The rationale for emerging markets has been challenged in recent years. Rachel Fixsen speaks to six investors and advisers
Andrea van Buren
• PMT cutting emerging markets exposure due to risks
• New strategy focuses on core European countries
Dutch pension fund PMT, which is managed by pensions service provider MN, is reducing its exposure to emerging markets property because of the risks involved. Most of PMT’s unlisted real estate investments are in developed countries but it also has some in a range of emerging markets — China, Malaysia, Poland and South Korea, for example.
“The exposure of non-listed real estate investments to emerging countries is decreasing,” says Andrea van Buren, MN’s international real estate analyst, adding that the decision to go in this direction was taken by PMT about a year ago. “The new strategy for non-listed international real estate is mainly focused on core countries in Europe, with low leverage and an emphasis on income.”
Within its listed real estate investments, PMT also has exposure to emerging countries, but the new strategy for this part of the property portfolio also puts the focus on core countries. “Exposure to emerging countries will also decrease for the listed part,” says van Buren.
PMT is avoiding emerging countries in the future because they see too many risks – for example, transparency risk, country risk, corruption, political risk and social issues.
“Besides, when investing in emerging counties, a large part of the exposure is to development and this does not fit in PMT’s new strategy. For that reason, investing in China currently is not on the radar,” she explains. “The nature of PMT’s funding requires a conservative and prudential approach to asset categories.”
During the past year — and for some time to come — MN has been implementing PMT’s strategy, which involves re-allocating a substantial part of the pension fund’s real estate portfolio from other regions to European core countries.
“The benefits of global diversification of direct real estate investments, when looking at the correlations within PMT’s total portfolio, appears to be limited,” says van Buren.
“PMT decided to focus on Europe, relatively close to home, in economically stable markets. The focus of the new strategy is on investing in stabilised assets, with low vacancy and a high proportion of income, in core countries.”
Standard Life Investments
• Resurgence of interest in developing markets
• Mexico and Indonesia interesting for investors now
Standard Life Investments has invested directly in the commercial real estate in Brazil, as well as indirectly in several developing real estate markets in Asia. Institutional investors as a whole, however, have been investing less in emerging markets real estate since the global financial crisis, says Andrew Jackson, head of wholesale and listed real estate funds at the firm.
“Institutional investors are driven by the risk appetite of their clients,” Jackson says. “The global financial crisis led to a marked reduction in risk appetites, and consequently investors reduced their exposure to less transparent real estate markets in developing economies and [placed a] greater focus on their domestic real estate markets.”
But as developed markets have moved further through their cyclical recovery, investors’ risk appetites have increased. “We are witnessing a resurgence of interest in developing markets,” he says.
Some developing markets, such as Brazil and China, are facing macro-economic headwinds, but others — Mexico and Indonesia, for example — offer interesting prospects for real estate investors. “With the continued economic recovery of its main export partner, the US, Mexico is also benefiting from the introduction of a REIT regime, known locally as Fibra,” Jackson says.
“Indonesia has benefited from strong economic growth over the last few years and the recent change in political leadership is expected to lead to further economic and regulatory reforms which should lower the not-insignificant risks faced by international real estate investors.”
To be successful in emerging markets real estate, investors need to understand the risks, Jackson says. Standard Life Investments has developed a Global Real Estate Implementation Risk model, which takes account of several factors including market liquidity, corruption and ease of doing business.
Countries with lower scores require a lower risk premium. “For example, from a total of 60 countries covering the Americas, Asia Pacific, Europe and the Middle East and Africa, the model shows the UK as the least risky country and Pakistan as the most risky,” Jackson says.
• Large investors now questioning rationale for emerging markets
• Still believes investors should have exposure to the sector
Many large institutional investors are now questioning whether to invest in emerging markets real estate, after the influx of capital over the past 10 years ended with largely disappointing returns, says Bastian Wolff, head of real estate Asia at Partners Group.
“Developing countries have experienced reduced inflows after the fall in Asian and South American currencies, and amid fears of slowing economic growth and rising interest rates in developed markets,” he says.
“Many institutional investors are questioning whether to invest in emerging markets. Back in 2006 to 2009, emerging markets attracted a great deal of interest, with investors lured by high returns regardless of the level of risk involved.
“But the returns have been quite disappointing,” he says, attributing much of this to the over-investment that took place in those years.
While investors may be nursing burnt fingers, Wolff says Partners Group still believes in the “compelling” emerging markets story. He says: “One should have an emerging markets exposure. There are sustainable, strong underlying fundamentals in these emerging markets.”
These markets may grow more slowly than before and are undergoing transition, but still offer good future returns, he says.
“India and China, for example, are looking more interesting today. In some of the cities we invest, construction and therefore upcoming supply is actually lower as a result of real estate companies being squeezed. But, because of this, prices are much more reasonable allowing you to negotiate much better terms.”
Markets in these two countries also have the advantage of possessing depth, which helps investors avoid a liquidity squeeze if markets do fall, according to Wolff.
Partners Group has been using different strategies for different property sectors in emerging markets, he explains. For residential, the group at times makes use of preferred equity and debt instruments that provide downside protection, whereas, for office properties, the firm manufactures core by fixing up the assets in supply-constrained markets.
