From the October 2011 issue of Investment Advisor • Subscribe!

October 1, 2011

Through the Roof

Real estate is set to take off in emerging market economies

When the Internet boom hit Ireland in the early 1990s, one of the first sectors of the economy to benefit from the creation of new jobs and the spike in wages was the real estate market.

“People began very quickly to go all out looking for better housing for themselves, and this led to a huge boom in real estate,” says Barry Strudwick, president of investment advisory firm Strudwick Wealth Strategies.

That same phenomenon, says Strudwick—an expert in international real estate and a long-time believer in its investment advantages—is happening today in the emerging markets, and it’s the reason why emerging market real estate makes for a compelling investment opportunity. The emerging market economies are among the fastest growing economies in the world, he says, and “there’s a new class of consumer in these countries that are looking for more and better real estate. Whether it’s for office parks, condos or shopping centers, we’re seeing a great deal of construction that’s meeting that demand.”

Everyone knows that the emerging markets asset class has been a hot bed for cashflow over the past several years. Rick Genoni, product manager for ETFs at Vanguard, says that Vanguard’s emerging market products (including its Global ex-US Real Estate ETF) have been attracting unprecedented attention. As more advisors have been considering emerging markets as a tactical play in their clients’ portfolios, the need to make that exposure more targeted and specific has also been growing. The market for international REITs and REOCs has also grown, which means that emerging markets real estate has become more interesting as an asset class unto itself, Genoni says, and it is being increasingly included in both funds and ETFs.

“On a market cap basis, we don’t expect emerging market real estate to be a large part of a client’s underlying asset allocation, but on a tactical basis, if you think there will be unprecedented growth and you expect REITs to take off, it’s a good play,” he says.

Of course, emerging markets real estate is still a fairly niche area and it has not yet attracted the attention that investors like Scott Crowe, senior vice president and global portfolio manager at Cohen & Steers, believe it should. That’s because investors have not been able to access this asset class to the extent that they could be through existing global or emerging market equity allocations, Crowe says, since benchmark indices just don’t have sufficient allocation to emerging market real estate. The MSCI World Index, for example, has no emerging market real estate exposure and the MSCI EM Index has a mere 1.7% allocation to emerging market real estate.

Yet about 8% of the $1.2 trillion global universe of listed properties is in emerging markets, Crowe says; 12% of the world’s underlying real estate is also located in these countries. Looking at things from a GDP-weighted perspective, emerging markets make up 33% of global GDP, so having some allocation to emerging markets real estate makes sense.

It is for this reason that investment managers like Crowe are setting up new funds to offer investors dedicated and direct exposure to emerging markets real estate. Cohen & Steers has already been investing in emerging markets real estate for four years through its global real estate funds, “but as the universe expanded, we decided to launch a dedicated emerging markets real estate fund to make it easier for investors to have access to this asset class,” Crowe says. “We may be a little early with this fund, but we see a great long-term future for this asset class because of the secular emerging markets story, and we believe that the best way to get access to their underlying economic dynamics is through real estate.”

Strudwick also believes that clients looking for targeted emerging market exposure would fare well with some allocation to real estate. But, he warns, this is still a fairly marginal area that is hard to get a proper handle on from the United States, particularly when it comes to assessing REITs and real estate companies on corporate governance. So while there are certainly opportunities for investors, those who are considering emerging markets real estate should definitely go with managers who have experience in international real estate investing, who know how to assess tax codes in different countries, who have the means to vet out management teams and who can perform proper due diligence.

To date, the number of investment products offering exposure to emerging markets real estate are few (Vanguard’s ex-US Global Real Estate ETF was one of the first ETFs to have an allocation to the asset class). But Strudwick believes that there will be a growth in product offerings as more people realize the benefits of the asset class.

Here’s what the experts have to say:

Scott Crowe, Cohen & SteersScott Crowe, Cohen & Steers’ Emerging Markets Real Estate Fund

Crowe believes that the emerging markets inflation scare, which dominated news headlines for some months and frightened people enough to withdraw their money from the asset class, won’t have any lasting impact on emerging markets. On the contrary, he says, developed markets are mired in such deep straits, that it will take them a long, long time to recover, and this makes emerging markets in general, and niche segments like real estate in particular, look very attractive by comparison.

