The appeal of emerging markets is the opportunity to tap into stellar growth from a low base. There are numerous economies around the world with the necessary population size and GDP growth to offer such potential, but why are global investors dismissing some markets in favour of others? Richard Lowe investigates

Institutional investors are increasingly seeking to structure their real estate portfolios on a global basis. Many of Europe's largest pension funds, for example, are building up their exposure to a number of markets across Europe, Asia and the Americas, and asset managers have launched or are in the processing of establishing global funds to invest across these three continents. The key buzz phrases echoing this trend are "global diversification" and "global opportunity set".

Yet, investing across three continents does not technically constitute global investment, since it discounts great swathes of the world's geography and population, not least Africa and the Middle East. Taking modern portfolio theory to the extreme, it could be argued that the ideal situation would be to have a property exposure in every country in the world. Aside from the unrealistic volume of capital required to do this, in reality institutional investors are restricted to a series of markets that offer scale, transparency and whose return prospects justify their country-specific risks.

Further ahead on the curve compared with Europe's institutions are the global opportunistic investors, who invariably have greater risk appetites and principally lead the first wave of foreign investment in new real estate markets. It is these, often shorter-term, investors who play a central role in establishing institutional investment markets around the world.

"They go in and make the first investments, allowing the more institutional investors like ourselves to follow," explains John Buckley, property economist at Morley Fund Management. "They tend to open up those markets to lower-risk investors." The emerging markets that have attracted the most interest are those with the largest scale and potential for growth: the so-called BRIC countries of Brazil, Russia, India and China, followed by the likes of Argentina, Chile, Turkey, Ukraine, Vietnam, Thailand.

According to a study by Property Funds Research (PFR), an independent research and information business, the six most popular emerging market and Asian countries defined by the number of real estate funds (and the size of their target gross asset value or GAV) targeting them are: Japan, China, India, South Korea, Mexico and Brazil.

If you remove the relatively more mature and lower-risk markets of Japan, South Korea and Mexico, it is no coincidence that the remaining markets - China, India and Brazil - are also in the top four emerging market and Asian countries as ranked by PFR in terms of population size and gross domestic product (GDP) per capita. Both population and GDP seem to be driving factors behind attracting cross-border investment.

However, Indonesia has a larger population and higher GDP per capita than Brazil, but according to PFR has only attracted four investment funds with a combined GAV of €482m, compared with the 38 funds targeting Brazil with a combined GAV of €8.27bn. Obviously, population size and GDP growth are not the only drivers behind the appeal of emerging markets.

Other factors include perceived political risks and transparency. The report compares its data against the Jones Lang LaSalle (JLL) Real Estate Transparency Index, which rates the world's property markets in terms of transparency. The PFR study finds that levels of transparency also appear to have "some explanatory power".

For example, Indonesia currently ranks 55th on the JLL Transparency Index and is included under the low-transparency category, compared to Brazil which is 36th and is considered semi-transparent by JLL. This could go some way then to explaining the difference in volume of capital chasing the two real estate markets.

However, there are a number of countries that PFR calls "outliers", meaning countries whose observed volume of investment is not in line with expectations. Countries with high population and/or GDP per capita and low investment included Taiwan, Saudi Arabia, Venezuela, South Korea, Indonesia and Iran.

"The research identified which markets had been the recipients of investments through unlisted property funds and related those countries to their size, their population, their GDP, how wealthy they are," explains Andrew Baum, PFR chairman and chief strategist at CRBE Investors. "We also compared them with the JLL transparency index. We then pointed out which ones are getting more money than expected and which ones are getting less. It leaves open some questions about things like exchange controls and foreign investor restrictions."

Baum adds that it is very much a work in progress and prompts more questions than it draws conclusions. For example, the report reveals that Venezuela and Iran are attracting no capital whatsoever.

The obvious factor here is political risk. Baum says that the assessment of political risk can involve a wide-ranging number of factors, from ill-informed "blind prejudice" to the more "genuine risk" of detrimental developments like nationalisation of land."All we can do is present the countries and leave people to make up their own minds about whether the risk is being underestimated or overestimated," Baum says.

Political risk is by its very nature very difficult to quantify. In the past, sovereign risk in the debt market could be used as a proxy for political risk but this no longer works for today's global economy. Investment in Russia, whether via equities or real estate, is recognised as involving a significant amount of political risk, and investor concerns are no doubt highlighted by the country's recent aggressive stance towards foreign oil companies operating within its borders.

Moscow is ranked as the most risky of European markets according to PricewaterhouseCoopers' latest Emerging Trends in Real Estate Europe report (although this takes into account other risks aside from a political dimension). But the recent military conflict between Russia neighbouring Georgia has brought the unpredictability of political risk into renewed focus.

