The emerging markets real estate securities universe has grown considerably over the past decade, generating investment opportunities that have attracted not only the global real estate securities industry but also the global general equities industry. Global Real Estate Securities (GRES) managers have begun to seek investment ideas within the Emerging Markets Real Estate Securities (EMRES) universe to deliver an alpha component to their global real estate portfolios.
We would go even further and claim that there is a standalone investment opportunity using EMRES for funds-of-funds, high-net-worth individuals and institutional investors. This opportunity provides an unexploited structural growth opportunity with access to emerging markets traditionally inaccessible via private real estate funds, offering benefits from risk diversification and lower intra-market correlation.
From the end of 2004, when real estate markets started to see significant growth in the number of listed companies, to the end of April 2011, EMRES delivered an annualized price appreciation of 12.7% in US dollars (USD) as measured by the Emerging Markets FTSE EPRA NAREIT Index (FENEI ticker)1 versus a total return of 5.9% in USD for developed markets as measured by FTSE EPRA NAREIT Global Developed Index (RUGL ticker). Some investors argue that investors were not rewarded with higher risk-adjusted returns during this time period due to the higher volatility in emerging markets. We argue that the difference in volatility between emerging and developed markets has been reducing. This is confirmed by an analysis of performance between 2004 and 2011.
Weekly return data suggest that the above-mentioned returns were achieved with 30.4% annualized volatility in emerging markets and 26.1% annualized volatility in developed markets. Hence, investors were able to reap benefits of higher alpha generation in EMRES. We believe that this investment opportunity has not yet been accessed fully, and the ability to reap outsized investment returns on a risk-adjusted basis continues to exist.
This is further supported by the possible convergence of valuation multiples between developed and emerging markets. We are not calling for full convergence, given the difference in cost of capital for emerging markets companies compared to those in developed markets. We do believe, however, that gradual rerating of multiples in emerging markets to levels above their historical averages should occur, given the higher growth premiums and the imbalance of available supply and pent-up demand for real estate space in these markets. This contrasts with relatively lower growth rates and subdued demand for real estate space in the developed world.
In addition, the developed market price to earnings multiples could witness gradual retrenchment relative to their historical levels, especially as the developed world enters the tightening cycle and the developed markets’ cost of capital begins to increase.
How is investing in emerging markets different from that in developed markets?
One factor when investing in emerging markets is the challenge in accessing information and the constantly changing nature of the real estate universe in these jurisdictions. It is fair to say that the majority of real estate companies in the emerging markets listed space are nascent and have limited experience of complying with public markets requirements. However, these companies have demonstrated quick progress up the learning curve and have generally improved their level of disclosure.
Most of these companies started as family-run companies with the relatively high sponsors’ ownership stake that limits free-float of shares and liquidity for outside investors. Family ownership can be both a positive and a negative influence. It can lead to problematic situations, where managers lose focus but could equally align family and shareholder interests.
Corporate governance has often been raised as a major deterrent to investing in many emerging markets. As global investors, we would like to point out that this issue is not unique to emerging markets but is a global issue. Comfort with management teams is one of the key variables in the underwriting process, as are risk assessment and investment pipeline feasibility. In India, we have recently witnessed a series of investigations into corporate governance and applied practices in the real estate sector. Despite the fact that only a few companies were involved in the investigation process, the market correction was undifferentiated as many companies with strong management teams saw a negative impact.
We see these companies as particularly attractive investment opportunities. Within the broader emerging markets universe, a number of companies are transparent entities adhering to sustainable development programs, fostering independent boards, and contributing to social and philanthropic activities. Although we take the issue of corporate governance very seriously, we believe the overall perception of questionable corporate governance has put an unjustified stigma on the sector as a whole.
Most emerging markets companies undertake development activity that entails higher risk per se. Further, this development activity is usually concentrated in the residential sector with more than 50% of the universe heavily exposed to homebuilding, which coincides with the investment opportunity in the residential sector. Today, the number of companies with stabilized income-generating asset portfolios is fairly limited, even though many companies have been building up investment portfolios as they reinvest their gains from development activity.
The majority of these companies are not tax-efficient real estate trusts, as only a few emerging markets have real estate trust laws or similar REIT-like structures in place. For instance, Malaysia, Mexico, South Africa, Thailand, Taiwan and Turkey do have REIT structures, but many of them have limitations. Also, the number of listed entities that provide stable dividend distributions is limited.
All these factors point to the somewhat opaque nature of investing in emerging markets and need to be understood thoroughly before investing. Allocation of time and resources, an on-the-ground presence and company visits are key elements that will drive the success of investment decisions. When properly understood, the market mispricing and inefficiencies of these seemingly non-transparent entities can lead to the identification of interesting investment opportunities and excess alpha generation.
What is the correlation between emerging markets real estate securities and general equities? Do these suggest investment benefits?
Our research suggests that the degree of intra-market correlation is lower in emerging markets than in the developed world. While correlations in the developed world tend to hover around 85%, they are closer to 30-40% in the emerging world. Similarly, correlations in the EMRES relative to their domestic equity market counterparts are lower at around 70%. These figures do suggest diversification benefits from portfolio construction and asset allocation perspectives.
Can emerging markets real estate securities be accessed via general equities emerging markets funds or private equity funds?
We would argue that real estate securities are under-represented in global emerging market equity indices with only a 3% weight. Thus, general equities emerging markets funds do not do justice to investing in real estate securities. Additionally, most private equity funds only offer exposure to the bigger emerging markets like China, India or Brazil. Today, very few private equity funds offer meaningful access to what we call frontier markets, such as Chile, Indonesia, Malaysia, the Philippines and South Africa, mostly due to a lack of potential exit routes. At different points in time, investors may want to access these markets via public markets allowing benefits of diversification and a liquid exit option. We believe EMRES offer a liquid option or even a short-term access option if needed.
