The Risks & Benefits of Investing in Emerging Markets

By: Jim Kean, Managing Director, Chief Investment Officer
       Mike Myatt, Executive Managing Director

Over the past 20 years, the commercial real estate market in the United States has developed a depth and sophistication that is beginning to approach the maturity and efficiency of alternate asset categories. Improved market efficiencies coupled with today’s surplus of capital flow have created the most competitive commercial real estate market environment in recent history. The confluence of these macro economic trends and current market conditions have created a reduction in the total investment returns that can be achieved on investments in U.S. commercial real estate assets.

Given the surplus capital flow and the fact that commercial real estate as an asset class offers many advantages over other investment alternatives, asset/investment managers will not be able to disinvest themselves from real estate allocations, rather they will simply begin to look around for other higher growth markets that will allow them to maintain yield. Emerging Markets in Eastern Europe, India, Latin America, China, and the rest of Asia present scenarios for higher growth, even on a risk adjusted basis. On an aggregate basis the statistics are impressive. For example, currently 80% of the world’s population accounts for 20% of world GDP. By 2015, 50% of world GDP will be accounted for by Emerging Markets.1 Consider the following:

• Rising Economies: Over the past decade, the twin drivers of expanding world trade as well as a more globalized production system have permitted a number of Emerging Markets to experience the highest GDP rates in the world. China has routinely experienced 8-9% annualized growth and India has followed closely with 7% annualized.
• Demographics: For the most part, Emerging Markets represent younger populations, growing numbers of well-educated professionals, an expanding middle class, growing consumer bases, urbanization, and rising incomes. In addition, the structure of family life for these modern middle class populations is assuming the “western” nuclear form and moving away from the more traditional extended cohabitating family unit.
• Commercial Demand: The economic expansion as well as the presence of global companies that bring employment oriented around intellectual capital is creating demand for modern, western style, commercial real estate infrastructure. Core assets such as office, industrial, retail, multifamily and hospitality are all experiencing rising demand.
• Residential Demand: One of the biggest exports the U.S. has had over the past twenty years has been culture and lifestyle. As the successful Emerging Market economies undergo the demographic shifts described above, demand for western style single family residences as well as modern multifamily is experiencing explosive growth. An example of this is in India. Investments of more than $25 billion USD will be required in the next 5 years to fulfill an expected shortfall of 22.7 million housing units.2
• Closed Market Systems Opening Up: Most successful Emerging Markets have been engaged in systematic reform of basic societal values we take for granted in the developed world. These include property rights, legal process, published regulations and statues, methods to ascertain and certify real property rights, etc… In addition, specific reforms such as privatization of state owned industry, relaxation of capital controls, and liberalization of rules regarding Foreign Direct Investment (FDI) are all encouraging growth and investment.

All of the factors described above play into a developing long run scenario where opportunities exist for the real estate investor interested in global real estate opportunities and higher returns. All of the asset categories we are familiar with in the U.S. market will be in demand within these developing economies. As well, with this demand for modern real estate built to developed world standards and quality will be a concurrent need for all of the ancillary services required to maintain a modern real estate infrastructure. Site selection, construction and property management, financing – all services will be in demand.

For all of the optimism surrounding the macro and micro economic trends driving the globalization of commercial real estate, investors wishing to approach emerging markets should rightly do so with some degree of caution. Some of the more common risks of investing in emerging markets include:

• Political risk: The process of modernizing the economies and systems of emerging markets does not represent a steady or predictable process. Many of these countries have experienced situations of two steps forward and one step back. Most of the setbacks are greatly influenced by political developments that at times represent backlash against western ways.
• Legal and regulatory transparency: Every country has a system for governing property rights and development. It goes without saying that an improper appreciation for how these systems work within a specific country could have a severe impact on investment returns.
• Property rights: In the U.S., title companies provide a very systematic, quickly researched method for determining legal descriptions of property as well as what constitutes a claim on the subject property. Things are not nearly as straight-forward in an emerging market. For example, in Panama, even after a local real estate attorney researches a property, “squatters” can step forward and file a legal claim of historical residency rights to the property. Many of the emerging markets have long running histories and complex, difficult to resolve boundary situations. An absence of a central database of titles and property deeds may also add confusion to the issue of who owns what.
• Lack of professional real estate skills: emerging markets are fragmented and lack the professional services a developed world investor may take for granted. Finding real estate professionals with the requisite skills to participate in a real estate transaction may be challenging.
• Operational and logistical concerns: maintaining offshore investments in commercial real estate can add to the complexity of operational and logistical efficiencies. Time zone issues alone can cause a burden to operational efficiency. Property and asset management, financing, and many other normal operational and logistical considerations cannot just be taken for granted.
• Liquidity concerns: Lack of central databases as well as public records of transactions means that there is a deficiency of market pricing information to make comparisons as well as drive transactions. Reduced market transparency also means that transactions take longer to close. Word of mouth selling methods because of a lack of a database driven listing service impedes transactions and liquidity.
• Infrastructure: In the U.S., there is an assumption of basic infrastructure as structured and mandated by an organized governmental authority. While there may be complaints within our system regarding the process developers may need to go through regarding sewer, power grid, water systems, traffic planning, clean air, parks, environmental issues, etc… in many cases rules governing infrastructure and who is responsible for it barely exist in these countries. A real estate investor and/or developer may end up assuming the development and capital needs for all the basic infrastructure usually provided by a more developed society.
• Zoning and impairment: Every market has a different approach to what the owners of properties around your property may or may not do. In many of these environments, little or no zoning exists. The risk of someone engaging in development detrimental to the value of your property is very real.
• Capital Controls: When confronting the issue of repatriating capital from a successful real estate investment, there is a real danger of not being able to extract capital and/or profits from the Emerging Market. For example, China has been known to impose “profit taxes” when foreign interests are trying to bring capital home from the sale of a property. Argentina currently requires the creation of a one year capital account in the amount of 30% of invested capital for every FDI in the country, which will be held by the Argentine government during the period of the investment. While the present situation has the government treating this capital well, in 2002 during the currency crisis, the government ended up seizing a number of large cash accounts.
• Currency Risks: Let’s say U.S. investor is taking dollars and purchasing an Indian property denominated in rupees. Two years later the property sells and you record a big profit. However, if you did not hedge the currency, you risk recording a loss or at least a reduced profit because of exchange differences. In the past five years alternatives for country specific currency hedging have become much more affordable but it still is a risk factor that needs to be addressed.

While all of the above risks (and more) can be present in emerging markets investments, these risk factors can be successfully managed by engaging the appropriate professional advisor. Entering an emerging market without an experienced country specific advisor in tow can cause at best project inefficiencies such as time delays and at worst total loss of investment. When considering the development of an emerging markets strategy, best practices would suggest that engaging a global commercial real estate investment bank with a local point of presence would assuage many of the concerns listed above.   

In summary, the opportunity to get involved on the ground floor of the growth markets in commercial real estate over the next twenty years is available. Undergoing the effort now to learn and understand how investments work in emerging markets will pay dividends for the persistent, patient, long run investor. If an emerging markets investment strategy is selected by an investor group, it is critical that a country specific set of risks is established and subsequently addressed to protect investor capital and returns. A successful strategy will involve selecting a set of advisors who can help a new investor navigate the maze of issues present in each geographic area.

For more information on investing in emerging markets, please contact commercial real estate lender Pacific Security Capital at www.pacificsecuritycapital.com or call 1-800-844-6085