During the past couple of decades the nature of the global economy has changed dramatically. Beginning with the Reagan/Thatcher reforms of the 1980s, many nations throughout the world have been engaged, to a greater or lesser degree, in a process of structural reform. Enterprises and even entire
industries that had been owned and operated by governments have been privatized. Government finances and those of individual firms are becoming more and more transparent. Governments have also been eliminating or reducing regulatory constraints, establishing more meaningful and enforceable property rights, moving toward more flexible exchange rate systems, relaxing restrictions on foreign investment and generally embracing more free-market-based economic systems.
These reforms have resulted in growing levels of cross-border investment, as capital is drawn to new areas of perceived opportunity in both industrialized and non-industrialized countries. The heightened mobility of capital that has accompanied these changes has created renewed interest in the theory of foreign investment. In light of these developments, this may be a particularly good time to take a closer look at a relatively underdeveloped subset of the theory of foreign investment, that involving international real estate investment.
Researchers and analysts conventionally classify foreign investment as falling within one of two categories, and the academic literature on foreign investment follows this distinction, with each category normally treated separately and independently. The World Trade Organization (WTO, 1996) makes the distinction as follows: "Foreign direct investment (FDI) occurs when an investor based in one country (the home country) acquires an asset in another country (the host country) with the intent to manage that asset. The management dimension is what distinguishes FDI from portfolio investment in foreign stocks, bonds and other financial instruments." Furthermore, FDI involves the transfer of much more than capital alone. Technological expertise, marketing and management skills, and other firm-specific resources are transferred to the host country as well.
Each country has its own way of defining whether a given investment should be classified as FDI or foreign portfolio investment (FPI). When measuring foreign investment flows for the United States, the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce (http://www.bea.doc. gov/bea/dnl.htm) categorizes investments on the basis of degree of ownership. Foreign investments involving ownership of 10% or less of an asset (such as a foreign corporation) are classified as portfolio investments, while those investments involving more than 10% ownership are classified as direct investments. Portfolio investors, with a small minority holding in the investment, exercise very little if any control in the asset and thus are typically passive investors. Generally, FPI is associated with the passive ownership of financial securities, such as shares of a corporation or a limited partnership. On the other hand, direct investors own a larger portion of the asset and are typically quite active in terms of management decisions
This paper analyzes foreign real estate investments in light of the obvious potential ambiguities in making the distinction between FDI and FPI and assesses the implications for international real estate investors. A model is proposed that does not require practitioners to make a black and white distinction, but rather consider both the direct and portfolio influences on their investment decisions. Since foreign real estate investment can often be quite complex in nature, a hybrid approach will allow researchers and practitioners to apply the full arsenal of foreign direct and foreign portfolio methodologies to allow comprehensive analysis of these investments.
The Eclectic Paradigm
The basis for the analysis that follows lies in the Eclectic Paradigm, which was introduced by John Dunning in 1977. Over the past three decades, the Eclectic Paradigm has provided a valuable analytic framework for evaluating economic FDI. The primary focus of the Paradigm is to explain why firms choose to engage in FDI to participate in foreign markets rather than employing other, seemingly more convenient, means of market penetration such as joint ventures, strategic alliances or management contracts. The Paradigm is centered on the notion that FDI is the most effective vehicle for serving foreign markets when the firm possesses an ordered series of advantages that arise under conditions of imperfect competition.
According to Dunning, in order to undertake FDI successfully, the firm must first have some competitive advantages in its home market that are specific to that firm. These ownership or "O" advantages must also be transferable to foreign markets. Then, given that O advantages exist, there must also be certain features or characteristics of the foreign market that will allow the firm to take full advantage of its O advantages in the host country. This second set of advantages is referred to as location or "L" advantages. Internalization or "I" advantages comprise the third necessary piece of the puzzle. The I advantages are those that allow the firm to maintain its competitive position by reducing transactions costs. These "OLI" advantages are described in more detail below.
