For limited partners around the world, the quest for higher returns and greater diversification is prompting them to lesserexplored territories. And the emerging markets of Asia have been fertile ground for LPs seeking to open up allocations to the emerging markets.
In the past year, both CalPERS and CalSTRS – the largest public pensions in the US – have made moves toward incorporating emerging markets as part of their real estate investment programme. At its August investment committee meeting, the California Public Employees' Retirement System (CalPERS) laid out the groundwork for its emerging markets strategy. According to the $223 billion pension, its long-term strategy should include increasing allocations to international markets, and particularly the emerging markets. The public pension's advisers argue countries such as China, India and Brazil are “huge markets of high interest”. By September, the pension fund had agreed to divide the $23.6 billion real estate pot into developed markets, emerging markets and frontier markets, as well as creating ranges and limitations for real estate investments in the three areas. Up to 20 percent of that “pot” could be targeted at emerging markets over the next decade.
The emerging market fever though has also caught hold at CalPERS' neighbour – the California State Teachers' Retirement System (CalSTRS). The $162 billion public pension invests in the emerging markets through its real estate portfolio, and further, adds a spokesperson for the pension, plans to continue to invest in those markets. It recently shifted from an “active/ passive mandate” to “100 percent external active managers in emerging markets”, according to the pension's annual investment business plan for 2008-09.
“Institutional investors are searching for ‘alpha’ in order to achieve returns that exceed their actuarial requirements,” says Bob Weaver, managing director and head of Morgan Stanley's real estate private equity placement group. “One way to do that [achieve alpha] is to identify top-notch managers in high-growth markets, such as China, Brazil, India and Eastern Europe.”
In Europe, LPs are already investing in the emerging markets. And in particular, the Asian economies have been at the top of the list as limited partners seek greater returns and increased diversification.
“We definitely see an increase in investors' interest in the emerging markets,” says Lisette van Doorn, chief executive officer of INREV, the European Association for Investors in Nonlisted Real Estate Vehicles. “We see it as being part of their move toward more opportunistic investments.” Also at play is the focus by pension funds and other limited partners on portfolio diversification, although returns are still the overarching factor: “If you look at what attracts them in those markets, it's returns and diversification – but to a large extent it's higher returns.”
As it becomes increasingly difficult to get “interesting” returns in mature countries, many investors start to look further afield. Bart Coenraads, head of real estate at Amsterdam-based Fortis Investments, says that with yields squeezed and rents already moving up, returns forecast in mature markets over the coming years will be quite low, pushing some LPs to seek opportunistic returns in the more emerging markets.
In its 2008-09 investment business plan, CalSTRS argues the emerging markets are still “enjoying high growth rates” especially with regard to China and Latin American countries, while some non-US developed markets are facing both inflationary and growth challenges.
In Asia, China has emerged as the emerging market where institutional demand is highest. In addition to its growing middle class and the urbanisation of the country, China is also relatively more transparent when compared to countries such as India and Russia. “China is without question a leader as it relates to demand from institutional investors,” says Weaver. India received considerable interest over the last few years, he adds, although it has begun to cool down as infrastructure support concerns get more attention and land prices continue to be highly volatile.
A large number of European LPs have already made commitments to Asia, says Van Doorn, with many fund of funds managers (originally European-based ones) also setting up Asia-focused funds.
In INREV's latest survey of institutional investors, fund managers and fund of funds managers, the pan-European body found that institutional investors invested on average 9.6 percent in real estate of which 37.8 percent was allocated to Asian real estate. However investors questioned in the Investment Intentions Asia Survey 2008 said they intended to increase real estate allocations to 12.2 percent and the amount allocated to Asian real estate to 39.3 percent of their total real estate allocation.
The survey, which included some respondents from the US and Asia, also revealed that close to 80 percent of respondents expected to increase their allocation to Asian real estate over the next three to five years. Specifically, the Japanese office sector was the top pick for all investors surveyed, with China's residential sector in second place. Other Asian markets of interest were India and Vietnam, particularly the residential markets of both countries (see chart).
Proprietary data from PERE magazine shows the number of private equity real estate funds targeting Asia and the rest of the world has grown significantly in the past year alone. By October 2008, 28 percent of all funds closed were focused on Asia and the rest of the world, compared to just 13 percent at the same time in 2007. The number of funds currently in market trying to raise capital to invest in Asia and the rest of the world was 24 percent by October 2008 – compared to 13 percent for the same period last year.
Firms such as Singapore-based AEW and Chicago's LaSalle Investment Management have already closed funds targeting the Asia market this year, with AEW raising $350 million for its AEW Value Investors Asia fund, and LaSalle closing on $3 billion for its LaSalle Asia Opportunity Fund III.
Just last month, Merrill Lynch closed the Merrill Lynch Asian Real Estate Opportunity Fund on $2.7 billion, a fund, it said, would focus primarily on Japan, China, South Korea and India. A report by New York-based real estate fund of funds, Clerestory Capital Partners, released in June, also confirmed Asia as the major investment destination for property investors. Of the $54 billion being targeted by small cap opportunistic real estate funds (those targeting less than $1 billion) during the first quarter of 2008, $22 billion was being raised for real estate in Asia, compared to $19 billion for the Americas and $11 billion for Europe.
