example. A seller wants to sell a property that has some vacancy. To attract investors, the seller indicates in the prospectus (property description) that rental guarantees close to market rent will be given. This interests some investors that normally would not be ready to invest in such a property, and the increased competition is likely to drive up the price. If the seller is a skilled leaser, he might be able to lease the vacant space within a short period of time. This space is leased at market rent. In the end, the seller has not only managed to sell the property at a good price, but has also made a small profit from the differences in the rental guarantees paid and the market rent received.

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7 Patterns in transactions This chapter covers observed patterns between the different categories of investors and sellers and, along with the properties involved in the transactions, presents different possibilities to link them together. The patterns observed can be divided into four different groups. If adding property as a new category to investors and sellers presented earlier, we get the following groups: 1. 2. 3. 4.

Patterns within the investor and seller categories. Patterns between investor and property. Patterns between seller and property. Patterns between investor, seller and property.

The different patterns are more easily understood when looking at Figure 7.1 below.

Figure 7.1 Patterns in transactions

Patterns within the investor and seller categories Throughout this paper, investors have been categorized into core, opportunists, and renting and they all have different approaches to some key issues. Clear patterns exist in leverage, investment horizon, and return demands. The German core investors experienced heavy inflow of money at the time of the investments and did not need to borrow much money. They are low risk focused with little exposure to interest rates. This indicates low leverage when financing the deals. The return can be seen from two perspectives. Either you focus on IRR or on long term and steady positive cash flows (from now on called coupon). The core investors are clearly focused on generating coupon profits with an investment horizon of about 10 years. The low risk strategy means that only high quality properties with small management needs will be considered for investments. The opportunists are extremely focused on high returns on equity. This requires a more aggressive investment strategy with high leverage and higher exposure to interest rates, thus making it riskier. To obtain fast profits, property portfolios of mixed quality are bought and sold forward piecewise with the investment lasting about five years. However, the portfolios often require a lot of management to make them profitable. The renting investors are highly financially driven, with little interest in managing the properties. Although using very high leverage, the long duration of the investment of 15-25 years, the requirement of strategically important properties, and the low real estate risk taking make it less exposed to total risk. The focus is on generating return on equity and not on coupons.

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The three types of investors and their investment styles are summarized in Table 7.1 below. Core

Opportunist

Renting

Leverage (%)

30-50

80-90

85-100

Return (IRR, %)

10 (Less important)

20

Important

Coupon (%)

4-6

Less important

Rental income

Investment horizon (years)

10

5

15-25

Investment style

Single properties of high quality. Little management

Portfolio of mixed quality. A lot of management.

Long contracts. Little management

Table 7.1 Patterns in investor category

For sellers, the initial categorization was made based only on the seller’s type of business. When trying to find patterns within the group one can look at two things: the type of transaction and the reason to sell. The only clear patter that seems to exist is among those companies that wanted to focus on core business and sale-leaseback transactions. This is logical since this kind of transaction releases capital in the properties to be used elsewhere in the organizations. All sellers, with their reasons for selling and transaction type used, are summarized in Table 7.2. Type of seller

Type of transaction

Reasons to sell

Real estate Drott

Acquisition

Increase turnover speed and slim down balance sheet

Wihlborgs

Acquisition

Property fully developed

Nordea

Sale-leaseback

Focus on core business

AMF Pension

Acquisition

Expected value depreciation

Skanska

Acquisition

Increase turnover speed and bring employed capital down

JM

Acquisition

Focus on core business and materialize values

ABB

Sale-leaseback

Focus on core business

SAS

Sale-leaseback

Focus on core business and release capital for new fleet

Financial institutions

Developers

Industry/service

Table 7.2 Patterns in seller category

Patterns between investor and property In the second group there seem to be patterns in property features such as physical state, location, lease contracts, tenants, and vacancy. For core investors all of these features are important and must be satisfied for an investment to be made. Opportunists are not as focused on new buildings as core investors. This makes them perfect buyers of mixed quality property portfolios. Also, their skills in management allow them to accept some vacancy and view it as a business opportunity. Renting investors require a credit worthy tenant and long lease contracts. Also, the strategic importance of the property for the tenant is of significant interest in order to secure the long term contracts and rental payments.

