A southern cure: Are Latin American REITs the perfect antidote to higher U.S. interest rates?
While analysts spent much of 2016 evaluating the impact of higher interest rates on U.S. real estate markets, Latin American public real estate had one of its best years on record — surging more than 24 percent — and finished the year as the top-performing strategy in the Morningstar Global Real Estate category.
Measured by the Solactive Latin America Real Estate Index (LARE Index), a relatively new entrant to the real estate space, Latin American real estate is again leading the pack in 2017 and outperformed broad regional equity indexes for the year-to-date period through February 2017.
Global real estate investors may want to pay extra attention to this segment as a potential complement to U.S. real estate exposure because of the following factors: (1) Latin American REITs are experiencing very attractive revenue growth (with projected growth of more than 20 percent in 2017), including healthy expansion of funds from operations and dividends, all of which contrasts sharply with U.S. REITs, which are expected to show revenue declines of about 1 percent in 2017; (2) the three-year U.S. dollar rally has made local assets very cheap for the global investor, with commensurately high dividend yields; and (3) local capital markets passed an inflection point since the 2009 recession and now are principally financed by local pension capital.
Latin American real estate is up more than 18 percent in 2017, as of the end of March, and has a forward dividend yield of about 9 percent. Public real estate also exhibits low correlation to major real estate indexes, as well as substantially lower volatility and correlation compared with all major Latin America benchmarks. Lastly, the LARE Index total return had a 1.69 Sharpe ratio (based on annualized daily standard deviation of returns) for calendar 2016 versus 1.17 for the broad MSCI Emerging Markets Index and 0.69 for the MSCI REIT Index.
Latin America real estate outperformed for several reasons, but we wanted to highlight two we feel are major themes for real estate investing broadly and, perhaps, a reason to rethink the Latin America space, as well.
LatAm REIT yields at historic highs. Latin America REITs pay very high dividends. The LARE Index tracks a basket of 63 locally listed equities, about half of which are REITs located in Brazil and Mexico. Brazilian REITs offer some of the most attractive risk-adjusted yields in the world, paying between 8 percent and 11 percent. Mexican REITs, following the post–U.S. election peso sell-off, now offer yields between 6 percent and 9 percent. By aggregating Brazilian REITs with their Mexican counterparts, this diversification results in performance that is not correlated to the underlying REITs nor to broader benchmarks, which leads us to our second theme of thinking regionally versus by country.
Non-correlation through diversification. Investors frequently allocate to emerging markets through a “country bucket” approach, but our research suggests real estate may be one sector where investors could reap the benefit of non-correlation simply by diversifying across the region and mitigating broad market volatility associated with the region. We can compare regionally diversified public real estate to the regional Latin America benchmark, MSCI Latin America, to quantify the benefit of combining real estate across different geographic regions. For the trailing 12-month period, through February 2017, MSCI Latin America had a 1.49 Sharpe ratio and a total return of 44.8 percent versus a 1.45 Sharpe ratio for the LARE price return index (30.4 percent return) and a 1.69 Sharpe ratio for the total return index (35.7 percent return). MSCI Latin America, however, exhibited about 50 percent more volatility during the period and tracked a dividend yield of less than 1.5 percent, whereas the LARE Index tracked a dividend yield north of 12 percent. In other words, even though public real estate had a 10 percent lower return, it displayed almost 40 percent lower volatility and tracked a significantly higher dividend yield.
We think two factors are responsible for this outcome. First, income-producing assets tend to have a lower risk profile versus traditional equities. Second, Latin American public real estate is under-owned by global investors and widely owned by local investors, who tend to be income-oriented.
Regional diversification offers the ability to capture dividends with less downside risk than is typically associated with concentrated exposure. The volatility of the average index component is roughly two times greater than the index itself, for example, but the average component is only 21 percent correlated to the index itself. Again, we attribute this to a low correlation between different countries and the unique characteristics of local income-producing real estate — namely, strong local investor demand.
The non-correlated relationship between countries is highlighted by the contrast between Mexico and Brazil on the monetary front. Brazil is in the second or third inning of an aggressive interest-rate-cut cycle that should last for another 12 to 18 months. Brazil also is digging itself out of a three-year recession, and many expect the country to finally grow again in the back half of 2017. On the positive side, inflation has slid remarkably fast from about 10 percent in 2016 to nearly 5 percent in February 2017. The country is, in effect, in a secular bull cycle that will remain choppy, but the impact of aggressive rate cuts likely will fuel continued capital investment into high-yielding local assets, especially real estate.
Mexico, on the other hand, has been raising interest rates in the face of rising inflation and stable growth, and because Mexican REITs are growing revenue at more than 20 percent per year, net asset values have been cushioned somewhat against the rising cost of capital. The major impact on Mexican REITs has been currency more than any other factor — and we believe the currency is 10 percent to 20 percent undervalued. Either way, we expect Mexican REITs to grow dividends in the 15 percent range or higher for the foreseeable future.
By diversifying geographically, an investor may capture not only very attractive, unleveraged yields offered by Brazilian REITs and appreciation potential as a result of lower interest rates, but also the dividend growth offered by Mexican REITs, fueled by robust, organic, top-line revenue growth as they continue to mature.
Emerging markets, and Latin America especially, are not for everyone. There is no free lunch in emerging markets — or anywhere, for that matter. Our view, however, is the risk-adjusted potential for further gains in the public real estate space is exceptionally compelling, and real yields in the region should not be ignored. Indeed, U.S. real estate has underperformed broad benchmarks since late 2015. One need only look at the fact U.S. REITs have been net sellers of assets for more than a year now. Absent a change in the revenue growth profile for U.S. real estate, we have to question the durability of yields remaining at these levels.
James Anderson is managing partner of Tierra Funds and Tierra Capital Partners.