Emerging markets play a key role in the global diversification of pension fund real estate portfolios. But investors must understand the risks. Richard Lowe reports
The emerging markets of central and eastern Europe (CEE), Asia and Latin America offer pension funds the chance to widen their range of opportunites away from the more mature markets, allowing them to target higher-risk investments and more opportunistic returns to compliment their core investment activity.
This is certainly the role of emerging markets in German institutional portfolios, according to Bernd Kreuter, head of alternative investments at Feri Institutional Advisors. "It is the growth component and the opportunistic component," he says."In the emerging markets you have more opportunistic strategies, such as development in Asia and Latin America.
"A combination of drivers are behind the motivation for investing in these markets. These are: to increase the regional diversification of a portfolio; to widen the range of opportunities; and to tap into the potential for higher returns.
"A lot of investors around the world are looking internationally to try to get more diversification and a bigger opportunity set and a bigger range of markets," says John Buckley, property economist at Morley Fund Management. "As part of that internationalisation, emerging markets have become an increasing focus for investors."
Buckley believes the emerging markets that are currently of most interest are those with the greatest potential: the so-called BRIC countries - Brazil, Russia, India and China - as well as Mexico and Turkey.
Tim Bellman, global head of research and strategy at ING Real Estate Investment Management, says he is seeing a great deal of interest in emerging markets from institutional investors of all types, including European pension funds. The principal geographical emphasis for global investors remains Asia, although European investors will probably look at CEE first. However, coming up fast behind these two regions is Latin America, particularly Brazil.
There is perhaps a growing logic for large investors to seek an exposure to the BRIC countries. "If you look at it over the long term, it is quite convenient that the four largest emerging markets - the BRICs - are as geographically dispersed as they are."
China and India are located on the same continent, but two very different parts of Asia. Russia is straddling both Europe and Asia, while Brazil is situated on an entirely separate continent.
"You also have differences in the drivers of the performance of those emerging markets," Bellman says. "China with its manufacturing strength, India with its strength in services, Brazil and Russia with their strength in commodities. So you have diverse economic drivers as well."
However, Herman Gelauff of the international real estate research team at MN Services, which advises Dutch pension funds, sees the likes of Brazil and Russia as presenting investors with different challenges to the markets in Asia. First, pension funds are invariably invested in the latter on a pan-Asian basis and are more likely to have a higher allocation to the less risky, more mature markets. Investments in Russia and Brazil on the other hand entail taking on country-specific risk, which is inevitably more concentrated than, say, a pan-Asian fund.
Gelauff also points to the high market risk in Russia, with high volumes of capital chasing deals at the moment, coupled with the specific political risk that comes with investing in the country. For Latin America, on the other hand, he says the track record of managers and exit strategies has become even more of an issue.Buckley says it is typical for institutional investors to have concentrated most of their Asian exposure in the more mature economies like Hong Kong, Singapore and Japan, and then begin building up more modest investments to China and India.
"Markets like China and India are still relatively small allocations," he says. "India really only opened up to foreign investors in 2005, so it is relatively immature. It is difficult to get a lot of capital deployed into those markets. The due diligence is considerable and the risks are greater."
He adds: "The majority of our investments are still going into the more developed Asian countries and the emerging countries are a smaller allocation, and I suspect that is reasonably typical for institutional-type investors."
Indeed, the €13bn Danish pension fund Kommunernes Pensionsforsikring (KP) has invested in three emerging market regions of CEE, Asia and Latin America. It was one of the first institutional investors in Denmark to enter into Asia three to four years ago, investing initially in the more mature markets of Singapore, Malaysia and Japan.
Recently it has invested in a pan-Asian vehicle that will include a small exposure to China. It has also has built up an exposure to office and retail markets in Poland, Hungary, Czech Republic and Slovakia, and made its first and only investment in Latin America when it committed to a Mexican logistics fund run by Prologis (KP was already invested in Prologis' European fund).
And a number of global funds have been launched or are in the process of being established by asset managers. These invariably include an exposure to emerging markets in CEE, Asia and possibly even Latin America. ING Real Estate Select's recently launched Global Osiris Fund, which has received £150m (€186m) seed investment from the London Pension Fund Authority in the UK, is targeting all three.
"We are really interested in the emerging South American markets," says Damien Smith, fund manager for the Global Osiris vehicle. He adds that the fund will invest in markets across the risk spectrum, including China and India."We have an allocation to high-risk markets," he says. "We think a number of those markets are still interesting for destinations of capital."
Fundamentally, pension funds are relatively risk-averse investors and are under pressure to demonstrate thorough due diligence when it comes to investing their members' capital. And so emerging markets represent a challenge - they offer diversification benefits and the potential for higher returns, but necessitate taking on greater risks.