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Different investors’ property preferences are summarized in Table 7.3 below. Property criteria

Core investors

Opportunistic investors

Renting investors GE

CGI

Deka

Whitehall

Blackstone

a. Favorable physical state of object

Important

Important

Important

b. New building or newly refurbished c. Good location

Important

Important

Important. Doesn’t want capital intensive properties. Some capital to change is ok. Not important

Important

Important

Important

Important

Important

Important

d. Solid tenant with long term lease contract e. Low vacancy rate

f. Property is strategically important for the tenant. Comment

Somewhat important. Looks for B+ locations. Important

Some vacancy is ok since could be an opportunity to increase value.

Somewhat important Somewhat important

Important

LRP

Important

Important

Important

Some vacancy is ok since could be an opportunity to increase value. Important

Would rather invest in new buildings than newly refurbished ones.

Location is picked out as particularly important since tenants can be changed but the location can't.

Favorable physical state of object and good location are picked out as particularly important. With a good building you can always get (new) tenants.

Most important is the strategic importance of the property for the tenant.

Focused less on government tenants, which have become too exposed to competition, compared with solid companies.

Table 7.3 Patterns between investors and property features

Patterns between seller and property The patterns in this group are not as evident. Developers Skanska and JM both wanted to sell big portfolios, but only Skanska succeeded. JM had to sell the properties piecewise. Disregarding this fact, developers seem to be interested in selling portfolios to opportunistic investors. This is a good match since the sellers get rid of some less desirable properties and the investors enjoy a portfolio discount. Another pattern is that all three sellers involved in sale-leaseback transactions (Nordea, ABB, and SAS) sold portfolios. This is probably due to the choice to focus on core business, with a complete sellout of all properties in the company as a result.

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The reasoning above is summarized in Table 7.4 below. Type of seller

What was sold

Real estate Drott

Portfolio

Wihlborgs

Single property

Financial institutions Nordea

Portfolio

AMF Pension

Single property

Developers Skanska

Portfolio

JM

Single property

Industry/service ABB

Portfolio

SAS

Portfolio

Table 7.4 Patterns between sellers and type of transaction

Patterns between investor, seller, and property The only pattern that can be said to exist between the different categories of investors, sellers, and properties is between renting investors and industrial and service companies. They have participated in sale-leaseback transactions with property portfolios traded in both cases. As mentioned above, these companies have had strategies that have been perfect matches for this type of transaction. The sellers wanted to release capital and focus on their core business, but the properties sold were crucial for their businesses. This fit the financially driven renting investors well in their search for long term investments in strategically important properties with credit worthy tenants. This only pattern in this group is found on the last two lines in Table 7.5 below. Seller

Category

Buyer

Category

Object

Drott

Real estate

Whitehall

Opportunist

Portfolio

Wihlborgs

Real estate

CGI

Core

Single property

Nordea

Financial institution

Cardinal Capital Partners

Renting

Portfolio

AMF Pension

Financial institution

Deka Immobilien Core

Single property

Skanska

Developer

Blackstone

Opportunist

Portfolio

JM

Developer

Vital Forsikring ASA

Core

Single property

ABB

Industrial/ service companies

London & Regional Properties

Renting

Portfolio

SAS

Industrial/ service companies

GE Capital

Renting

Portfolio

Table 7.5 Patterns between investor, seller, and property

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8 Will the investors stay? In the last chapter we saw some different patterns that foreign investors have followed. This chapter presents some thoughts on how future changes in interest rates and on the rental market will affect these various investors.

