Post-Trump Sell-off Offers an Attractive Entry Point for LatAm REITs

The Solactive Latin America Real Estate Index (LAREPR) is +19% year-to-date but in mid October the Index was up over 32%. What happened? Well, Trump did, that’s what. Everybody knows that Mexico received a disproportionate beating from investors following the US election but the knee-jerk reaction increasingly looks like a gift instead of a disaster. Some broad perspective: the local benchmark is up over 50% since 2010 but the USD-denominated Mexico ETF is actually down 20% over the same period. And Mexico REITs are no exception as the basket is down over 20% year-to-date with the bulk of those losses occurring after the US election. So what’s an investor to do? Well, for one, pay attention to the fact that Mexican REITs now offer yields that are about 2x versus US REITs and they are growing revenue, funds from operations and dividend yields. US REITs? None of the above.

Brazil REITs took a hit too but not nearly as much as their Mexican counterparts. Notably, both Mexico and Brazil REITs now trade at comparable valuations but Brazil REITs carry zero debt so their yields are even more interesting in that they are unlevered.

reit-comps-11302016

As we’ve been saying for the last year, real estate yields in Latin America offer some of the most compelling risk-adjusted income opportunities which combined with fundamentally attractive growth prospects, suggest that LatAm real estate is an ideal vehicle for the long term investor.

Fibra Uno: The Crowded Trade

We’ve written from time to time some of the issues facing Mexico’s Fibra Uno (FUNO11), including an overextended balance sheet, over reliance on USD debt and an increasingly complicated portfolio. While we see Fibra Uno being a major player in Mexican real estate for a long time to come, shareholders will suffer in the short term as the Company works through portfolio issues. More importantly, we see little indication that management intends to slow the pace of acquisitions, which are the root of the problem. Investors should recognize that the combination of higher USD borrowing costs and management’s failure to temper acquisitions, could force the Company to become a forced seller of assets. We will see….

All of that said, Fibra Uno remains the go-to REIT for global funds seeking LatAm REIT exposure. Liquidity, in our view, is the main reason for this. Instead of evaluating relative fundamentals, global investors poured capital into the REIT over the last several years and have continued to do so. Pension-manager Los Angeles Capital, Principal, Dimensional and AQR, combined held almost $100 million worth of shares as of 9/30/16 which are down 20% over the last two months.

fibra-uno-11142016

Indeed, Fibra Uno is now down over 25% year to date versus the Solactive Latin America Real Estate Index which is up 14.4% and tracks a comparable dividend yield as well. Going regional and diversifying across managers, property types and geography are cornerstones of successfully navigating the Latin America markets in our view. While we continue to see Fibra Uno playing a major role in Mexican real estate, we believe the Company is being re-rated from a growth concern to a pure yield investment. Fibra Uno’s main challenge for the next two years will be how to grow funds from operations? Our view is FFO growth will be very muted for the next one to two years and investors expecting dividend growth may be disappointed.

Brazil Story Little to Do With Trade, Trump Impact Is an Illusion…

Don’t take our word for it, look at the data and see for yourself the degree of impact a full scale US trade war would have on Brazil:

brazil-mexico-trade-2014

That’s right. The total value of Brazil exports to the US is less than 2% of GDP and trade overall is only 26% of GDP. The country you want to watch is Mexico, which we’ll drill into another time when there’s more information from the new Administration. But the fact is this: from a trade standpoint commodities are its main export. IF you believe commods are going higher (or at least NOT going lower), the collective impact of a full blown trade war with Brazil is zilch. And arguably, IF you believe the US is entering a period of deficit spending focused on infrastructure, where do you think the raw materials for all of those bridges comes from? Ohio? No. Brazil.

 

For US REITs Revenue Growth Has Left the Room…

Most are aware that US REITs are staring down the barrel of a steady process of re-rating as interest rate expectations move higher. This is a broad statement and the investor can certainly find examples of REITs and real estate companies that are growing revenue as a result of unique positioning and exposure to growth assets – but for the average investor, the prospects for US REITs are mediocre at best.

