Friday Letter The sound of money

The North American Free Trade Agreement (NAFTA), which liberalized trade restrictions among Canada, Mexico and the US, went into effect on January 1, 1994 despite fierce opposition from American labour unions, Mexican farmers, Zapatista revolutionaries and an outspoken US presidential candidate—Texas billionaire Ross Perot infamously remarked that NAFTA would create a “giant sucking sound” as American jobs were lost to cheaper labour south of the border. More than a decade later, it seems those anxieties were misplaced. Domestic workers had much more to fear from the Far East than they ever did from Mexico.

Yet as India and China have replaced Mexico as the whipping boy of displaced American labourers, Mexico has, in turn, increasingly come to resemble its Asian counterparts: impressive economic growth, a burgeoning middle class and a friendly, pro-business government. And, for US investors, it all comes without the jet lag.

Predictably, Mexico’s economic emergence has attracted a number of well-established real estate investors including Equity International, Black Creek Group, Prudential and Hines.

Although private equity real estate activity has focused on a variety of property sectors, from retail to industrial to residential, one area that is drawing a significant amount of interest these days is hospitality. According to the consulting firm Deloitte & Touche, direct investment in the Mexican hospitality sector grew by 39 percent in 2004, 19 percent in 2005 and 13 percent in the first six months of 2006, totaling $11.6 billion of direct investment over the past five years.

According to Mauricio Monroy, a Tijuana-based partner at Deloitte & Touche, approximately 80 percent of the increase in 2005 came from Mexican investors. By contrast, domestic players only accounted for five percent of the growth in the first half of 2006.

Over the past two to three years, Monroy notes, the Mexican government has enacted legislation to encourage foreign direct investment in the hospitality sector and beyond, including the extension of tax holidays for hotel developers and the elimination of VAT on the construction and sale of home units. Equally important has been increased access to leverage, particularly the rise of peso-denominated debt financing, which allows foreign investors to reduce their currency risk. And Monroy notes that US title insurance companies, driven by the influx of investors in beachfront and resort properties, have significantly expanded their presence in Mexico.

At the same time, the development of the Mexican stock market has provided exit opportunities. In 2004, for example, Homex, a Mexican homebuilder funded by Equity International, went public on the New York Stock Exchange and the Mexican Bolsa—a secondary offering followed earlier this year. The liquidity of the stock market will likely be enhanced as Mexican REITs, known as FIBRAs, become established. (Though legislation was enacted in 2004, no FIBRAs have yet launched, though Monroy points out that several are in the works).

Despite these advancements, however, opportunistic investors in Mexico face the same problem they do in other markets around the world, developing or otherwise: there is too much capital. Gary Garrabrant, the chief executive officer of Equity International, puts it, Mexico is now “de rigueur” for real estate investors.

As the world’s largest private equity firms push into the far corners of the world, interest in Mexico is likely to accelerate, competition is likely to intensify and the ability to generate above-market returns will undoubtedly become more difficult.

American jobs may not be fleeing south of the border, but institutional capital certainly is. The only question now is whether it can find its way back.