Ownership. A firm's O advantages must be unique to the firm, and it must be possible for those advantages to be transferred abroad. These O advantages largely take the form of the advantages of common governance or the possession of intangible assets such as specific know-how, proprietary technology, patents or brand loyalty, which are exclusive or specific to the firm possessing them. A firm may have substantial financial strength or huge economies of scale, for example, but these would not necessarily be unique to the individual firm, since many firms can develop such advantages, and so competitive advantages such as these may not be O advantages. The greater the O advantages of enterprises (net of any disadvantages of operating in a foreign environment), the more incentive firms have to exploit those advantages in foreign markets.
Location. Location advantages are due to economic differences among countries and may take many forms. The host country may offer such features as low-cost labor, labor with unique skills, better access to vital raw materials or a large relatively untapped market. In addition, it may simply offer the opportunity for a firm to make a defensive investment to prevent its competitors from gaining a foothold. In the absence of L advantages such as these, there would be no incentive for the firm to engage in FDI, and foreign markets would best be served entirely by exports.
Internalization. When O and L advantages exist, to warrant the risks of ownership, the firm must also possess I advantages. Internalization advantages allow the firm to minimize transactions costs and other agency costs that would likely occur if the firm engaged in some other form of market penetration like a joint venture, for example. This would mean that the cost of having the firm manage and control all of its activities in the foreign country directly would be less than the cost of operating in any other fashion. For example, the costs of monitoring foreign partners, having information filtered through third parties, dealing with foreign financial institutions, etc., would be mitigated. If the firm has the ability to thus effectively exert control over its value chain, it would be more beneficial to the firm to utilize its I advantages than to enter into leasing, franchising or other types of agreements with foreign firms in advantageous locations.
Dunning (1988) utilized the Eclectic Paradigm framework to analyze advantages in the international hotel industry. He found that traditional foreign hotel operators (such as Hilton, Sheraton, etc.) possessed firm-specific advantages that motivated their international investments, as predicted by the Eclectic Paradigm. However, other investors purchased hotels in foreign countries simply for the purpose of diversifying their investment portfolios. These investors did not possess the OLI advantages. As Dunning pointed out:
Ownership of a hotel can be generally viewed as more in the nature of portfolio investment where the objective is to maximize the capitalized value of a future stream from the asset acquired. This might be done by reading the market correctly and taking advantage of differences in capitalization ratios and exchange rate expectations; this is Aliber's explanation (Aliber, 1970) for movements in direct investment between different currency areas, and would seem borne out by the marked rise in net inward investment into the U.S. hotel industry in the last decade, particularly by the Japanese (Dunning, 1988:262).
Even though many of the hotel investors studied appeared to be motivated by portfolio considerations, the ownership of the hotels was clearly classified as a FDI in that substantial active involvement in the management of the property was required. Investments that are motivated by portfolio considerations, but end up having many characteristics of direct investment, must inevitably cause problems for the investor. To mitigate this problem, and in light of the unique features of many real estate investments, a hybrid of direct and portfolio investment theories is needed in order for investors to make a proper evaluation.1
Real estate is often a hybrid of direct and portfolio investment. In evaluating the active nature of Japanese investments in U.S. real estate during the 1980s, Holsapple, Ozawa, and Olienyk (2002) found the distinction between FPI and FDI to be quite complicated in practice. They concluded that internalization and control were often a prerequisite to successful investment in real estate for the Japanese investors. Internalization and control were required to capture the portfolio benefits associated with real estate investment at that time, since the option to invest in real estate investment trusts (REITs) or a minority ownership interest in a real estate limited partnership was limited.2
The activity level required of owners was found to be quite important in distinguishing between (passive) portfolio investment and (active) FDI. Factors such as ownership structure, investment type and phase of the business cycle were all posited to impact the activity level required of owners of real estate. For instance, a general partner is more active than a limited partner regardless of the percentage of ownership. Ownership of a 50-year-old multi-tenanted building is more active than ownership of a new single-tenant building with a triple net lease to a credit tenant, and ownership during times of recession (when tenants are downsizing) tends to be more active than during times of prosperity (when tenants are stable or expanding). The study concluded that many Japanese direct investors in U.S. real estate were motivated primarily by passive portfolio considerations, and therefore capital arbitrage and portfolio diversification theories offered the best theoretical explanation of much of the Japanese investment. However, due to the active nature of real estate in the dynamic U.S. market, the analysis of most large-scale real estate assets during that time warranted active FDI methodology, even if the primary motivating factor for the investment was passive portfolio diversification.