8.1 Rental market The overall office vacancy rate in greater Stockholm has increased over the last few years, and is currently at 12%. The difference between the local markets is large, with lowest vacancy in prime suburbs and CBD and highest in peripheral suburbs. Rents do not follow the same pattern. The highest rents are found in CBD, but are followed by central areas rather than prime suburbs. Ranked last are the peripheral suburbs. The market outlooks for vacancy and rents from 2005 to 2007 are found in Table 8.1 below. Only CBD, if any of the areas, is estimated to get lower vacancy and higher rents in 2005 (indicated with a +). The other areas will see no improvements (indicated with a 0). As can be seen, the peripheral suburbs lag behind CBD by two years. Location

Vacancy (%)

Rent/m2 (SEK)

2005

2006

2007

9

2400-3800

+/0

+

+

Central area

15-10

1500-2300

0

+

+

Prime suburb

5-10

1200-1800

0

+

+

15-30

1000-1300

0

0

+

CBD

Peripheral suburb

Table 8.1 Future outlooks on the Stockholm rental market

58

When considering the state of the office rent in all of Sweden, only Stockholm CBD show increases in rents. In Malmö the rents have reached their bottom and it is believed that they will start increasing. All other Swedish cities, such as Göteborg and the university towns, have not yet seen their rents bottom out. (See Figure 8.1).

Figure 8.1 Office rental cycle for first quarter 2005

58 59

59

Newsec Analys (2005) Newsec (2005)

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What does this mean for the core, opportunistic and renting investors? Core investors have focused on good locations and can be found in the CBD and prime suburb areas where vacancy rates are the lowest. This goes well in hand with what the previous chapters’ discussion about their demand for steady cash flows. With the forecast that vacancy rates will be falling and rents increasing as soon as 2005 in CBD and 2006 in prime suburbs, the Stockholm outlook for core investors is good. Investments made in the rest of Sweden will take more time before they begin to pick up. For opportunistic investors that have mostly invested in central areas and peripheral suburbs in Stockholm, the estimated lower vacancies are, of course, good. This gives them a chance of improving the structure of the portfolios bought by leasing more space to generate better property cash flows and then sell these properties. If looking at the rental cycle, the short outlook is not very good since the portfolios bought are often spread out over the country and not just located in the greater Stockholm region. This means that for a lot of properties in the portfolio, the rents have not yet flattened out. For renting investors, the effect of vacancy and rent levels should be close to none. The advantage of this form of investment is that external issues don’t affect what has been agreed upon between the investor and seller.

8.2 Interest rates

12

12,00

10

10,00

8

8,00 Percent

Percent

Inflation is forecasted to stay well below 2% for 2005 and will probably remain low for a longer period of time, keeping interest rates low. However, sooner or later the economy will pick up with an increase in interest rates as a result. This will cause margins on the investments to become smaller with the increasing expense of borrowing money.

6 4

6,00 4,00

2 2,00 0 0,00 1995

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E2006E -2 Year

Figure 8.2 Inflation in Sweden 1990 to 2006 (estimated)

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

60

Figure 8.3 Swedish 10 year T-bills January 1995 - March 2005

61

Core investors will not be much affected by this change since they use a large portion of equity in their investments. But for opportunistic investors, with their use of high leverage, it will have a deep impact. With increasing loan costs, their demand on a high IRR might not be possible to satisfy. This means that no investments will be made and opportunistic investors might start looking toward other countries that provide better prerequisites for high returns on equity. Sweden will become too expensive for them. The renting investors will be somewhat affected by an increase in interest rates since the rents they receive often are connected to STIBOR. However, the overall effect should be small for the same reasons described in section 8.1.

60 61

Statistics Sweden (2005); Newsec (2005) Riksbanken (2005)

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8.3 Yield demands Yields are going down on the Stockholm, Göteborg and Malmö markets. Figure 8.3 shows this trend. 7,5

Percent

7

6,5

6 1997

1998

1999

2000

2001

2002

2003

2004

Year

Figure 8.4 Office yields in Sweden 1997-2004

62

Falling yields together with the estimated increasing inflation and interest rates means that the yield gap will narrow. The yield gap is the difference between the yield and the interest rate. If we combine yields and T-bills in a very simplified figure (see Figure 8.5), the yield gap and its estimated narrowing becomes evident.