Finding the right balance between these two drivers appears to be key.
"To do something that is much further away from your domestic market you really need to be much more comfortable with the investment idea," says Steven Grahame, senior investment consultant, manager research at Watson Wyatt. "Brazil and Russia have become topical. But just as they play it for the economic development, there are the political risks.
A product manufacturer might see economic growth, economic development; an investor might see political risk. So investors are trying to assess where it meets their diversity and return-seeking requirements."One of the biggest issues for pension funds is that taking on the added risk of emerging markets - be it development risk, currency risk or political risk - does not automatically guarantee higher returns.
Bellman says this is a point that many investors find difficult to swallow. "It is just as true of emerging markets as it is of developed markets - that local capital will dominate the capital market and will effectively price the asset," he says. "Any investor going into these markets thinking there is a shortage of capital for real estate investments has been badly advised."Bellman adds that any shortage of capital will be by design, such as in China where the government is attempting to cool its real estate markets by tightening foreign investment regulations.
"But an international investor is unlikely to automatically find investment returns that are significantly greater than they might achieve at home," he says. "You can achieve that, but you can't do it by simply buying the market. It has to be done with carefully selected local advisers, a local presence and an understanding of where the opportunities are in that market. It will not automatically generate those returns for you."
Grahame adds that there are a lot of investment managers in the market talking "the economic growth story" of emerging markets - in other words, high GDP growth from a low base driving the investment returns of a real estate market, such as the creation of new jobs and the subsequent demand for new space this brings about.
"You access real estate because you believe the returns are going to improve and be superior than elsewhere.
That is an economic growth story and we see a lot of investment managers talking that story in terms of periods of buying and selling and finding new regions and areas to invest," he says. "When you start talking about emerging markets, you've got the economic growth, which has been quite extraordinarily high, but you also have the economic development that is coming from a low base. We are seeing people recognising that you can capture that from real estate investments."
But pension funds can look at emerging markets from a multi-asset perspective.
Real estate is fundamentally a lumpy and illiquid asset class and entails taking on asset-specific risk, whether it is held directly, in an unlisted fund or even in a derivative exposure. Grahame believes this is an important point to remember when extolling the virtues of new property markets. An institution may prefer to capture the economic growth of Brazil through more liquid equities or even through alternative managers, such as hedge fund or private equity managers.
"Our clients are not necessarily confined to just thinking about the ways of being able to access the myriad of global opportunities just in real estate. They are thinking about it in a portfolio context," Grahame says. "There might be better approaches and it might not be directly through real estate."
A more recent development that is complicating the issue of assessing emerging markets is the advent of distressed opportunities in the more mature Western markets. Global opportunity funds are certainly eyeing the UK and US markets for distressed sellers and assets when in the recent past they were more exclusively focused on emerging markets.
This point was discussed at the Real Estate Investment World conference in Singapore in June this year, when Richard Croft, chief executive officer of GPT Halverton, questioned whether European pension fund commitment to Asia Pacific would continue to be as strong as it had been in recent years. Distressed opportunities in the UK, Europe and the US would slow down institutional capital flows to the emerging markets. In one sense, he said, the UK is more like an emerging market than China currently is.
It is interesting to note that the KP pension fund will be taking a step back from any further emerging market investments in the near future in favour of concentrating on opportunities in the US real estate market.
Once it has completed the due diligence for one more pan-Asia fund, KP will not be looking to increase its exposure in the region, explains Henrik Kolind, head of real estate investments at Sampension, the wholly owned asset management arm of KP. In fact, Kolind will not be focusing on other emerging markets after this, including further investments in Latin America, but rather will be concentrating on assessing funds offering exposure to the US and infrastructure, respectively.
"We have now allocated around 10% of our total property investments to Asia and have decided only to do one more, which we are doing the due diligence for now," he says. "If that happens we will say we have a good diversification in Asia and we will look into the US property market in 2008-9."
It is also interesting that when Denmark's largest pension fund ATP made its first real estate investments outside Europe this year, it identified the US as the target market and not Asia Pacific.
Furthermore, Norway's largest privately owned life and pension insurance company Vital Forsikring has decided to steer clear of Asia for time being in favour of investing in the US as a diversifier from Europe. Stein Berge Monsen, senior portfolio manager at Vital Eiendom, which manages Vital's real estate investments, reveals that the institution is avoiding emerging real estate markets at the moment.
He is sceptical of investing in Asia and China and is avoiding Eastern Europe too, which he believes is often over-valued. "These days it seems to be not so good timing," he says. "We try to avoid it. We are looking at United States at the moment."