"How can you define political risk on a day-to-day basis?" asks Rosemary Feenan, head of research at JLL. "As we are seeing at the moment, with all the problems with Russia and Georgia, it really is a difficult one. We used to talk about risk in terms of sovereign risk and even that is becoming more difficult to define at the moment."

A factor that is far more quantifiable is transparency and this is what JLL attempts to do with its index by compiling the results of a survey that assesses five key attributes of any given real estate market:

• Performance measurement
• Market fundamentals
• Listed vehicles
• Legal and regulatory environment
• Transaction process

The latest index, which includes a number of new countries for the first time, shows that the transparency of many emerging markets continues to improve, with nearly half of the countries surveyed posting higher transparency scores than they did two years ago. Only Venezuela has been downgraded, principally due to changes in government regulations and taxation policies targeting foreign investors.

But to what degree can transparency explain the behaviour of cross-border capital targeting emerging markets? Jeremy Kelly, a contributing author on the transparency index, explains there is a degree of correlation between real estate market transparency and investment volumes, but "it is not a close one".

Instead a closer correlation can be detected between real estate investment flows and overall transparency of economies. A good example would be Japan, which sees high levels of investment flows (in the PFR report it is ranked top for the number of real estate investment funds and combined GAV), but is only 26th in the JLL transparency index, below Portugal, Malaysia, Czech Republic and Poland. What the Japanese economy does have, however, is "relatively high overall transparency", Kelly says.

In fact, it might be surprising if transparency of real estate markets correlated closely with the volume of cross-border investment they attracted. For some investors, a low level of transparency may be seen as a positive advantage if they are able to source deals where others are not. It should also be remembered that transparency is no longer a pre-requisite even for core investors like pension funds.

"That is no longer the case now there are so many different styles of investment where people are prepared to take on extra risk and indeed in some markets where low transparency can be a positive advantage to getting your performance, if you are knowledgeable about how those markets really work at a ground level," Feenan says.

According to Kelly, some of the biggest improvements to transparency in recent years and months have been made in emerging European economies, as well as the Middle East and North Africa. The effect has been that the likes of Poland, Czech Republic and Hungary are catching up with their westerly neighbours in terms of transparency.

Even more significantly, the GCC countries of Bahrain, Qatar, Kuwait, Oman, Saudi Arabia and United Arab Emirates are making up a similar amount of ground on some of the markets in Asia Pacific. But markets in the Middle East and North

Africa are certainly not attracting the same levels of interest from global real estate investors as their counterparts in Central and Eastern Europe, Asia and Latin America, despite this reported progress in transparency.

Tim Bellman, global head of research and strategy at ING Real Estate Investment Management, notes that North Africa and the Middle East are often grouped together today as a single region. However, while he sees less opportunity in the latter - especially among the oil rich, capital-exporting countries - he anticipates Africa becoming "an increasingly interesting area as the next frontier market for global investors".

Bellman sees "a few small pockets of opportunity" on the African continent as a whole, although these are predominantly restricted to South Africa, which, according to the International Property Databank (IPD) index, has been a global outperformer over recent years.

"A critical mass of opportunity in the region is not there at the moment. There is a pocket of interest, but there is nothing much else around it right now," he says. Until such a time that Africa can generate a required level of critical mass, the continent will remain outside of most investors' global strategies, Bellman concludes.

Buckley agrees that the African continent houses a number of countries that could be of interest to real estate investors in the future. But realistically, only South Africa, Nigeria, Ghana, Kenya and Egypt have the necessary scale, he adds. In fact, two of these countries have made it on to Goldman Sachs' list of emerging economies to follow in the footsteps of the BRIC countries, a term originally coined by the investment bank.

The list includes eleven countries across the four continents of the Middle East, Asia, Americas and Africa, and is called the Next Eleven or N-11. Both Nigeria and Egypt have now been dubbed N-11 countries, since they have the potential to challenge the major developed economies in terms of their weight (although only Mexico and possibly Korea have the potential to become as important globally as the BRICs).

Buckley says the strong and consistent economic growth in much of Africa has been somewhat overlooked. "If that is maintained, those countries could become of interest, because they have the scale and are quite underdeveloped," he says. "From a real estate perspective, that can introduce a lot of opportunities."

The term ‘emerging market' is a slippery beast and can often share the same meaning as ‘frontier market'. Kelly reveals that some of JLL's clients are beginning to refer to Egypt and Kazakhstan as emerging, while India and China have become thoroughly mainstream in their eyes. For most institutional investors, however, the BRIC countries will remain emerging for sometime and the likes of Egypt and Kazakhstan definitely frontier.

But Feenan admits it can be difficult to keep track of what is considered frontier and emerging. With China outsourcing much of its production to Vietnam, for example, the latter is perhaps making the transition between labels. "Where is frontier now? Where is going to be the next destination? Indonesia?" she asks rhetorically. "We had a client recently talking about Tibet."