FEATURE: Mexican evolution

To say that times have changed in Mexican real estate is an understatement, as investment vehicles and new capital sources that weren’t available five years ago now have become dominating forces in the market. With the public markets attracting the bulk of real estate capital in Mexico, however, the country’s private real estate industry has been largely missing out on much of the action to date. 

One of the most sweeping changes to Mexico’s property sector in recent years has been the evolution of its capital markets. Following the 2004 passage of federal legislation to allow the creation of publicly-traded real estate investment trusts, the new law finally was adopted on the state, county and municipal levels in 2011, leading to the creation of the first fideicomiso de inversiones en bienes raices (Fibra) that year. 

Also that same year, Mexico amended regulations affecting listed private equity funds, known locally as certificados de capital de desarrollo (CKDs), to allow for a capital-call structure and to increase the maximum amount of capital that a single investor may contribute to the vehicle. With such an issuance, Mexico’s pension plans, which currently are not permitted to invest in private vehicles, buy the certificates when they list on the Mexican Stock Exchange and retain them until expiration as they not ‘traded’ on the exchange like the shares of public companies. While regulations allow for CKD issuance in any industry, the majority so far have targeted the real estate sector. 
“The fact that there is a public market for income-producing real estate is completely transformative in terms of the landscape,” says Brian Finerty, senior vice president and co-lead of investments at Equity International. “When you have a clear path to liquidity at the onset of an investment, it changes your view on the investment.”

Indeed, Mexico has received the lion’s share of real estate capital raised through the public markets in Latin America, having attracted $2.6 billion of equity at the end of the first quarter – an amount that already exceeds the total for all of 2012, according to Prudential Real Estate Investors (PREI), which has raised and invested capital through both a Fibra and CKD. The Latin American nation also is expected to continue dominating capital-raising this year, with at least five Fibras anticipated to launch during the second half of 2013 and an equal number of CKDs scheduled to go public later this year, the firm notes.

Local liquidity

Much of the capital in both Fibras and CKDs is coming from Mexico’s local pension plans, or Afores, which began investing in real estate through CKDs in 2009. As of March, the pension plans were managing more than $152 billion in assets, of which up to 12 percent may be allocated to CKDs, according to PREI. Such vehicles had issued Mx $62.58 billion ($4.88 billion) at the end of the first quarter, with real estate accounting for 37.3 percent, or Mx $23.35 billion, of that amount.
“Before, we used to depend on foreign capital,” says Gregorio Schneider, managing partner and chief investment officer of Terranum Capital. With Afores now active investors in real estate, “that completely changes the dynamic, the risk profile.” 

Local investors, after all, provide assurance for international investors, as was the case with Terra-
num’s debut real estate fund. The backing of local pension plans helped to attract foreign capital to the vehicle, which held a final close on $235 million in equity in June. “As a foreigner, I would trust a local more than anyone else,” Schneider says. “The local endorsement is very powerful.”

To date, Afores have contributed approximately 90 percent of the capital in CKDs and a significant share of the capital in Fibras, according to Francisco Andragnes, head of real estate at Compass Group, an investment advisor specializing in Latin American investments. Together, both local and foreign investors “have generated more transaction activity in terms of assets trading in the last 18 months than the previous five years put together,” he adds. 

Indeed, some $2.8 billion of real estate transactions in Latin America were completed during the first six months of the year, of which nearly two-thirds occurred in Mexico, according to PREI. In contrast, the country accounted for only 27 percent of transaction volume in the region during the previous year.

Re-entry, expansion in Mexico 

The robust transaction activity has contributed to the compression of yields on income-producing properties as acquisition capitalization rates have fallen from 9.5 percent two years ago to below 8 percent in some cases. “I think that’s a permanent change in the market,” says Finerty. 

Moreover, the spread between the acquisition cap rates on stabilized properties and development yields currently is between 200 to 300 basis points, Finerty estimates. “You’re able to get a return on your capital that is justifiable for the risk that you’re taking, and I don’t think that’s been the case in Mexico for many years,” he adds. 