Let’s start with revenue:

top-10-us-reit-revenue-growth

The Top 10 US REITs with over $270 billion in market cap, are actually projected to see lower sales in 2017. Think about that for a second: real estate is fundamentally a vehicle to capture rent revenue. In a stable or declining interest rate environment, such as the one we’ve been in for six years, revenue growth doesn’t matter as much as cost of capital and prevailing yields. US REITs were major beneficiaries of lower interest rates. That is over. REITs now have to perform and that means growing rental revenue. The issue of course is the larger REITs are generally correlated with the US economy and with tepid GDP growth, they’re just not going to see the kind of growth to sustain current valuations.

We foresee a stairway down versus a broad fire sale each time the market prepares itself for another Fed hike. This process will take time but over the course of two or three years, asset values will be lower and yields will rise. Growth for US REITs, in our opinion, won’t really start to kick in until mid 2018. So what’s an investor to do? Look south…

Latin America REITs are attractively valued, are growing revenue and dividends are expected to increase. The Solactive Latin America Real Estate Index tracks all major listed REITs and real estate operating companies in the region and offers a uniquely diversified access to the growing asset class.

Mexico REITs, for example, are relatively new but are in expansion mode and expected to grow revenues by over 24% in 2017. Commensurately, with revenue growth, we expect dividends to grow as well. Given that the Mexican economy is closely tied to the US, impacts from higher interest rates in the US will be partially, if not entirely, offset by organic growth. Brazil REITs, on the other hand, offer attractive valuations and high dividend yields. Brazil, as many know, is expected to return to growth in 2017 and is at the front end of a multi-year process of cutting interest rates. In other words, the same conditions that existed for US REITs a few years ago exist in Brazil today. As interest rates come down in Brazil, economic recovery will strengthen and asset prices should appreciate.

latam-reits-revenue-growth

Finally, a word on relative valuation. US REITs are at a historically high valuation by almost every metric – including price-to-earnings, price-to-sales, and price-to-book value. But what should really concern investors is price-to-FFO or Funds from Operations which stands at 16.6x or about a 6% FFO yield. That number is the one that tells you how tight yields are and the main reason why we’ve seen constant selling in US REITs since September when it became clear that the Fed intends to raise interest rates at least 25 bps. The combination of low FFO yields, muted or no revenue growth and higher interest rates means simply that asset prices will come down. It may take a while, but whatever dividend yield the investor is getting today will be more than offset with a capital loss later on.

Latin America REITs are not only reasonably valued from price-to-earnings standpoint but have FFO yields well north of 8%. The fact that they are growing revenue also suggests that dividends can increase. In the particular case of Brazil, it’s the trifecta: improving economic conditions, attractive yields and declining interest rates. Mexico, on the other hand, will boost dividends through organic growth and as revenue growth is expected to top 24% for 2017.

reits-p-to-ffo

About Those Mexican REITs….

The Wall Street Journal recently did a focus piece on Mexico real estate and in particular, the REIT sector, in which Tierra Funds was quoted. While the piece was interestingly written and very well-sourced, broader, more relevant themes were glossed over in our view.

First, the WSJ story narrowly focuses on Mexican REITs. While we believe the proper view would discuss Mexican REITs in the context of the Latin America real estate asset class overall, we think isolating Mexican REITs from their non-REIT counterparts (listed Mexican real estate operating companies), misses an opportunity to help the reader understand how much and why the Mexican real estate industry has evolved over the last twenty years. Further, failing to appreciate the symbiotic relationship that exists between non-REITs and REITs, misses an opportunity to capture the core themes at play: (1) relatively attractive valuations and (2) the rise of local institutional investment.

On valuations, let’s keep it simple: Mexican REITs are cheap and are expected to grow revenue, in aggregate, by almost 30% which means dividend yields should increase. The Top 10 US REITs, in contrast, will see overall revenue decline in 2017. Think about that for a second: real estate growth, in the long run, is all about rental growth. Revenue growth happens through organic rent increases and/or acquisitions. If a REIT isn’t growing, it is either financial engineering or selling assets, neither of which bodes well for the investor. Mexican REITs are growing and they will be for the foreseeable future. On the valuation front, Mexican REITs (as measured by the Solactive Latin America Real Estate Index) will see FFO expand 15% to 20%, trade at less than 12x forward earnings and a 22% discount to tangible book value.

Local pensions, in short, are the primary source of real estate investment in Mexico. To date, they’ve invested around $25 billion (~5% of total pension assets) into listed real estate, including closed-end funds and REITs. Their allocations are only going higher and they are price takers at the end of the day. Global PE, and by extension global pensions simply cannot compete. The rise of local pension capital is the story of the century for the investment industry in Latin America.