Figure 8.5 Illustration of yield gap and its future estimated decrease

A narrowing yield gap implies decreasing profits on real estate investments. Again, the opportunistic investors are most likely to take the hardest blow among the various types of investors studied due to their use of high leverage and high return demands.

8.4 Future outlook On the basis of the thoughts presented in this chapter, core and renting investors are likely to stay on the Swedish real estate market. Their investments are fairly safe and will probably not be too affected by the scenarios described. Opportunistic investors, however, will probably move on to other markets that provide better loan conditions and higher returns on equity.

62

Swedish property index (2005)

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9 Final thoughts Through interviews with foreign investors, Swedish sellers and advisors, this paper has provided some data that point toward some patterns in foreign real estate investment in Sweden the last five years. What could this mean for the players in the real estate business? Well, once competitors’ patterns are mapped out and strategies are identified, the process to replicate them is rather straightforward. This brings tougher competition for existing investors and increases the difficulty of generating acceptable returns. However, it could also produce a creative environment where new business ideas are born and applied. Investors who remain in Sweden may experience this. For investors that have left Sweden, this new activity could provide new opportunities to re-enter the market. Promissory notes and guarantees, briefly discussed in this thesis, are matters that need more attention. It will be interesting to see how long sellers will be allowed to continue with this activity of bumping up the sale price with their own money, so to speak. This could be a topic for future researchers to explore.

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References Axelsson, H & Victorin, M (1999), Foreign investors on the Swedish real estate market, Master of Science Thesis, Stockholm: KTH. Brueggeman, W & Fisher, J (2005), Real estate finance and investments, International edition, Twelfth edition, p. 380, New York: McGraw-Hill. Catella Property Group (2004), European Office Markets, March. CB Richard Ellis (2004), Market Report, Autumn. Deka Immobilien Investment (2004), The basis of our success, September. ING Real Estate Investment Management (2004), European View, May. Invest in Sweden Agency (2004), Real Estate, A liquid, transparent and international property market. Jones Lang LaSalle (2004), Nordic City Report, Autumn. Lind, H (2000), Jakten på det optimala fastighetsbeståndet, Om beståndsförändringar på den svenska fastighetsmarknaden, Research Paper in Swedish nr 5, Avd f Bygg och fastighetsekonomi, Stockholm: KTH. Lind, H (2004), Strukturförändringar och ägande på den svenska fastighetsmarknaden, PM, Avd f Bygg och fastighetsekonomi, Stockholm: KTH. Lindgren, R (1998), Hur bör fastigheter ägas?, Ekonomisk Debatt, Vol. 26, No. 5, pp. 351358. Liow, K & Ooi, J (2004), Does corporate real estate create wealth for shareholders?, Journal of Property Investment & Finance, Vol. 22, No. 5, pp. 386-400, Emerald Group Publishing Limited. London & Regional Properties (2004), Presentation 2004:2 Newsec (2003a), Nordic Report, Spring. Newsec (2003b), Nordic Report, Autumn. Newsec (2004a), Nordic Report, Spring. Newsec (2004b), Nordic Report, Autumn. Newsec (2005a), Nordic Report, Spring. Newsec (2005b), Behöver ni frigöra kapital? Skanska Project Development (2004), Relationships that are built to last, 2004:1.