Some significant private equity real estate exits that yielded strong returns over the past 18 months include Walton Street Capital’s sale of all of its industrial assets from its first 
Mexico-focused fund, Walton Street Mexico Fund I, to Fibra Uno in August and the sale of 49 shopping centers by Mexico Retail Properties (MRP) to Fibra Uno in July. The latter deal, which was the largest property transaction in the history of the Mexican real estate market, involved properties that MRP initially acquired through three of its institutional real estate funds.  

Given this enhanced risk-return profile in the property sector, Equity International is preparing to return to Mexico’s real estate market after a five-year absence. The Chicago-based firm made a handful of investments in portfolio companies such as Corporate Properties of America and MRP during the late 1990s to early 2000s, but it had exited those transactions by 2008 amid significant compression in development yields and greater competition. As of press time, the firm was in the final stages of closing a new investment in Mexico, its first in the country in five years.
Meanwhile, the exits offered by Fibras and CKDs have encouraged Terranum to expand its property investments in Mexico beyond the self-liquidating strategy of for-sale residential. “We’re considering a lot of mixed-use projects,” says Schneider, who anticipates reaching an agreement on its first such venture by the end of the year. “Before, we only used to look at the housing side, but now we’ll look at residential with a component of office or retail.”

Lack of private capital

Outside of the public markets, however, “there hasn’t been a lot of new capital that has been deployed in Mexico,” says Finerty. “I think it’s coming, I just don’t think you’ve seen it significantly yet.” 

Finerty expects that, as firms exit their investments to Fibras or CKDs, some of the original investors may redeploy the capital returned to them back into Mexico. Such investors could include the Government of Singapore Investment Corporation, which had acquired Equity International’s stake in Mexico Retail Properties in 2008, and US pension plans such as the Arizona Public Safety Personnel Retirement System and the Chicago Teachers’ Pension Fund, which were limited partners in Walton Street Mexico Fund I. 

Even though prospects in Mexico have improved, some US investors aren’t ready to step up their investments in the country just yet. The Oregon Public Employees’ Retirement Fund (OPERF), for example, doesn’t have any immediate plans to deploy new real estate capital in Mexico, where it currently has invested $100 million in Clarion Partners’ Lion Mexico Fund. 

“Conceptually, I do think the Fibras and CKDs give an investor additional exit opportunities and perhaps competitive pricing for stabilized assets,” says Anthony Breault, senior real estate investment officer at the Oregon State Treasury, which overseas OPERF. “This is certainly a consideration when underwriting continued exposure to Latin America and Mexico.”

Breault anticipates that OPERF’s primary real estate focus will remain on the US for the time being. He adds that he would need to see more data supporting the premise that US investors can receive appropriate risk-adjusted returns for the country and currency risk involved with investing in Mexico, relative to investing domestically. 

“It is my opinion that Mexico is trending in the right direction for further consideration,” Breault says. “But I am comfortable giving it more time to mature and hopefully viewing more transaction volume and trades for stabilized real estate product to prove out the idea of improved liquidity.”

Private obstacles

US and other foreign investors, however, will find heightened competition in the Mexican real estate market from the Afores because of the number of public vehicles that are targeting the capital of local pension plans, says Finerty. In contrast to their activity in the country’s public real estate market, “international capital has shown significant interest, but maybe not on the scale yet committed to the private real estate market.” 

Part of the challenge is the availability of private real estate investment opportunities, particularly for smaller investors. “Mexico offers a lot of opportunity,” says Jeffrey Sobczynski, managing partner at Accord Group, a San Francisco-based multi-manager focused on emerging investment strategies. “The difficulty is in gaining access.” 

While managers such as Paladin Realty Partners and Terranum are raising or have raised real estate funds with pan-Latin American strategies, many of the sponsors that previously raised traditional private equity real estate funds dedicated to Mexico currently are not pursuing such offerings. For some firms, one challenge of raising new Mexico-focused private real estate funds is the underperformance of such vehicles. For example, the New Jersey Division of Investment’s most recent investment report showed that its investment in Walton Street Mexico Fund I was worth 89 percent of its original value as of May 30, while OPERF’s investment in Clarion’s Lion Mexico Fund generated a 0.88x multiple as of March 31, according to the pension system’s website.

