Investors are faced with a number of options when gaining access to emerging markets, but each comes with its own challenges. Shayla Walmsley reports
Emerging economies are expected to overtake economies in developed countries in terms of their share of global GDP this year. PwC's prediction highlights the speed with which the global economic centre of gravity is shifting towards the east.
It is a transformation that global real estate investors should take into account and it explains why some institutional real estate investors are looking to enter emerging markets despite their inherent risks and at a time when risk appetite is quite low. Arguably, it is better to take on some risk now in order to be better placed when these markets mature.
"Emerging markets are underdeveloped in terms of the infrastructure for investment, including stable tax regimes and the rule of law," says John Forbes, real estate funds partner at PwC. "Investors entering them on a significant scale now are accepting a higher degree of risk but for potentially higher returns. And they will be establishing themselves in markets that will be very important in the future."
But pension funds and institutional investors still face a problem in matching their liabilities. In today's uncertain environment, investors are largely risk averse, but emerging markets are, in the main, risky. The choice of vehicle or means of access is therefore often determined by investors' desire to mitigate certain risks.
According to the Asian Association for Investors in Non-listed Real Estate Vehicles (ANREV), the headline return for non-listed Asian real estate funds in 2012 was 8.2% (13.8% for multi-country funds) in local currencies, comparing favourably with Europe - ANREV's European counterpart INREV posted 3.7%.
Alan Dalgleish, director of research and professional standards at ANREV, says little has changed in the motivation for investing in Asian markets since last year. Diversification, higher returns relative to investors' local markets (European non-listed funds returned 3.7%) and access to domestic markets in Asia are still driving factors behind investor appetite for these funds.
However, the 79 investors surveyed for the ANREV index have reduced their return expectations by 100bps uniformly across fund styles. Core strategies are now expected to deliver returns between 7% and 9%, while value-added and opportunistic investment styles are projected to return 9-13% and 14-18% respectively.
David Boyle, executive director of Morgan Stanley Alternative Investment Partners, says few European investors will enter emerging markets looking for core. "Some large investors have invested in Asia on a core basis, but they are few and far between," he says. "Often investors will look at their home market for core income return and then seek a higher risk-adjusted return in emerging markets." Typically, an emerging market allocation will make up 20-30% of a global portfolio.
Route to (emerging) market
Some of the larger institutional investors are entering into joint ventures to target emerging markets, including APG, the Dutch pension fund manager, which has acquired a stake in Lemon Tree Hotels and set up a joint venture development programme. Others are looking to invest in traditional pooled vehicles and funds of funds. IP Real Estate is aware of one large Swedish institution that has committed to an Asian fund of funds in the past few months.
However, it might be a mistake to split investors into joint venture participants and limited partners (LPs). A number of indirect investors - both funds and funds of funds - might switch to a more direct route in the future.
According to Boyle, while more mature pension funds will often be looking to match their liabilities using an income-based return and protection of the principal, younger schemes and sovereign wealth funds will often look to capture a liquidity premium and capital appreciation. "They come to us because they want to get started quickly, then may take back parts of the portfolio as they get more comfortable with investing in emerging markets," he says.
The bigger the investor, the more likely it is to opt for a joint venture - or, in the case of Ivanhoe Cambridge, a joint venture with a joint venture. The subsidiary of Canadian pension scheme Caisse de dépôt et placement du Québec has done much of its investing in Brazilian shopping centres via a joint venture set up in 2006 with Brazilian firm Ancar, which owns or manages 15 shopping centres. Earlier this year, the joint venture partnered for the first time with the Canadian Pension Plan Investment Board (CPPIB) to increase its interest in Rio de Janeiro shopping centre Botafogo Praia for CAD40m.
CPPIB has done its own fair share of complex consortium investing, notably acquiring a stake in an Italian group whose holdings operate Chilean toll roads. CPPIB's existing Brazilian portfolio comprises three retail, two office and eight industrial assets.
APG's aforementioned deal with Lemon Tree Hotels in India entailed acquiring 6% of the firm and a separate investment of €284.3m in a joint venture to develop a portfolio of mid-market hotels by 2016. A spokesman for APG said it had opted for a combination of equity and co-investment due to APG's interest in a specific activity, as well as the company itself. If the deal is large enough, APG will put together a club, he said.
The spokesman cited other examples where the pension fund manager had taken two routes simultaneously, notably with Goodman. "We're diversifying risk. In real estate, we target specific activities - logistics or office. If a big company does hotels and residential, but we want to invest in hotels, it makes sense to co-invest. Besides, in real estate you always need an operator - and we don't want that role," he said.
A third way?
