By Ralph Block

Several powerful trends, advancing simultaneously, have caused U.S. investors to become more interested than ever in both domestic and foreign commercial real estate. Motivated by a desire for broader portfolio diversification, investors have been directing capital toward less well-known asset classes, such as emerging market equities, timberland, commodities—and real estate. Owners of commercial real estate—wherever located—have benefited substantially.

Other trends, including globalization and expanding capital markets, have facilitated U.S. investors’ ability to buy real estate assets virtually anywhere in the world, and the increasing securitization of commercial real estate is no longer limited to the U.S. According to UBS Investment Research, REIT-like business structures are now operating in roughly 20 countries, and other nations such as the United Kingdom and Germany will soon follow. These foreign REITs provide U.S. investors with diversification benefits and a hedge against weakness in the U.S. dollar.

But foreign REITs and their holdings can be challenging for many U.S. investors, due to different accounting principles, less transparency, unfamiliar locations and sometimes—to Americans—different real estate customs and practices. Furthermore, many foreign REITs are not actively traded here. As commercial real estate investors tend to be a conservative lot, many of them prefer to own their foreign real estate indirectly, through share ownership in some U.S. REIT organizations that have been making international investments.

Foreign investing by a U.S. REIT may be a winning idea for U.S. investors, but this depends upon the soundness of the REIT’s strategy and its ability to execute. A significant number of U.S. REITs have proven that commercial real estate expertise can be “exported,” but it must be done carefully and intelligently. The development strategy deployed in Japan by Chelsea Property Group, acquired in 2004 by Simon Property Group (NYSE: SPG), is an excellent example of how value can be created when talented U.S. REIT executives develop a solid game plan and team up with the right foreign partners.

However, as we are sometimes reminded when looking at ancient maps, “here there be dragons,” and not every investment will succeed. REITs that elect to allocate capital to investments outside of their existing markets have long had the burden of proving that such a strategy creates value for the shareholders from a risk-reward standpoint, and investing in foreign countries where laws, markets, currency and property dynamics are different from ours magnifies the risk significantly.

Some relevant questions might be: Is the REIT teaming up with knowledgeable, experienced foreign partners with an established presence in the local market, or, alternatively, has it diligently established its own local infrastructure and management team? Are the prospective returns worth the extra risk? Is value being created, i.e., is the REIT simply making a passive investment in a foreign country, or is it building a long-term business capable of creating value over many years? Has a substantial amount of analysis, utilizing local real estate expertise, preceded the investment—or is the REIT merely bandwaggoning on a popular trend? When the overseas investment business is fully operational, will it contribute significantly to company-wide profitability, or is the business merely ornamental?

Diversification is a strategy that makes sense for almost all investors, but it’s not always the right strategy for any particular business. A REIT doesn’t have to be all things to all investors, and not every REIT has the expertise to deploy capital outside of the U.S. effectively. But some will create value for their shareholders by leveraging their capabilities and business relationships into growing markets beyond our shores. As always, both a solid game plan and old-fashioned blocking and tackling will be crucial to success.