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Newspaper articles Byggindustrin Issue 8, 2004

Utländska investerare tar över fastighetsmarknaden

Dagens Industri 1997-06-25 2002-09-19 2003-07-14 2003-11-12 2004-02-20 2005-01-25

Miljardaffären i hamn Utländska fonder tar sikte på noterade fastighetsbolag Drott säljer fastigheter för 5 miljarder SAS säljer sitt huvudkontor Sveriges nya fastighetskungar finns i London NCC tar strid mot USA-jättar

Dagen Nyheter 2003-07-15 2004-01-02

Fastighetsaffärer gör Stockholm mer amerikanskt Svenska storföretag säljer ut sina fastigheter

Veckans affärer 2003-04-14 2004-05-17

Special: Fastighetsinvasionen – Utsikt för 2,3 miljarder Special: Fastighetsinvasionen – Utländska köp i Svenska öppna landskap

Interviewed investors, seller and advisors Investors Anders Johansson Evelyn Laqua Hans-Joachim Kühl Jake Franco Peter Stoll Udo Wasmer Ulf Roseen Åke von Ajkay

London & Regional Properties Deka Immobilien CGI Goldman Sachs Blackstone Group Deka Immobilien GE Real Estate GE Real Estate

2005-01-12 2005-02-04 2005-02-04 2005-02-09 2005-02-14 2005-02-04 2005-01-25 2005-01-25

Sellers Bo Ranhamn Björn Frivold Claes Larsson Eva Eriksson Gösta Ångell Jacob Grinbaum Joakim Einarson Johan Thermaenius

Nordea SAS Group Skanska Project Development Sweden JM ABB Nordea Formerly at Drott AMF Pension

2005-01-12 2005-01-27 2005-01-13 2005-01-24 2005-02-16 2005-01-12 2005-01-26 2005-01-26

Advisors Anna Essén Jens Nagel Johan Elfstadius Karl Persson Lars-Erik Nyman Lennart Ingefeldt Niklas Zuckerman Tom Lindahl

Catella Formerly at Niam Jones Lang LaSalle Jones Lang LaSalle Leimdörfer Formerly at Newsec Catella Catella

2005-01-18 2005-01-10 2005-01-14 2005-01-17 2005-01-20 2005-01-17 2005-01-21 2005-01-18

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Internet sites Investors Blackstone Group, Cardinal Capital Partners GE Real Estate Nordic CGI London&Regional Properties Vital Forsikring

www.blackstone.com www.cardinalcapital.com nordic.gerealestate.com www.hausinvest.de www.lrp.co.uk www.vital.no

2005-03-04 2005-03-04 2005-03-04 2005-03-04 2005-03-04 2005-03-04

Sellers ABB AMF Pension Drott JM Nordea SAS Skanska Skanska Project Development Wihlborgs

www.abb.com www.amfpension.se www.drott.se www.jm.se www.nordea.com www.sasgroup.net www.skanska.com www.fastigheter.skanska.se www.wihlborgs.se

2005-03-01 2005-03-01 2005-02-28 2005-03-01 2005-03-01 2005-03-02 2005-03-01 2005-03-01 2005-02-28

Other Dictionary of Small Business InvestorWords.com Riksbanken

www.small-business-dictionary.org www.investorwords.com www.riksbank.com

2005-03-21 2005-03-03 2005-03-21

Other sources Henrik Bauer

Newsec Analys

Newsec Analys. Statistics Sweden (Statistiska Centralbyrån). Sweden’s Central bank (Riksbanken). Swedish property index (Svenskt fastighetsindex).

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Appendix 1 Interviewees were categorized into investors, sellers and advisors. The questions were somewhat different for each category depending on their different roles in the transactions.

Questions to investors Introduction to transaction 1. What initiated the transaction? Did you find a property that seemed to fit your investment criteria or were you contacted by either the seller or a consultant? 2. How long before the actual sale did the process start? 3. Was there competition between different buyers? 4. Did you consider investing in other properties?

Financial criteria 5. Whose money was invested? – Private equity, funds, etc. 6. Did these investors have a specific yield requirement? If not, who decided yield requirements? Specific for this transaction? 7. How did interest rates and amortization rates affect your position in the transaction? What kind of loan was used? 8. How high was the leverage in the transaction? 9. Did you go through a Swedish or a foreign bank or both?