And when it comes to fund of funds, the outlook is again slanted towards emerging markets.
By October this year, more than half the fund of funds currently in market, according to PERE magazine data, are targeting the emerging markets or a global strategy.
The supply of commercial real estate in the emerging markets also speaks volumes for the scale of the investment opportunity. Based on research by Morgan Stanley, among the BRIC countries China has the largest supply of commercial real estate with approximately $1 trillion as of 2007. By contrast, Brazil, Russia and India have approximately $374 billion, $465 billion, and $317 billion respectively. Commercial real estate in China has also benefited from relatively higher level of securitization.
When deciding on investing in emerging markets though, there is also the trial of choosing an appropriate fund manager for the job.
One way that limited partners have been going about choosing emerging markets fund managers is to invest with a fund of funds manager, says Van Doorn. Going the fund of funds route is the quickest way for LPs to acquire knowledge on these markets, she says. Through the fund of funds manager, they are able to learn who the local players are, as well as become more familiar with the local market and what returns they can expect. And then in the second phase, says Van Doorn, they go themselves.
Still other limited partners choose to go with a fund manager they already know: “We've seen all the major European fund managers, the well-known names: AEW, ING, Morgan Stanley, you name it – they've also set up a business in Asia as well. What's really important to investors is having that local network, local presence and local track record.”
According to Claiborne Johnston, executive director at Morgan Stanley, many investors received their exposure to emerging markets through allocations to global property funds which over the past five years have begun to invest a portion of their equity into the emerging markets. Exposure to emerging markets through these funds has served as the basis upon which many investors have begun to build both their direct and indirect allocations to these property markets.
It is important for LPs to see that fund managers have people on the ground as there is such a lack of information on these markets. “We will never invest in a manager that is coming out of London and trying to do investments in Turkey for instance,” says Coenraads. “It doesn't make sense. You have to be local.”
More importantly, proper due diligence is critical for emerging markets investments. And just as it is more difficult given the limited information available, it is also more time-intensive. With investments in mature countries, investors are able to look at real estate indices, at the cycles, and also the correlation between some of the markets, says Coenraads. New markets, however, require that investors dig deeply into whether regulations are in place to invest as a foreign investor, and also that there is not too much flexibility or change in the regulation. Another pitfall facing investors is the tax risk and legal risk. It is an additional layer of risk that they have to add on on top of their investment decision, says Coenraads.
Furthermore, by its very nature, real estate is not a liquid asset class, entailing greater caution when investing in emerging markets. “Private real estate is an asset class where you cannot sell your shares, you cannot sell the bonds,” says Jack Foster, managing director and head of real estate at Franklin Templeton Real Estate Advisors. “It is an asset class where you need a true and stable rule of law in countries to maintain your ownership and clear title.”
It is something that likely keeps LPs up at night. INREV's Asia survey showed that the lack of transparency in some of the emerging Asian markets was an important concern for investors.
Ultimately, it is all about risk, adds Coenraads. Investors have to carefully identify the risk involved in emerging market investments, especially given the difficulty at times to really assess the kind of risks inherent to investing in these markets. Especially with countries like Vietnam, but also countries like Russia and Thailand – where there is huge political risk involved – and in Vietnam, economic risk as well. There is generally a herd mentality to rush to certain markets, he says, and it is crucial to really have your own top down view.
“When we look at the opportunities and we talk about some of these emerging markets, it's not just the emerging market aspect of it,” says Foster. “It's the whole dynamic of the quality of the manager; the legal structure of the country; the structure of the fund; the taxation. It's really a multifaceted approach in terms of investing in a real estate fund.”
For real estate GPs, the increased interest among pension funds, insurance companies and other limited partners in emerging market countries has fuelled robust fundraising, although recent events may cloud the environment in the coming months. Funds focusing on countries such as China, India and Latin American markets, such as Brazil, have proliferated in recent years.
“Over the last several years, the number of property funds dedicated to the emerging markets has grown substantially,” says Weaver. “And similarly, the number of investors underwriting these markets has never been higher. I believe investor demand is growing and as a result there will continue to be a proliferation of managers seeking to capitalize on opportunities in these markets.”
In Asia, China has emerged as a clear favourite among investors. “China would be my number one choice,” says Coenraads. But he adds that “you have to be very very careful about investment strategy and structuring investments” in the country.
There has been a rush to countries such as India and China, says Glenn U'ren, managing director at Franklin Templeton Real Estate Advisors. “We see that in the number of planeloads of investors flying to those countries,” he says. “We also see it reflected in the number of funds being offered in those countries.”
Still, the recent tumultuous events in the US and global financial markets have put a damper on real estate investing generally, which could also have effects on investments in the emerging markets. At the moment investors are waiting to see what the impact will be, and meanwhile LPs will likely look twice before raising allocations to emerging markets, says Coenraads.
But the beckoning arm of the emerging markets – home to potentially higher returns at the price of higher risk – will be hard for any limited partner, whether in the US or Europe, to ignore. Emerging market fever will likely live on. As CalSTRS stated in its latest annual investment report – it planned to charge ahead with “more global investments”, and a “greater footprint in the emerging economies of the world.”