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.