A Synthesis of Foreign "Direct" and "Portfolio" Investment in Real Estate
Traditionally, FDI and FPI are treated as mutually exclusive. Researchers have attempted to explain FDI and FPI separately and independently, viewing any particular investment as being either one type or the other. This paper proposes a hybrid approach. Since there are clearly hybrids of direct investment and portfolio investment in real estate, it follows that there should be a corresponding hybrid methodological approach to analyzing foreign real estate investments. Evaluation of FDI and FPI as separate sub-paradigms within the Eclectic Paradigm would enable measurement of the independent and aggregate influences and result in more well-informed investment decisions.
Industrial organization theories of FDI were pioneered by Hymer (1960) and are evaluated by Dunning within the ownership sub-paradigm.3 Hymer theorized that the removal of conflict and possession of certain competitive advantages are major motivations for FDI, but that diversification should be a minor motivation for FDI since control is not typically necessary in order to achieve diversification. The firm could achieve a desired level of diversification by simply buying minority shareholding positions in foreign companies. However, pure portfolio investment opportunities tend to be somewhat limited in the case of foreign real estate investments.4
Although diversification is a key motivation for foreign investment in real estate, it has been downplayed as a motivation for FDI generally and has not previously been embodied in the Eclectic Paradigm.5 Capital arbitrage theories of FDI (Aliber, 1970) along with some industrial organizational theories have recently been included in the ownership sub-paradigm (Dunning, 2000), but broader portfolio diversification considerations have so far been absent.
One way to more adequately evaluate FDI in real estate is to create a new portfolio ("P") subparadigm to separately evaluate the capital arbitrage theories along with the diversification theories pioneered by Markowitz (1959) and Grubel (1968). The central question for international portfolio investment in real estate is the following: Do the portfolio advantages outweigh the disadvantages of being a foreign owner? To cite just one example, can a foreign landlord lure a tenant by charging lower rent, and thus be forced to capitalize an income stream at a lower rate, but still secure an acceptable rate of return due to exchange rate changes?6 Portfolio benefits such as these should properly be measured in concert with OLI advantages in the case of FDI, and can be measured as "stand-alone" benefits in the case of pure FPI.
When explaining foreign investment by industrial firms, ownership advantages traditionally delineated in the Eclectic Paradigm are typically more germane to the analysis than are capital arbitrage or diversification considerations. However, since many foreign real estate investments are essentially hybrids that exhibit significant characteristics of both direct and portfolio investment, analyzing both types of features within one cohesive methodology is highly beneficial.
Extending the Eclectic Paradigm
Exhibit 1 demonstrates how the Eclectic Paradigm can be extended to specifically identify and evaluate (FDI) ownership advantages and (FPI) portfolio advantages both independently and in the aggregate by adding a new sub-paradigm to account for the portfolio advantages separately. The addition of the portfolio sub-paradigm allows the disadvantages of direct investment in a foreign environment (the costs of being foreign) to be explicitly incorporated into the paradigm in three different ways, as follows:
The fixed costs of being foreign ("f") that dissipate over time (such as unfamiliarity with language, market customs and laws, or lack of associations with agents and tenants) can be measured directly against O advantages;7
2. Foreign exchange risk, a recurring influence to be incorporated within portfolio conditions "Pe"; and
3. Other recurring costs of being foreign (such as being located at a long distance from the investment, inconvenience of operating in multiple locations, or differential treatment), which are evaluated in the location (L) sub-paradigm.