The WSJ story, instead, focused on price performance of the shares (without mentioning that US REITs have been pummeled as well) and then diverted into the topic of external versus internal management structures and how that may be an obstacle for foreign investors in the shares. While we tend to agree that Mexican REITs will ultimately need to internalize management and align compensation with shareholder returns, the misalignment issue is really concentrated in one REIT, not the entire segment. Ultimately, the issue is whether or not compensation is aligned or not. To the extent an external structure uses competitive, market-based comp, we believe shareholder interests are not impacted negatively.

The second and related issue the story completely misses is structural to the market: market caps are too small for global investors to meaningfully allocate. While there has been some new investment into a few names, most foreign capital is concentrated in one REIT – Fibra Uno. Why? Market cap. Global managers will tell you that they based their allocation on complex, proprietary research which only they are capable of performing but the fact is a $1 billion AUM mutual simply can’t invest in a $500 million or $1 billion market cap company and move the needle without triggering the 5% ownership threshold. So, they simply don’t invest. Fibra Uno, on the other hand, sports a $6 billion market cap so allocating a 1% position inside a $1 billion fund is relatively easy to do. But there’s a catch….

Fibra Uno has issues. Specifically, the Company’s return on invested capital is at or below their cost of funds and the primary culprit is they opted to fund in USD a couple years back in order to keep acquiring properties as Mexican lenders pulled back. To make matters worse, Fibra Uno began acquiring portfolios of lower quality assets and/or assets that included development risk and leasing risk. In effect, Fibra Uno increased the risk profile of its portfolio dramatically, lowered its current cash flow profile by acquiring development projects and funded it in large part in USD just as US rates were bottoming. Why did they do this one may ask? Fees.

What the WSJ gets right is in the case of Fibra Uno, the external management structure really is problematic because of the fees they charge for every acquisition and for the fact that management has close to zero skin in the game if the common suffers, since they already made their money. How bad are the fees? Bad to obscene. For example, in many acquisitions, Fibra Uno actually pays the seller a management fee for a specified period of time post-closing on top of their baked-in management fees, which effectively doubles the cost. Fibra Uno management charges an acquisition fee, a leasing fee, a disposition fee and a development fee, if applicable – all of which are based on appraised value of the assets, not market cap or performance benchmarks. To make matters worse, Fibra Uno now has a standalone development company that charges fees on projects that once stabilized, will be dumped into the REIT. The issue of related party transactions is material.

Now, we are not saying that there is anything illegal going on here. On the contrary, these fees are all disclosed in the filings. They are perfectly legal. But what we are saying is global investors aren’t paying attention because, as single stock pickers, they aren’t looking at the broad landscape and, instead, buy the shares because it’s what other global managers are doing – it’s “safe”. And, look, let’s be honest, if a 1% position goes down by 30%, who cares? It’s only 1%.

When we developed the Solactive Latin America Real Estate Index, we did so with the global investor in mind as much as the foreign retail investor. The regional approach solves the issue of investing in small and mid caps and it offers the inherent diversification of going regional versus betting on one company in one country. We think a global manager would not have only outperformed any real estate benchmark by being exposed via this strategy, but their risk profile would have been lower versus the MSCI Emerging Markets Index. So, for LatAm real estate, think regional, think LARE.

A Young Mexican REIT Market Evolves

A Young Mexican REIT Market Evolves

Fibra industry grows into major channel of public capital for nation’s commercial property sector

 By Peter Grant and Janet Morrissey

Mexican real-estate investment trusts have had a bumpy ride since their launch five years ago and today many of them are trading below their initial public offering prices.

But signs are emerging that the industry is gaining traction as it tries to become a major channel of public capital into the country’s commercial property sector. For example, one of the few IPOs currently in the pipeline in Mexico’s anemic stock market is a REIT, named Fibra Plus.

Moreover, the industry has begun to respond to some of the earlier criticisms of its transparency and management structures. And analysts say that the sector may benefit by a victory in the U.S. presidential race by Hillary Clinton over Donald Trump, who has promised to overhaul the two countries’ trade agreements.

 Some investors and tenants may be holding back on decision-making until results of the Nov. 8 U.S. election are known. Mexican REIT share prices rose after each of the three presidential debates, which Mrs. Clinton is widely believed to have won, according to an event study by the Advisory Group at real-estate research firm Green Street Advisors.

