Trading volume in emerging markets fell off a cliff in 2014, spending 2015 bouncing along the bottom before spiking higher as 2016 came into view. LatAm real estate was no exception. Total trading volume for LARE Index holdings got as low as $100mm per day in 2015 before spiking higher in early 2016 as smart money poured into the sector. What we’re seeing now is the trailing three month average clearly moving higher, with many weeks exceeding $1b in USD volume or about $200mm per day. We expect USD liquidity to increase considerably as both public and private capital increases exposure to thee real estate sector and new issuances come to market.
But that’s only part of the story since USD volume doesn’t take into consideration the impact of 50% FX devaluations; rather it is exacerbated by the currency impacts. We normalize historical trading volume and it’s clearly evident that while USD volume continued to decline in 2015, nominal volume did not. Why? Local investors. In effect, while global investors were busy selling the currencies (and local assets), local investors were buying.
As the chart above illustrates, nominal trading volumes are actually above 2012 levels, whereas USD volume has a little ways to go. Our take on this is over the last five years, local participation in capital markets only grew stronger which means, in effect, that global buyers are now competing for even fewer assets as local buyers tend to be large institutions who buy and hold. Given global demand for income producing assets, we see this as a perfect storm of sorts for public real estate – in particular REITs – since yields are exceptionally attractive for foreign investors. Notably, interest rate cuts in Brazil could really accelerate capital flows into the sector. Brazil non-REITs, for example, are up 34% on average in January 2017 alone.
Lastly, we index both USD and normalized trading volume and in our view, we think liquidity in the sector could easily surpass the 2013 highs – perhaps averaging somewhere around $2b to $2.2b per week by 2018. Based on our stress tests, a listed product that references the LARE Index could easily handle $1b assets under management given current, historic and projected liquidity in the space.
Now may be the time to invest in LatAm REITs.
The Tierra XP Latin America Real Estate ETF can be used to gain exposure to LatAm REITs.
Demographics and relative valuations make LatAm REITs look attractive.
For investors focused on the long term, it looks like a good time to invest in Latin American real estate. Yes, this is even after considering that near-term volatility will likely be high in Mexico during Donald Trump’s presidential term.
An investment vehicle that provides diversification and exposure to LatAm’s real estate market is the passively managed Tierra XP Latin America Real Estate ETF (NYSEARCA:LARE). It’s a relatively new, small ETF with a 12/3/2015 inception date and only about $2.7 million AUM.
As of December 15, 2016, LARE held over 50 securities. The top 10 holdings make up about 27% of total AUM, with the top holding accounting for about 3.4% of fund assets. LARE’s country exposures to Brazil, Mexico, Chile, and Argentina are 43%, 42%, 5%, and 2%, respectively.
While the fund is relatively small right now, assets could grow if the fund is successful at getting its story in front of US-based RIAs and institutions. LARE provides global retail investors an opportunity to access difficult markets like Brazil, and it’s a unique investment vehicle. How unique? Over 80% of LARE’s components are unavailable in competing products.
Fund asset growth could come if the fund lists on another exchange. According to James Anderson, Managing Principal at Tierra Funds, LARE may cross-list in Mexico early next year. If this happens, access to local pension capital in Mexico could be a source of AUM growth.
Latin America REIT Valuations Appear Favorable on a Relative Basis
While risk remains elevated in Brazil and Mexico – Latin America’s two largest economies – fundamentals look attractive on a risk-adjusted basis. Brazil and Mexico REIT P/E’s and P/FFO’s (Funds from Operations) are well below U.S. REITs. This should be the case considering emerging markets (i.e. Brazil and Mexico) have meaningfully different risk profiles and higher interest rates when compared to developed markets. It is to be expected that LatAm would have lower valuation multiples, so what is more important than them being lower is the amount by which they are lower.
According to LARE’s website, Mexico and Brazil REITs trade at a P/E that is less than half that of the MSCI US REIT Index. Relative valuations also appear favorable when considering price-to-FFO. P/FFO, which is often considered a better indicator of fundamental valuations for REITs, is 16.6x in the U.S. compared to 10.9x and 11.1x for Mexico and Brazil REITs, respectively.
One could make the argument that US REITs are simply overvalued. The MSCI US REIT Index’s forward P/E is around 30x versus about 17x for the S&P 500 Index. These high US REIT multiples are a consequence of the prolonged low interest rate environment. Yield hungry investors have had to look beyond bonds for income, and REITs have been a viable alternative. Therefore, it will be important to continue monitoring market sentiment as it relates to REIT risk premiums.
PE Real Estate Coming Back to LatAm?
Anderson mentioned LARE was in part created as a response to declining opportunities in the private equity real estate space in LatAm. It’s been reported that real estate managers are cautiously returning to places like Brazil, which may be a signal that real estate valuations are appealing there.