A viable foreign real estate investment must have either ownership advantages or portfolio advantages, or both. Furthermore, the advantages must outweigh the fixed costs of operating in the foreign environment (f). If this condition is satisfied, the localization and internalization parameters of the paradigm can then be evaluated.
The extended paradigm provides a lexical ordering of ownership, portfolio, location and internalization ("OPLI") independent variables and subparadigms. The foreign investment in real estate decision process can be viewed as a "what," "where" and "how" sequence as follows:
What: Does the firm or investor possess any ownership advantages to exploit and/or are there portfolio advantages present?
The "what" is answered in the first two sub-paradigms described in detail in Exhibit 1. (1) The ownership sub-paradigm evaluates motivations for FDI arising from imperfect competition and weighs these against the fixed cost of being foreign; and/or (2) The portfolio subparadigm evaluates diversification and capital arbitrage motivations for FDI, including foreign exchange risk.
Where: In what countries do location advantages exist?
(3) Location sub-paradigm. Factors influencing location decisions include pricing of factor inputs or assets, host country political risk, regulations and laws, and fiscal and monetary policies. Location advantages are measured against recurring costs of being foreign (other than exchange risk), such as operating a long distance from the investment or differential treatment in the host country. When host countries are found that satisfy the necessary condition in (1) or (2) and the sufficient condition described in Exhibit 1, firms possessing O advantages may potentially be successful in building or acquiring real estate assets in the host country and actively managing them. Firms relying only on P advantages may simply acquire passive interest in existing real estate assets in the host country, if available.
How: How should the foreign activity or investment be structured?
(4) Internalization ("I") advantages. When L advantages exist, it must be more beneficial for the firm possessing O advantages to own the investment itself rather than sell, lease, or franchise the advantage to foreign firms located in the host country. Otherwise a developer or contractor possessing O advantages could simply provide a fee for service to a third party firm with less risk. For instance, McDonalds or Sheraton often times find it more advantageous to franchise than have a corporate-owned location. An international real estate firm might possess coordination advantages with contacts with international tenants. In some foreign markets it may acquire the land, build a shopping mall, and fill it with its tenants. In other instances, it may simply broker the tenants to local owners for a fee, as it is unable to secure a site or justify the risks of ownership in that foreign market. An investor possessing P advantages does not generally require a controlling interest in the real estate asset unless there is also the simultaneous existence of ownership advantages. If the investor possesses only P advantages and there is a lack of passive portfolio vehicles available in the host country, FDI may be required to capture the portfolio benefits.
The what, where and how decision sequence is illustrated in the decision tree in Exhibit 2.
In summary, FDI in real estate may be motivated primarily by either FDI or FPI considerations. In the case of the investor motivated primarily by traditional FDI-type advantages (e.g., developer or contactor), the magnitude of the ownership advantages must be compared to the fixed costs of investing in a foreign environment and the portfolio considerations of the investment. In the case of the investor motivated primarily by portfolio considerations, but without more passive portfolio diversification vehicles available, the magnitude of any portfolio advantages must be weighed against the advantages held by host country landlords and the fixed cost of operating in a foreign environment. If the aggregation of ownership and portfolio advantages is favorable for either type of investor, the investor should proceed to evaluation of location and internalization sub-paradigms applicable to real estate investments.
