Can you name major Korean institutional investors which are active outside of Korea?
Most would recognize the $430 billion-plus Korean National Pension Service (NPS) and the $85 billion-plus Korea Investment Corporation (KIC). But beyond those two widely recognized investors, many Korean insurance companies, pension funds, endowment funds, securities firms and family offices have also been actively investing in offshore real estate properties in the past several years. While these ‘smaller’ institutional investors may not be household names in the sector, in aggregate, they should be recognized as important sources of capital.
For the past few years, the amount of equity invested by Korean institutional investors in offshore real estate has grown. In 2014, they invested nearly $3 billion in offshore real estate compared to $5 billion domestically. In H1 2015, approximately $1.7 billion went abroad while only $1.9 billion stayed within Korea. Barring unexpected turbulence in global capital markets, the demand for offshore real estate by Korea’s investors should continue to increase in the foreseeable future.
There are certain causes for this increasing appetite for offshore property. First, because interest rates have fallen and remained low, Korean investors, just like their counterparties abroad, increased their allocations into alternative asset classes, especially real estate. And with the ever-increasing amounts of available capital for real estate investments, investors have had difficulties sourcing an adequate supply of ‘reasonably priced’ domestic assets.
Second, their portfolios of real estate assets were getting sufficiently large that they’ve had to diversify into properties other than Seoul office buildings.
Unfortunately, they fall off of a liquidity cliff once they journey into provincial markets or other property types domestically (selected hypermarket retail and master-leased hotels being two exceptions). Therefore, in search of higher relative value and diversification benefits, investors have ventured into offshore markets.
Many of these investors expect real estate investment to deliver strong current income with potential for some upside at exit. In other words, they see real estate as an enhanced fixed-income asset that can deliver a sizable spread over government bond yields for sacrificing on liquidity. The investors, by and large, expect to achieve minimum cash-on-cash yields of between 5 percent and 6 percent, and IRRs of between 6 percent and 7 percent (net of taxes and fees).
Accordingly, they target core assets, particularly fully-stabilized CBD office buildings. In order to achieve the necessary running yields, investments are typically leveraged around 50 percent. Currency hedges are put in place normally for 100 percent of the equity and roughly 80 percent of the distribution. Since currency hedges become expensive beyond five years, a majority of investments have a target holding period of around five years. In the current environment, investing in a euro-denominated market, for example, can boost investment IRRs by approximately 150 basis points, purely from the currency hedge. Assets with a low tenant turnover ratio are preferred, especially master-leased assets with long weighted average lease expiry, because they can generate steady distribution during the holding period.
In terms of asset size, Korean investors prefer larger, Class A buildings – typically in excess of $150 million in value. In almost all cases, a Korean fund manager would create a ‘club,’ pooling together a group of like-minded investors to acquire a target asset. However, if an asset size is too big, then putting together a club becomes more challenging.
There is a pattern in the ways in which Korean institutional investors have been acquiring offshore hard assets in the past few years. The first set of destinations included the US gateway cities and London. Today, as fully-stabilized CBD office assets in top-tier cities have become expensive, investors have adjusted their targets to still achieve their target risk-adjusted returns and so top Germany cities, such as Frankfurt, have become attractive. Some investors have shifted to focus on mezzanine debt to reduce risk, while others have turned to the CBDs of second-tier cities, fringe submarkets of top-tier cities, or non-office assets like logistics and hotels where going-in yields are marginally higher than those from traditional office assets.
Looking ahead, Korean institutional investors, as they get more experienced in investing in offshore assets, are likely to gradually increase their risk appetite to explore specialized property types like student housing, senior living and parking properties, value-add strategies, and, geographically, some of the smaller markets in Europe and the US. But it will be a case of one step at a time and investment managers that would work with Korean institutional capital will do well to remember that.