Transactional data shows emerging nations will change the real estate landscape, both property markets and sources of capital. David Green-Morgan explains
The tag ‘emerging market' has long been associated with locations where above-average returns were possible as long as investors were prepared to take on the additional risks. Following the turn of the millennium, and as the speed of globalisation increased, the mystique around many emerging markets began to disappear as investors' knowledge improved and the performance of early adopters was recognised.
Since the onset of the global financial crisis, many cross-border investors have turned their attention to these emerging markets as a source of growth. This has increased their importance in the global commercial real estate investment market, and moved some of them (such as Poland) out of the emerging market category and into the mainstream of core investment portfolios.
Jones Lang LaSalle's (JLL) global real estate transactions database covers the period from 2003 to the present day. This period is widely accepted to be one of the most tumultuous and volatile economic periods in modern history. Huge and rapid growth followed by the inevitable bust is a story that has been repeated many times during the last 200 years. But what was different about this period for commercial property? For the first time direct investment into commercial real estate was talked about alongside equities, bonds, commodities and cash as a major investment class. This change in emphasis increased the sophistication, the structuring and the reach of commercial real estate investment, bringing markets from all across the world into the global investment sphere, some for the first time.
The importance of emerging markets has increased consistently over the past eight years. The global financial crisis had a material impact on transactional volumes globally and particularly in the US (the world's largest investment market), with falls of 72% and 87% respectively from peak to trough. However, in emerging markets the decline was only 33%. As global volumes tumbled, the share of transactional activity allocated to emerging markets increased. Between 2007 and 2011 it almost tripled from 5% to 14% of global commercial investment activity.
Much of this continued activity in emerging markets during the financial crisis was down to domestic investors, which in many instances took advantage of departing foreign investors to build up their portfolios. Emerging real estate markets have traditionally been characterised as locations with a significant amount of foreign investment once a market becomes established within investors' minds as a legitimate destination. Indeed in the run up to the global financial crisis, some markets were completely dominated by foreign buyers, who were left looking at each other when the time came to sell, with domestic investors looking for steep discounts to re-enter the market.
This anecdotal evidence is backed up by our analysis. For four consecutive years more than 50% of all transactions were undertaken by foreign buyers. The decline was stark: in 2009 foreign buyers accounted for only 15% of all transactional activity in emerging markets, a drop of almost 80% compared to the previous year, while overall transactions declined by 17%. The ratio has since recovered to stand at 27% for 2011.
So which emerging markets have been attracting the capital over the past decade and how will this change over the next 10 years? The usual suspects dominate the top three spots, with three of the BRIC nations (China, Russia and Brazil) at the top of the transactional activity standings. India is the notable exception. While having one of the largest property markets in Asia by area, the lack of transparency (Indian tier-one cities are ranked 41st out of 80 markets in the Jones Lang LaSalle Transparency index 2010) in the market, together with a fragmented ownership structure, makes it a challenging investment market for domestic and overseas buyers.
Other less well-known commercial real estate locations have grown in importance in recent times as they have improved their market transparency and have embedded international accounting and capital management standards into their internal systems, making real estate investment more attractive and easier for buyers. Emerging markets are not confined to Asia-Pacific or Latin America. Many of the markets in central and eastern Europe have benefited from membership of the European Union in the last decade. Indeed, Estonia and Lithuania now regularly appear in our transactional database.
The BRIC nations have been at the forefront of the increase in transactional activity across emerging markets, with China leading by some way. It now ranks as one of the largest markets in Asia-Pacific on a quarterly and annual basis. Russia and Brazil are equally matched, while India remains the laggard with transactional volumes below $10bn over the past eight years.
One of the features of emerging market activity in recent times has been the high concentration of foreign buyers; this has at times crowded out the domestic investors and has also led to problems for the foreign buyers when they look to dispose of assets.
While China has had the highest concentration of foreign investment over the past eight years, much of this was prevalent in the years prior to the global financial crisis. Since 2008-09, domestic investment has been a much more important aspect of the commercial property market in China. Recent research by JLL, China50, has shown that investors are also moving deeper into China's secondary and tertiary cites to tap into the growth opportunities beyond China's more familiar tier-one cities.
Transactional activity also provides investors with much greater clarity and visibility on the wider property market. LaSalle Investment Management undertakes an annual survey which values the global commercial property market at around $36trn. Of this, emerging markets make up approximately $7trn, or 19%, which is slightly ahead of their share of global transactional activity. Of the $7trn, China accounts for $2trn, while the other three BRIC nations are each around the $500bn mark. Certainly, the level of transactional activity within China enables us to put a more accurate assessment on the overall value of commercial real estate markets in emerging nations.
As well as being an important destination for cross-border capital flows, emerging nations are increasingly important sources of new capital for vendors in developed markets. Investors in emerging markets are currently seizing the opportunity to acquire prime, core commercial real estate in Europe and the US. Values in Europe and the US dropped dramatically in the wake of the financial crisis and this together with an increased number of properties available have encouraged emerging market investors to seek out opportunities. Increasingly, owners in Europe and the US are marketing their properties in emerging nations first, because they recognise that the buyer is likely to come from one of these locations.
The Middle East tops the list, with investors from Israel and the United Arab Emirates being the most prolific purchasers from emerging nations. Another trait of emerging nations is the significant role that governmental controls and changing regulations play in the movement of capital. One of the trends we have seen in recent times is for Asian pension funds to be much more active in cross-border purchasing activity. This is primarily due to the loosening of regulations in countries such as South Korea and Malaysia. Governments have realised that in order to diversify risk these funds must be able to invest in real estate outside of their home country. As such, we have seen these funds buying up some of the most high-profile and core office and retail assets globally.
Although the sources of capital are diverse, the destinations among the investors are very focused. The UK and US are a long way ahead of any other country in our analysis. Other developed and emerging markets feature but they are a long way behind the $40bn in capital that has been devoted to the UK and US.
What makes these two countries so attractive and appealing to emerging market investors? It is a mixture of hard business and softer issues. The UK and US are large, mature, liquid real estate markets with stable governments, and transparent and well-understood tax and regulatory frameworks. Investors have very clear visibility and information on the assets and when the time comes to sell they know that there will be a deep pool of buyers - so disposal is rarely an issue.
In addition, investors from emerging nations will probably at some stage in their lives have lived, worked, studied or spent significant amounts of time in the UK or the US. This makes the decision to invest much easier when you have personal experience of a country and are able to speak the language and navigate the potential pitfalls.
As the UK and US are the most popular countries for investors, their two largest cities are the most attractive for many of the reasons already mentioned. In fact, in 2011 over 60% of all purchasing activity in London was from overseas capital, demonstrating its attractiveness globally.
There is no doubt about the effects emerging market participants are having on global real estate capital flows. Whereas they were once the destination for developed market investors looking for enhanced returns, they have now also become an important source of new capital in the global real estate marketplace.
Many of these emerging markets are maturing - transparency and the quality of the real estate stock are improving, their corporate occupier base is deepening, and their financial markets are gradually becoming more liquid. These developments suggest higher investor activity both as sources and destinations of capital. And long term, new emerging markets in Africa, South America, and other locations will appear.
Given the growth outlook for the global economy, we are likely to see emerging markets become even more important in the global real estate investment market for both the increasingly sophisticated domestic investor and cross-border purchasers.
David Green-Morgan is global capital markets research director at Jones Lang LaSalle