“I think we’re on the cusp of a dramatic shift back into emerging markets and because of that, I expect that our fund will generate a lot of interest going forward,” he says.

Launched in March, Cohen & Steers’ $60-million Emerging Markets Real Estate Fund invests in a mix of REITs and listed property companies in the Asia-Pacific region, Latin America, Central and Eastern Europe and South Africa. The fund was one of the main investors in the first Mexican REIT IPO, Crowe says, and it has a positive outlook on the development of the REIT market.

“They are a powerful catalyst to drive the securitization of real estate,” he says.

Thus far, REITs have been introduced in only a few emerging market countries, such as Mexico, Malaysia and China. But other countries like the Philippines are working on getting REIT legislation in place, Crowe says, so “I expect the REIT universe to grow going forward. We have already seen numerous new REIT IPOs in countries that are creating more infrastructures for a service-based economy, where you need malls rather than markets to service growing needs, and where you need hotels. All this goes hand in hand with the economic development of these countries.”

While he sees opportunity in many emerging market countries, the standout nation for Crowe is Brazil.

“It has more of the benefits and less of the pitfalls of emerging markets,” he says.

Brazil has a solid economic framework, bolstered by a strong central bank that has a firm hold on inflation. It benefits from natural resources and derives strong export revenues from these, but most importantly, Brazil is a functioning democracy that is fully committed to capitalism, Crowe says. Unlike China, which has had a thriving real estate market but has, in Crowe’s opinion, only made a “half-hearted commitment to capitalism,” Brazil is going the whole hog and this is important for the growth of all sectors of the economy, including real estate.

“When you have a country that’s fully committed to capitalism, you do find management teams that are better incentivized,” he says. “I think Brazil offers the best long-term opportunities because of its strong foundations and this is why it’s our largest overweight.”

Crowe believes that more firms will look to launch dedicated emerging market real estate funds and that the asset class will continue to generate interest going forward for anyone who wants to diversify their emerging markets exposure. But, he cautions, it is important for both managers and their clients to be fully aware of the risks of investing in emerging market real estate. It isn’t just that the asset class is relatively new; each emerging market country is different and unique, he says, both culturally as well as developmentally. Regulatory environments are also different, and all this comes to bear upon the real estate market.

“We took three years understanding management teams and underlying property types, so I wish our competitors well as they get their strategies going,” Crowe says. “Corporate governance is also challenging, so as much as there are opportunities in emerging market real estate, there are also a lot of differences between the various markets. As an investor, you really have to understand those and be able to work through them.”

Michael McGowan, Forward FundsMichael McGowan, Forward Funds’ International Real Estate Fund

Although the Forward International Real Estate Fund currently only has a 5%-plus weighting toward emerging markets, it doesn’t mean that its manager, Michael McGowan, has a poor opinion of the asset class. The fund has, in the past, had a 20% direct exposure to emerging markets real estate, but now McGowan is looking to get the best of what that market has to offer in a more indirect manner, by focusing on REITs and real estate developers in developed markets, which through their business models and expansion plans, have a direct link to the emerging market upside.

McGowan gives the example of Quill Capital Trust, a Malaysian REIT controlled by Singapore property developer Capital Land, which invests in China, Malaysia and Vietnam, among others.

“Capital Land farms a lot of investment and then skims that off into listed REITs in which they retain a big stake,” he says. “By investing in Quill Capital, I feel we are getting the best of everything—good quality management from Singapore, Malaysian currency exposure and the benefits of Malaysia’s growth, for which the government has much planned.”

While he’s watching the development of local market REITs in different emerging market countries, McGowan is nevertheless somewhat wary of investing in them (Malaysia is the exception, he says, because it already has a well-established REIT market). He prefers to invest in local developers, but again his present strategy is to go with companies like Singapore’s Keppel Land, which is very well-established in Asian countries like China and Vietnam and has a growing presence in India.