AXA Real Estate
• Capital deployment in China has become selective
• Firm looking to do deals in Poland
Investors are now noticeably more cautious in their real estate investments in some of the bigger emerging markets, observes Dennis Lopez, global CIO at AXA Real Estate.
“People are putting money into Brazil, but are probably doing that more carefully than they have been, because we are now towards the end of the cycle there,” he says. “China continues to attract capital, but this has become selective; at this point in the cycle, markets are aggressively priced and there is a lot of supply.”
Russia, on the other hand, is not highly attractive to institutional capital, Lopez says, adding that even the bigger investors are staying away from it.
This reluctance to be exposed to Russian property is not just a reaction to the trouble between it and the Ukraine, but rather a result of longer-term factors, he says.
“Within Eastern Europe, we find Poland interesting and we are looking to do some investments there,” he says. Elsewhere in the region, Lopez says the Czech Republic is interesting.
“The big key to success with emerging markets property investment is having a good local partner. Being an investor coming from another country is always a challenge.”
To operate effectively in these countries you need to know how to work relationships with the stakeholders. “In emerging markets opportunities are typically in development because they don’t have a large base of institutional-quality investment,” Lopez says.
And development can be more complicated to achieve in these countries than in developed countries, involving a lot of additional effort and risk than simply buying existing properties.
Even with a local partner, there are still many elements of construction projects that have to be negotiated and carried out, including relationships with local authorities, building permits, putting together a team as well as the physical build, he points out.
“In pre-financial-crisis days, these markets had almost universal appeal. Now timing is more important, and how you do it — as well as the type of property you choose to invest in,” says Lopez.
• Global strategy does not distinguish between developed and emerging
• Investing in Chile, Malaysia where insurance business operates
Zurich Insurance has one overall global real estate strategy, which does not distinguish between developed and emerging markets, says Alessandro Bronda, head of global real estate investment strategy.
The institution also has significant life and general insurance business operations in Chile and Malaysia. “We have balance sheets in both of these countries, and we are also invested in real estate in those areas,” he says. “We have local people on the ground there, and because of that we have the ability to source good opportunities there.”
When considering investments in any part of the world, the investment management team at Zurich Insurance looks at the same range of factors, such as market transparency, liquidity and financial stability. “These factors are not specific to emerging markets,” Bronda says.
Bronda’s view is that the Chinese residential market is experiencing a correction, with both sales and prices falling. “We’re not expecting a crash – just a re-pricing,” he says. “We think it’s important to distinguish between tier-one property – that is holding up much better – and tiers two and three.”
While the institution has no real estate investments in Eastern Europe, Bronda says Poland is probably the most interesting country in the region, with the trend towards urbanisation driving the market.
Brazil is not under consideration, he says.
When entering any new real estate markets, institutional investors need to look out for the same set of characteristics, he says. “There should be clearly defined property rights, no restriction on repatriation of assets, a good balance of supply and demand, the ability to source deals,” he says. For this, he says, an investor needs to be local or else have good local partners to work with.
Zurich Insurance currently has $12bn (€9.5) invested in real estate overall, with this exposure mostly spread across the US, UK, Switzerland, Austria, Germany, Italy, Spain, Chile and Malaysia.
The investment team is gradually increasing this exposure — a development that will continue for the foreseeable future partly because of the institution’s asset growth and partly because it is raising its relative allocation to the asset class, Bronda says.
• Few investors have taken firm steps but sector gaining attention
• ‘Quiet rotation’ in real estate markets has taken place
Emerging markets real estate is gradually winning attention from pension funds and other institutional investors, although many investors have not made firm steps into the sector, observes Paul Jayasingha, senior investment consultant at Towers Watson.
“Most of our clients haven’t materially gone into emerging markets property since 2009,” he says. “It was thought that the best risk-adjusted returns were likely to be from developed markets, because these markets in general had been so depressed post the financial crisis, so emerging markets hadn’t been a big focus for our clients.
“That said, there has now been a quiet rotation in real estate markets with more compelling arguments now for a reallocation away from markets like the US and UK, into emerging markets. So we are now looking more at emerging markets than three or four years ago.”
Jayasingha says some investors have accessed emerging markets property though a broader Asian real estate mandate. “That’s been a reasonable way to think about it,” he says. “The manager then takes the decision on whether the best returns are likely to be from China itself, or whether exposure to this market should be accessed via, say, residential in Australia, for example, in areas where Chinese investors are cash buyers.
“You can believe in the Chinese middle-class-wealth theme, but the best way of accessing that theme may well be in developed markets where the governance and the pricing are more transparent,” he says.
“In many emerging markets, institutional quality stock doesn’t exist, so you have to do development, and this is a big component of many emerging markets strategies,” Jayasingha says.
When considering development projects in these regions, he says, investors need local partners and must be very confident of those partners, making sure they are well-aligned. “In emerging markets generally, you have to be conscious of the risks of currency, fraud, and general counterparty risks,” he says.
Jayasingha emphasises the importance of timing when investing in emerging markets. He cites veteran American investor Sam Zell, who “has noted, you have to be very early or very late in emerging markets — you don’t want to be in between.”