Yields and Expenses
LARE yields a respectable 4.2%, which is similar to the 4.1% dividend yield on the MSCI US REIT Index (as of 11/30/16). We should also be mindful of expenses when investing in ETFs or mutual funds. The expense ratio is relatively high for LARE compared to many US REITs. For example, LARE’s expense ratio is 0.79% versus 0.44% for the iShares US Real Estate ETF (NYSEARCA:IYR). However, expense ratios tend to be higher for emerging market ETFs when compared to developed market peers.
ETF Heavily Weighted to Brazil and Mexico
The fund is heavily weighted to just two markets, Brazil (43%) and Mexico (42%). This may be a gift or a curse.
A gift if we believe historically high interest rates in Brazil will continue to help the fund earn high yields from Brazilian assets; or if we believe the narrative that real estate values will rise if the Central Bank of Brazil continues cutting benchmark interest rates.
LARE’s concentrated position could also work in the funds favor if the Mexican Peso decides it’s finally done depreciating. MXN recently hit record lows and hasn’t recovered much from there which has negatively affected many US investors holding Mexican assets. Nevertheless, yields and REIT valuations appear favorable in this region.
Alternatively, the fund’s concentrated geographic position could be problematic if Brazil continues to muddle thru its persistent, ongoing corruption scandal(s). Also, Mexico could see its currency weaken further, which could limit LARE’s capital appreciation.
Demographics and Valuations Make LARE Worth the Risk
Ultimately, an investment in LARE is a bet on demographics and favorable relative valuations. When an investment has those two things working in its favor, that is a bet I am willing to take.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the author. Opinions expressed herein are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
Read the report: LAREPR Index 2016 Review
With a year-to-date price return of more than 18% and a total return of 24.7%, The Solactive Latin America Real Estate Index (LAREPR) outperformed all but one of the 190+ globally-listed real estate funds in 2016 and is the only index to track the expanding real estate asset class in Latin America. LAREPR is currently licensed to the first US-listed exchange-traded fund (ETF) with exclusive access to this growing asset class.
During 2016, LARE Index tracked a 13% dividend yield and a 16% distribution yield – driven by high yielding, un-leveraged Brazil REITs, broad appreciation in Brazil real estate operating companies and attractive dividends from Mexican REITs. Based on forward street estimates, 2017 is looking to shape up similarly to 2016 as many analysts believe top line revenue growth will drive further dividend appreciation as well as a continuation in the rally in asset prices.
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.
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.
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.
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.
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:
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.
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:
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.
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.
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.
Prudential Global Investment Management (PGIM) has a terrific platform – professional, transparent, proven track record & diversified. A couple years back, we performed a deep analysis of their Mexico platform for a leading sovereign wealth fund in connection with a follow-on fund. We came away very impressed overall.
We were intrigued to see this recent piece – Where Smart RE Investors Are Putting Capital in Latin America – sponsored by PGIM, that suggests they’re seeing increased interest from global LPs in the LatAm real estate asset class. It’s a good discussion and they make some interesting observations, including the challenges facing multi-family housing, residential development in Mexico, compelling risk-reward in Brazil and, drum roll, the rise of local institutional capital.
First, Pru is spot regarding Mexico housing. Many are aware that this segment crashed and burned with the heat of a flaming habanero pepper a few years back when the newly installed Pena Nieto government announced a sweeping restructuring of Mexico’s housing subsidy program, the changes of which rendered builders’ land reserves essentially worthless and over-indebtedness pushed most of public home builders into bankruptcy. What we saw over the next year was a series of high profile defaults, shareholders lost everything and the industry ground to a halt. Housing was really the only real estate segment that went through a distressed period since the 2008 peak – and it all happened in the public markets.
As Pru points out, Mexico’s housing industry totally recapitalized and, again, is positioned to take advantage of the favorable long term demographic opportunity. Notably, Sam Zell got back into Homex last year after having invested in & exited the builder nearly 10 years ago, and he’s doing it all through the public equity. And that is the conclusion that Pru leaves out – you can get exposure to the space through the half dozen or so public companies and in fact that’s what the shrewd managers, like Zell, are doing. But why you ask? Because private equity returns have converged with public equities.
This brings us to the next theme that Pru discussed – the rise of local capital. We’ve been writing about this for the last several years and, indeed, was a major impetus for our launching the Solactive Latin America Real Estate Index. The new era of real estate investing in Latin America is not on the private side but through listed equities, driven by local capital. Pru openly admits that local capital is willing to take lower returns but suggests that the shift hasn’t really happened yet. We beg to differ. The shift has been happening for the last five years and we see it everyday in the projected returns of direct investment deals in the region. Private returns aren’t going to generate any material benefit to the investor and, in reality, may even underperform as a result of high fees. Overlay the fact that locking up your capital has an opportunity cost associated with it, and the underwhelming proposition of going direct versus the public strategy becomes even more stark.
And this brings us back to the question of why is Pru cranking up the PR machine? Our suspicion is they’re likely sniffing out interest from LPs in a new fund but not the cookie cutter global fund where target LPs are US and Canadian pensions. Our guess? They’re looking at locally-listed funds with a regional (vs. country) focus. The piece is less about CalPERs than it is about local pension funds….