How have emerging markets performed in the pre-crisis and post-crisis environment?
From 2004 to 2007, when high beta investments were favored by the investor community, emerging markets outperformed developed markets three times on a risk-adjusted basis. Emerging markets delivered a cumulative return of 207% with an annualized standard deviation of 22% while developed markets delivered a 51% cumulative return with 15% volatility. Not surprisingly, emerging markets underperformed in 2008 as the lower liquidity profile, risk-off trade and fear of development exposure put downward pressure on performance.
Emerging markets sold off 64% compared to developed markets at 48%. To the surprise of many, emerging markets were the first subset of the investment universe to recover post-crisis. Chinese real estate developers started the recovery in the fourth quarter of 2008. In 2009, emerging markets witnessed a V-shaped recovery with a stunning 83% return, compared with a 38% return for the developed world.
A number of emerging markets real estate companies actually managed to surpass their previous valuation peak in 2009 and 2010. Since 2010, emerging markets lagged the developed world, delivering a 15% return in 2010 (versus 20% for developed markets) and -4% year-to-date return in 2011 (versus +8.2% for the developed world). The underperformance in the emerging markets universe is primarily due to a tightening bias as these countries began to tackle inflationary pressures and implement selective policy measures to prevent the formation of residential bubbles.
We conclude that the cycles between emerging and developed markets differ: the peak in developed markets was achieved before the peak in emerging markets. Emerging markets bottomed earlier and reached their a peak earlier. Although EMRES witnessed sharper correction, EMRES were able to recover faster. The peak to trough decline from today’s point of view has been similar, at around 20%, as the numbers below suggest.
We would also argue that sophisticated investors with global real estate portfolios should seek emerging markets portfolio inclusions due to the different timing of cycles and lower correlation benefits highlighted above.
Are there indices that offer reliable benchmarking?
From 2004 to 2008, there was no reliable emerging markets benchmark against which an investment manager’s performance could be compared. The efforts undertaken by EPRA to develop an emerging markets index have been broadly welcomed by the client, investor and consultant communities. The index was launched at the end of 2008 and the EPRA committee has since fine-tuned and improved the index. Today, EPRA’s emerging markets index is the most suitable index for benchmarking purposes, offering a range of back-tested performance series.
There are still a few issues to be resolved and we trust EPRA’s emerging markets index will be the proxy going forward. From a managerial perspective, we see three areas that could eventually be addressed. We think that the China weight is under-represented within the benchmark, which we believe EPRA will address via inclusion of H-shares. Relative to China and India, Brazil seems to be over-represented in the index at 30%, as does South Africa with a weight of around 15%.
How do we define emerging markets?
Our firm’s definition of emerging markets includes companies with a dominant presence by asset location in emerging markets, regardless of the country of listing. For practical investment purposes, we look at companies with market capitalization in excess of US$100 million. Thus, a Chinese developer listed in Hong Kong, in our view, is an emerging markets company, as is a Russian developer listed on the AIM in London. A Singapore-listed entity with over 50% of its assets located in emerging markets would also be considered an emerging markets company. This is a very pragmatic definition of the emerging markets space with a looser interpretation of the investment subset than that used by FTSE EPRA NAREIT. Hence, our investment subset is larger than the one defined by the FTSE EPRA NAREIT index. We present the investment universe below and provide a comparison to the emerging markets universe defined by the Emerging Markets FTSE EPRA NAREIT index.
Where do we see investment opportunities today?
As we head into the second half of 2011, the outlook for emerging markets real estate securities is starting to look more attractive than the outlook for developed markets, specifically within the traditional BRIC markets. We expect to see a reversal in the underperformance seen in emerging markets in the past 18 months.
The tightening cycle in emerging markets, which caused major headwinds in performance, seems to be nearing its end. However, developed markets are likely to be challenged by the ending of quantitative easing and loose monetary policy. Our risk-adjusted returns currently suggest a 1,000bps gap between emerging and developed markets, which indicates around a 20% absolute return for emerging markets. On a risk-adjusted basis, that would equate to around a 750bps spread or a 16% annualized absolute return in local currencies.
There is additional capacity for higher performance when considering potential emerging markets’ foreign exchange gains. While in 2010 our investment team was more focused on investment opportunities in frontier emerging markets, such as Indonesia, Thailand and the Philippines, in 2011 they will likely see better risk-adjusted return opportunities in the major BRIC markets. We believe that the number of players and the emerging markets landscape will continue to grow and change.
Undoubtedly, there will be regions that will outperform and underperform and the spread between the best and worst-performing emerging markets will continue to be large. Either scenario will present investment opportunities for outperformance. Unlike some sceptics, we believe that emerging markets real estate securities do not only represent higher beta, but a higher beta with outsized alpha when a selective approach is applied.
Our experience suggests that the higher beta risk can be managed with selected hedging instruments without necessarily sacrificing long-term returns. In our investment experience, the partially hedged version of emerging markets securities portfolio actually offered superior risk-adjusted returns by not necessarily sacrificing absolute returns. We view the nature of the investment opportunity described above as structural rather than cyclical.
Jana is Executive Director and Global Portfolio Manager at Forum Securities.
Previously, she covered European, Australasian and emerging markets real estate companies and spent a significant amount of her time on the ground in the US, Europe and Asia. She holds an LLM in law (summa cum laude) from Charles University’s Faculty of Law in Prague, Czech Republic. She also holds an MBA from the University of Economics in Prague, where she participated in an MA exchange program at the University of North Carolina’s Kenan-Flagler Business School and an LLM exchange program at the University of Hamburg in Germany. Sehnalova speaks seven languages.