Perhaps more significantly, however, firms such as Walton Street and LaSalle Investment Management are preparing to launch new CKDs in the coming months. “Currently, there are not a lot of groups in the private equity space with widely-marketed funds that could be available to smaller investors,” says Sobczynski.

Some of these firms are said to be considering plans for a two-tier structure, where they would raise a separate feeder vehicle for US investors concurrently with the CKD. However, foreign investment in a Mexican public instrument generally creates a lot of issues, says Eduardo Guemez, managing director and chief executive of LaSalle’s Mexico operations. 

“The current CKD structure was developed for Mexican pension plans,” Guemez says. “It operates through the Mexican Stock Exchange without providing the liquidity of truly public instruments, and this has made it complicated for foreign investors that are used to the traditional limited partnership structure.” 

LaSalle, which has been investing in the country since 2004, raised nearly $300 million with its first Mexico-focused private real estate fund in 2007, with capital coming primarily from foreign investors. In filing for its first CKD on the Mexican Stock Exchange earlier this year, the Chicago-based real estate investment management firm is hoping to capture a new source of capital from Afores. 

LaSalle’s longer-term plan, however, is to raise another Mexico-dedicated private real estate fund. Indeed, Guemez anticipates that the country eventually will pass legislation that would allow the Afores to invest in private vehicles. 

“We would expect that we would be able to have both our traditional clients as well as the Afores investing side by side, hopefully in the next round of funds,” Guemez says. “We hope to be able to capture these new investors and maintain the capital and relationships with foreign investors as we go forward.” 

Revisiting Mexico

A number of economic and political factors are contributing to the appeal of the country’s real estate market

Beyond the capital markets, Mexico’s shifting economic and political climate also has been a boon for real estate investment in the country.

“People are revisiting the Mexico thesis and why it’s such an important place to invest,” says Brian Finerty, co-lead of investments at Equity International. Some of the renewed interest in the country has to do with the current economic cycle, with the Latin American nation increasingly being perceived as an attractive place to do business as US companies have refocused on locating their distribution closer to home in the face of rising labor and transportation costs in China.

Rising demand for distribution, logistics and manufacturing facilities has a direct correlation to Mexico’s industrial real estate market. “There are not a lot of developers competing for that product,” says Finerty. “I think you’ll see capital allocated in the real estate markets to meet that demand.”

Moreover, the country currently is benefiting from its proximity to its neighbor to the north. “The fact that people are becoming more bullish on the US has a spillover effect on Mexico because they are inevitably tied together in a lot of ways, and a lot of growth in Mexico comes from investment from the US,” Finerty explains.

The election of President Enrique Peña Nieto last year also “creates a new dynamic in the country,” adds Gregorio Schneider, managing partner and chief investment officer at Terranum Capital. The new leader has introduced numerous reforms in the country’s policies affecting education, taxes and various industries. “If all these reforms really come through, Mexico will have the best five years in a long time.”

Reforms relating to Mexico’s oil and energy industries would have the most impact on the country’s real estate market, says Francisco Andragnes, head of real estate at Compass Group. “If Mexico opens up the market to foreign investors in terms of oil and energy, that would have an impact on real estate, directly in terms of office demand but also indirectly through the inflow of employment and foreign capital to the country.”

Compass currently is focusing its real estate investments on multifamily development, a relatively new strategy in Latin America, where residential typically is for-sale and therefore a self-liquidating strategy. While Andragnes already had helped to develop a multifamily platform while serving as chief investment officer at PREI Latin America, he says proposed reforms to Mexico’s housing policy will help to further bolster investment in the property type. 

The housing policy, which previously focused on supporting single-family homebuilding, would be expanded to also include the renovation of existing homes as well as the development of multifamily rental buildings. In fact, Instituto del Fondo Nacional de la Vivienda para los Trabajadores (Infonavit), the Mexican federal institute for workers’ housing, already has established a pilot program to develop rental housing.

“Multifamily is a very attractive proposition, it goes hand-in-hand with the push for smart growth in the largest Mexican cities,” says Andragnes. And because of the lack of apartment rental properties available for acquisition in the country, “we believe we can obtain attractive yields developing this asset class.”