Strategic criteria 10. Do you follow a specific investment strategy when doing these kinds of deals? 11. Do you prefer to buy at a certain phase in the business cycle? Why did you buy at this point in time? 12. Was the transaction the consequence of a predetermined investment strategy or did you act more opportunistically? 13. Was your strategy affected by other real estate related companies increasing interest in Swedish property? 14. How has the strategy changed over time?

Investment criteria 15. Do you think that you appreciated the value of the property differently than the seller did? 16. Did you think that you could run the property more effectively than the seller?

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17. How risky was the transaction according to you? Do you believe it was less risky for you than for the seller?

Object criteria 18. Which were the most important features of the objects according to your investment strategy? a. Favorable physical state of object – well positioned in lifecycle. b. New building/newly refurbished c. Location – city center or outskirts d. Solid tenant (government, institutions, etc) with long term lease contract e. Low vacancy rate

Other questions 19. Did you run into any obstacles in particular along the investment process?

Questions to sellers Introduction to transaction 1. What initiated the transaction? 2. Who initiated it – in-house or contacted by buyer or consultant? 3. On what criteria was buyer selected? 4. How long before the actual sale did the process start? 5. Was there competition between different buyers?

Financial criteria 6. What were the financial motives for the sale? 7. Did you sell to free resources to buy other properties? Other investments? What type? 8. How was the price determined? What kinds of appraisal methods were used?

Strategic criteria 9. Do you follow a specific divestment strategy when doing these kinds of deals? 10. Do you prefer to sell at a certain phase in the business cycle? Why did you sell at this point in time? 11. Was the transaction the consequence of a predetermined sale strategy or did you act more opportunistically? 12. Were you affected by the increasing popularity of removing real estate from the books, such as sale and lease back deals, etc? 13. How has the strategy changed over time? _____________________________________________________________________________________________________ Patterns in foreign real estate investments in Sweden

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Sale criteria 14. Do you think that you appreciated the value of the property differently than the investor did? 15. Was the sale favorable from a taxation view point? 16. How and why was the object selected? Did it no longer fit your portfolio/strategy?

Other questions 17. Did you run into any obstacles in particular along the investment process?

Questions to advisors Introduction to transaction 1. How did you get involved in the transaction? Were you contacted by the buyer or seller or did you contact them? 2. What was your role? Were other consulting firms involved? 3. On what criteria was buyer/seller selected? 4. How long before the actual sale did the process start? 5. Was there competition between different buyers/sellers?

Financial criteria 6. What do you think were the financial motives for the investor in this transaction? On micro economic level yield issues, etc and on macro economic level tax legislation, etc? 7. What do you think were the financial motives for the seller in this transaction? To free resources to invest elsewhere, to focus on core business, in need of money and difficult/costly to lend hence had to sell, etc? 8. What kinds of appraisal methods were used? According to you, were they correct?

Strategic criteria 9. Was the transaction the consequence of predetermined strategies or did the parties act more opportunistically? 10. Why did this transaction happen at this point in time? 11. Were strategies affected by increasing real estate related transactions made by other players? 12. Did strategies change along the process? 13. Do you think strategies are followed in general?

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Sale/investment criteria 14. How come that the buyer appreciated the value of the property to be higher than the seller did? Did the investor consider it under priced or did he think he could run it more effectively? 15. What was the value of the property according to you?

Questions about investor 16. How was the object selected? Did it fit specific investment requirements or was the transaction of more opportunistic character? 17. How risky was this transaction for the buyer? 18. What do you think is the most important investment criteria in deals like this one?

Questions about seller 19. Why was this property in particular sold? 20. How risky was this transaction for the seller? 21. Was financial distress a major motive to sell? 22. Were there any favorable tax benefits in selling?

Other questions 23. Did you run into any obstacles in particular along the process?

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