Mrs. Clinton has been leading in the polls. But it isn’t over yet, says David De La Rosa, senior vice president of advisory and consulting at Green Street. “Given the surprise of Brexit, we could see a surprise of Trump in the U.S.”

Mexican REITs—called Fibras or Fideicomiso de Inversión en Bienes Raíces—made their debut in March 2011, after government regulatory changes made the structure possible. Fibras offered investors an easy way to own Mexican real estate and pick up an attractive dividend at the same time. Like U.S. REITs, Fibras avoid paying corporate taxes as long as they distribute at least 95% of their income to shareholders as dividends.

Numerous emerging countries have been cultivating REIT industries to increase investment in much-needed development, says  Matthew Cypher, director of Steers Center for Global Real Estate at Georgetown’s McDonough School of Business. “You’re bringing a public capital source into very important areas such as housing and infrastructure,” he said.

There are now 10 equity Fibras in Mexico with a market cap of $13.3 billion, up from one Fibra with a market cap of about $300 million in 2011, according to Green Street Advisors. Most of the Fibras went public in 2013 and 2014.

Shares of many of the REITs initially rose thanks, in part, to the country’s growing economy.  As multinational auto makers, aerospace companies and other industries set up shop in Mexico, demand increased for office, industrial manufacturing and distribution space, as well as business-traveler hotels in Mexico.

An index of eight Mexican Fibras showed total returns averaged 71% in 2012, 10.4% in 2013 and 20.8% in 2014, according to S&P Global Market Intelligence.

But some investors steered clear of Fibras because most were managed by outside companies rather than hiring their own internal management staffs. These so-called external management structures have fallen out of favor in the U.S. because of concerns of possible conflicts between the interests of managers and investors.

“It’s a big reason why a lot of U.S. REIT investors won’t look to invest in Mexico,” said Mr. De La Rosa.

Also, last year, Mexico’s economy was hit by a falling peso, ballooning debt and falling oil prices. Mexico’s Central Bank raised interest rates three times this year to fend off inflation and the effects of the depreciating peso, and cut growth forecasts to between 1.7% and 2.5% from 3%.

The Fibra index fell 7% in 2015, according to S&P Global Market Intelligence.

But the industry’s performance has improved this year. S&P Global’s index of Fibras is up 8% and most of the companies have solid balance sheets, occupancy levels and profit margins.

For example, Fibra Prologis, which is 46% owned by San Francisco-based Prologis Inc., last month reported that its third-quarter occupancy was 96.7%, up from 96.3% in the same quarter last year. The company signed 2.3 million square feet in leases during the quarter, up from 1.8 million in the same quarter in 2015, thanks in part to strong demand in Mexico City fueled by e-commerce.

Meanwhile, the critics of external management are being heard. Fibra MTY and Fibra HD, which went public in 2014 and 2015, respectively, are both internally advised. Also, Fibra Inn recently announced plans to bring its management arm into the company, putting pressure on other Fibras to follow suit.

“It’s a good direction for the companies to move in,” said Jason Yablon, a senior vice president and U.S. and Global portfolio manager at Cohen & Steers.

While some investors are taking a wait-and-see approach until after the U.S. election is decided, others think the election risk brouhaha is overblown.

“It’s really a bunch of election year hooey,” said Jamie Anderson, managing principal of Tierra Funds, which includes the Tierra XP Latin America Real Estate ETF (LARE). “Capital has continued to move into Mexico this year, and businesses are in general unfazed.”

 Mr. Anderson noted that Citigroup recently unveiled plans to inject $1 billion into its Mexican consumer-banking operations.

“Foreign multinationals have not stopped their announcements on investments in Mexico,” said Alberto Moreno, senior director at Fitch Ratings Mexico.

And Fibras stand to benefit from this as the Mexican economy rebounds.

“Mexico has 66 free trade agreements with countries around the world—and Nafta is one,” said Alfonso Munk, chief investment officer of the Americas for PGIM Real Estate (formerly Prudential Real Estate Investors), which is the adviser for Fibra Terrafina. “Whether trade agreements get revised or changed, it won’t have an impact. Mexico is going to continue to be one of the big manufacturers around the world.”

Write to Peter Grant at peter.grant@wsj.com and Janet Morrissey at janet.morrissey@wsj.com