An Application8
The analytical approach embodied in the ownership and portfolio sub-paradigms displayed in Exhibit 1 can be applied to selected Japanese investors in U.S. real estate during the 1980s and 1990s. Holsapple, Ozawa and Olienyk (2002) analyzed the equity investment positions of Japanese investors in U.S. real estate and highlighted specific transactions that occurred between 1980 and 2000. Japanese investors, who were primarily attempting to capture portfolio benefits, often failed to recognize the FDI characteristics and active nature of their investments. This failure exacerbated operating problems and contributed to the huge losses they incurred and the banks that were financing them experienced. For example, Mitsubishi's real estate group purchased the Rockefeller Center in New York City in 1989, and sold it six years later with an estimated loss of $2 billion. Mitsubishi Bank sold the Hyatt Regency Waikoloa in Hawaii for a loss of close to $300 million in 1993. Real estate loan losses have been a major portion of the losses absorbed by Japanese banks. These losses were reported to be $1.25 trillion in 2001.9 The full extent of Japanese losses related to U.S. real estate are not tracked or reported by any known source.
This application highlights the ownership ("O") and portfolio ("P") sub-paradigms. The location ("L") advantages for Japanese investing in U.S. real estate during this period, such as asset price differentials, cash flow differentials, favorable balance of trade considerations, and the relative availability of U.S. real estate assets, have been well documented.10 The necessity of direct investment or internalization ("I") to capture portfolio benefits of U.S. real estate has been documented earlier in this research and elsewhere. Any internalization advantages that Japanese developers and contractors operating in the U.S. might have had during this period, as compared with development and contracting for third parties, are unknown. In general, however, it can be said that most Japanese firms found location L advantages from investing in the U.S. market during this time frame and it was often necessary to make direct investments [or internalize ("I")] to capture the available portfolio benefits. The question poised in this application is limited to whether or not the Japanese firms studied possessed adequate ownership ("O") or portfolio ("P") advantages to warrant direct investments in U.S. real estate. The broad classifications of direct investors, traditionally explained by FDI methodology, and portfolio investors, traditionally evaluated by FPI methodology, are utilized.
Direct Investors
The relevant question is whether or not the combination of asset-specific and coordinating advantages outweighed the poor portfolio conditions. If the combination of advantages outweighs the cost of being foreign, the investments can be explained by theories embodied in ownership and portfolio sub-paradigms. The critical challenge is to use the information available to make the best possible decision regarding the likely returns on the investment. The fact that the investors make an investment and are later wiped out does not by itself negate the possibility of adequate motivation-it happens all the time.
These investments may be more appropriately characterized as speculative or aggrandizing ("trophy syndrome"). For instance, Shuwa Investments Corporation, which accumulated a $10 billion international real estate portfolio financed by debt and delegated management to local real estate brokers, would most likely be categorized as speculative and lacking sufficient ownership or portfolio advantages to warrant the investments.
Conclusion
Once the active nature of direct real estate investment is established and the effects of numerous international portfolio considerations are unveiled, the advantage of combining existing foreign direct investment (FDD and foreign portfolio investment (FPI) methodologies to evaluate foreign real estate investments becomes apparent. A hybrid methodology should prove to be quite useful to international portfolio managers evaluating and structuring foreign real estate investments, and to researchers attempting to explain international capital flows. When evaluating foreign direct real estate investments resulting in management control, international portfolio managers should consider any competitive advantages they may possess (or lack) that will enhance (or diminish) their ability to compete with local landlords and negotiate with local tenants, and evaluate portfolio considerations such as diversification benefits and exchange risk associated with international real estate investments. The ability to layer and separately evaluate and compare ownership ("O") and portfolio ("P") considerations as developed in this research, as well as evaluate location ("L") and internalization ("I") considerations embodied within the Eclectic Paradigm will enhance the managers' ability to fully evaluate the investments thus increasing investment returns.
Once the ability to layer these methodologies to evaluate international investment in real estate is further refined and accepted, broader application could follow. If it is accepted that virtually every large scale foreign investment has a significant portfolio element, then the ability to layer and separately evaluate and compare portfolio influences with the ownership advantages that typically motivate direct investment may prove to be a valuable contribution to the formulation of a general paradigmatic approach to analyzing all types of international capital flows.