The road to emerging markets for real estate investors is not necessarily split between blind pool funds and joint venture/club deals. There are other options available.
According to Boyle, a multi-manager makes sense in emerging markets for both large and small, direct and indirect investors, albeit for different reasons. First, most indirect investors are trying to reduce the number of their manager relationships, but this is hard to achieve when looking into expand into emerging markets where local operators are important.
At the same time, large pension funds and sovereign wealth funds would struggle to gain a comprehensive exposure to multiple emerging markets through joint ventures. "So you see larger pension funds that might not use a multi-manager in their home market or region taking that approach in emerging markets," Boyle says.
"You need a significant budget in terms of time and expertise to understand emerging markets, even if only focused on the larger markets such as Brazil and China. When it comes to smaller markets or more complex markets such as India, or South East Asia, the cost and time needed rises exponentially.
"Each market has its idiosyncratic issues in terms of tax, the depth of the market, and even the type of assets foreign investors are allowed to own. Geographical spread is a big barrier. If you're located in Europe, it's difficult to monitor a portfolio spread across the emerging markets, especially when the best funds tend to be small and mid-caps."
Another avenue likely to prove popular among emerging market investors is ‘secondaries'. Jones Lang LaSalle (JLL) forecasts that the secondary market for non-listed real estate funds could reach $7bn (€5.4bn) this year - a 30% increase over 2011 - with the maturing of funds in emerging markets meaning investors can more accurately price opportunities.
"You need significant resources to price assets," says Ashley Marks, corporate finance associate director at JLL, pointing out that investors are more likely to look at opportunities if they know whether other investors have bought or sold at roughly the same price.
According to Marks, funds are maturing to the point where they have to draw capital down if they are going to do so at all. "They don't want to be pricing managers' capabilities - which they would, in a blind pool, because there are no assets to judge," he says. "They're interested in the material of the funds themselves."
Marks says there is a new generation of investors in the secondary market, but they have yet to achieve critical mass to help increase liquidity. "It needs pension funds to make the market and it's still a fraction of overall investment in Asia," he says. "But I can see a situation where European pension schemes and consultants would become more active as the market becomes more liquid. The higher the transaction volumes, the higher levels of liquidity and the greater the number of investors."
A barrier to pension fund investment in Asian secondaries is the lack of availability of information on funds themselves. Some fund managers are helpful; others do not provide, for example, asset-level information, often citing confidentiality restrictions. "They don't want that information getting into the market and they control the information flow so tightly it won't leak. The situation is improving - there's a positive trend towards transparency - but it's hard work," says Marks.
The ANREV survey shows that core investors will stick with mature Asian markets - 89% of survey respondents expressed a preference for core funds (20% higher than in 2011). In less mature markets, the preference is for opportunistic funds, suggesting very different kind of investors in each.
The majority (82%) of investors in the ANREV survey also said they planned to increase their allocations to non-listed funds over the next couple of years (up 20% from the previous year), as well as a significant rise in their intention to increase investment in joint ventures, funds of funds and listed real estate. Interest in club deals has plummeted, which Dalgleish says is most likely because of the difficulties in sourcing and executing opportunities.
Risk-averse investors seeking the closest thing to core in emerging markets are likely to pursue opportunities for which there is strong competition. John Mancuso, director of real estate at Russell Investments, points out that "a wave of capital" in BRIC economies will benefit the market long term because it creates depth - but his firm will target more attractively priced niche markets and sectors.
APG does not target specific emerging markets - or even specific cities - but rather specific opportunities. "We're very focused," says APG's spokesman. "Even though India is an emerging market on a macro level we're looking at specific sectors. Hotels is one of them."
Yet moving outside the mainstream in search of returns creates a whole new category of risk. Mancuso claims that many of the investors entering India between before 2007 were unprepared for the complexity of the market and have since retreated. It has thus fallen from the top of the wish list for many investors, but Mancuso says this as an opportunity to benefit from a lack of capital concentration. "It has strong characteristics in capital formation but not as much competition at the asset level," he says.
Outside the BRIC markets, transactions are thinner, which creates concerns in an illiquid market about the exit. "There is a need to spend significant time thinking about the exit," says Mancuso. "It's difficult to sell assets, but it's also difficult to get the money out."
Getting money out of emerging markets is likely to be more difficult than putting it in. So this is where most due diligence should be done.
"Very thorough due diligence is always in order," says the APG spokesman. "Investors shouldn't be blind about transparency and governance in western Europe, either. In both cases - in western markets and emerging markets - due diligence is necessary.
"Don't underestimate emerging markets in that sense. You have to do your homework."