“There’s a lot of regulatory risk to investing directly in a place like Vietnam, so going through Keppel, which is an established company with a large market cap, I feel I can get good exposure to Vietnam and to the growth story there,” McGowan says.

Although Forward has significant experience in international real estate investing, being so far away from many of the countries in which the fund is putting its money is quite challenging, which means that McGowan and his team like to really take their time in getting familiar with opportunities, making sure to scope them out thoroughly. On-the-ground research and hands-on due diligence to vet out property developers and see that they’re really doing what they promise to do is a key part of their strategy, he says, “because you have to layer on several different kinds of risks when you’re investing in many of these countries. It’s very important to have that first-hand view.”

Because proper corporate governance is so important to Forward, companies in countries like India and Russia, despite the great potential they offer, are unpredictable on this front and very difficult to get a handle on, so they don’t make the cut at all, McGowan says.

Currently, members of the investment team are touring properties in Buenos Aires, Argentina, and McGowan himself will be headed to China shortly—a country that, contrary to what’s in the news, he believes to have the greatest potential for real estate growth.

Many market watchers have been cautioning about a China real estate bubble, but McGowan still believes that the market has a long way to go before imploding. Policy risk is the greatest risk in China, he says, but beyond this, “every Chinese province is like a country, the economy continues to grow and people have the money so they are buying.”

Admittedly, China has been building and building, and there are scores of empty buildings across the nation, but according to McGowan, they will fill up over time as both Chinese and foreign business continues to expand. On the retail side, “people have the means to buy homes for their children and grandchildren,” he says, “and housing is seen as a good alternative investment to the banks.”

Forward invests in China through Hong Kong-listed property developers whose sole business is in mainland China. “We benefit from Hong Kong accounting and liquidity and established companies that have been around for a long time,” McGowan says. Forward also buys shares in companies that do the majority of their building in Hong Kong, but are now branching into China with some key projects.

Jeremy Schwartz, WisdomTreeJeremy Schwartz, WisdomTree Investments

The driving theme behind WisdomTree Investments’ Global ex-US Real Estate Fund (DRW) is the growth in the emerging markets, and more specifically, the growth in emerging Asia.

“We launched the fund in June 2007 and focused more on places like Hong Kong and Australia as indirect emerging market plays, and those are still important to us,” says Jeremy Schwartz, deputy director of research at WisdomTree. “But at our annual rebalancing program in June, we added in some direct emerging market exposure, which is going to be very important to us going forward.”

While DRW’s direct emerging market holdings are still small, the importance of adding real estate companies and REITs in countries like China, Taiwan, Turkey and the Philippines, is significant, Schwartz says, “and as much as we still make the indirect plays on Asia and other emerging markets, we have to also make the direct plays, to better capture growth and to keep pace with what investors want.”

Currently, DRW seeks to capture the emerging market upside through its investments in names like Hong Kong-based Sun Hung Kai Properties and Cheung Kong Holdings, which make up the biggest portion of the fund. But Schwartz expects names like Taiwan’s Farglory Land Development Co. to become more important over time as Asia continues to grow and occupy a greater portion of the fund.

He also expects more investors to want exposure to niche segments within the emerging markets, including real estate. And as U.S. investors continue to seek out income-producing assets, and look for exposure beyond emerging market equity and fixed income, the number of emerging market funds offering greater exposure to real estate, as well as dedicated emerging market real estate funds, will increase, he says.

WisdomTree’s modus operandi for both international and emerging markets real estate is to zero in on dividends. If real estate companies have the means to pay dividends to their shareholders, that means that they are in good financial shape, Schwartz says, and investors are guaranteed an additional layer of corporate governance—the greatest unknown when it comes to managing risk in emerging markets real estate.

“When you focus on dividend-paying stock, you are also focusing on income, and receiving 5% or 6% in dividend payments means that the level of protection increases,” he says.

Diversification is also key when trying to get it right with emerging markets real estate, Schwartz says, because “it’s very hard to understand the dynamics of these companies unless you have a basket that focuses on diversification.”

Fifty-four percent of DRW is invested in international and emerging market REITs while the rest of the portfolio is allocated to real estate companies. 

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