Where now?

Look for countries with strong middle-class growth -- say China or Brazil. Stick mainly to housing and retail. Focus on the long term. And don't attempt to do it without a local partner.


That was the consensus among the global real estate developers, investors, finance specialists and executives who spoke at the recent Emerging Markets Forum at Wharton. With the economy in a tailspin and demand drying up in the U.S. and Western Europe, it’s not surprising that real estate investors are more attracted to emerging markets than ever before.

In the U.S., for example, housing starts are at an all-time low — down 2.7 percent in December, according to Bloomberg — and builders have seen their share values drop 76 percent since the housing bubble burst. In early January, research firm Reis reported that mall vacancies have reached a 10-year high and are likely to go up as more stores claim bankruptcy and close their doors following six consecutive months of declining sales in 2008.

Now it seems that the unstoppable consumer demand and high returns once guaranteed by “hyper-growth” markets like the fabled BRICs — Brazil, Russia, India and China — are no longer a given. Although the panelists saw value in individual markets, they agreed that the “decoupling” hypothesis — the notion that emerging markets can maintain growth independently of any major disruptions in the U.S. economy — has proven to be untrue. In fact, as one panelist noted, the current situation would be more accurately described as “turbo-coupling.”

Ignatius Chithelen, managing partner of New York investment firm Banyan Tree Capital, pointed out that between 2003 and 2007, the Standard & Poor’s Index rose by 80 percent, and during the same period, the MSCI Emerging Markets Index was up nearly 400 percent. “Today, the U.S. market is down 50 percent, and emerging markets are down 60 to 70 percent. This isn’t decoupling. Very simply, when the U.S. market goes up, it goes up much higher in emerging markets, and when it goes down, it goes down much worse.”

Chithelen noted that the BRIC classification was originally developed for marketing purposes. “You can’t view these markets as one single entity. Each one needs to be judged individually according to the underlying fundamentals.” Within the BRIC classification, for example, China stands apart “as the world’s banker,” he said, citing the country’s $4 trillion in reserves, its trade and budget surpluses, and its ability to allocate huge resources to infrastructure projects. “Today, China is the best-situated country.”

Crumbling BRICs
Because it has been singled out as the world’s fastest-growing economy, China is perhaps the poster child for the kind of trouble that may lie ahead for emerging markets. Far from being immune to the ongoing recession in the U.S., China has seen a dramatic drop in exports, and manufacturing job losses are on the rise, numbering close to four million so far. In mid January, Fitch Ratings issued a statement that China’s economy will experience a “hard landing” in 2009, with growth estimated at 6 percent. A growth rate below 8 percent is considered a recession by the Chinese government.

The economic uncertainty has filtered down to the real estate sector — particularly in housing, where consumers’ lack of confidence is being felt. According to the January 16 edition of China Daily, housing prices are likely “to see a huge downward pressure” as prospective buyers put their purchasing plans on hold. Meanwhile, the government has asked developers to lower prices to stimulate sales, and large developers are cutting back on the floor area of new projects — some by as much as 30 to 40 percent — to hedge against any reductions in sales.

But despite current ills, China does have one thing that several participants viewed as critical for evaluating investments in emerging markets: its huge population of 1.4 billion people, which, long term, will fuel the demand for affordable housing and retail. “GDP growth will ultimately follow population,” said Philip Mintz, managing director of Warburg Pincus Asia in Hong Kong. Selecting a market with long-term prospects for growth and choosing the right asset class can give a “semblance of decoupling,” Mintz noted, because the investment is driven by macroeconomic trends, not by current market forces.

In fact, Warburg Pincus recently launched a $1.5 billion fund with 75 percent focused on Asia. Of that amount, 60 percent is focused on China where Warburg Pincus has invested in existing, stabilized assets with only 40 to 50 percent leverage. It has also started businesses from scratch. “You couldn’t do the latter in the United States,” Mintz said. “The U.S. is not a growth market.”

Sam Zell, chairman of Equity Group Investments and Equity International, underscored that point. When asked why he would look to invest in emerging markets like Egypt or Mexico versus the United States or Europe, Zell responded, “The answer is demand.” When the world begins to recover from the current economic turmoil, he said, the populations in these regions will be looking to fill their basic needs first, like housing. That’s not the case in markets like the U.S., Japan and Western Europe, where “the only play has been to leverage things up.” And although growth in emerging markets has slowed considerably “from 100 to 60 percent, that’s still 60 percent growth over zero.”

Brazil or bust
In addition to projects developing affordable housing in Cairo and Mexico, Zell’s Equity International is focusing heavily on Brazil, which he singled out as a particularly strong opportunity for investment. Like Mexico, Brazil subsidizes low-income mortgages, so consumer access to financing has been largely unaffected by the markets. The country also has “unlimited natural resources,” and, unlike Mexico, a strong executive talent pool to help outside investors achieve scale in operations. On the retail side, Zell noted that store sales are up 12 percent from last year in the malls owned by his group — a stark contrast to the recent U.S. figures. “If you look at all of the facts, I don’t think there’s another environment in the world that’s better than Brazil.”

According to Tom Shapiro, president and founder of GoldenTree InSite Partners, a New York-based real estate investment firm, Brazil is not seeing the distress found in other markets. Mortgages account for only 2 percent of GDP in Brazil, he noted, versus 65 percent in the United States and 74 percent in the UK, so consumers aren’t feeling the effects of credit contraction. Demand is high, and unlike other markets which have seen rampant speculation, there hasn’t been any over development. Shapiro said that his firm typically sees 40 to 50 percent of condominium units in a given complex sold within two weeks. Recently, GoldenTree sold 70 percent of the units in an office project in Sao Paulo in only 10 days.

In Brazil, real estate purchases require 15 percent cash up front and a 1 percent monthly pay-down on the principal. If the financial crisis has a wider impact, Shapiro said, market growth may slow among middle class homeowners, who don’t receive government subsidies for mortgages.

India and Russia on hold
India, with more than one billion people and rapid growth in its middle class, should be high on anyone’s list for investing, but Zell and others noted drawbacks — specifically, widespread corruption and arcane formal processes that hamper any real progress. “In India, there’s bureaucracy beyond belief,” Zell said. “We tried to go down that road several times, but we never got anywhere.” For the time being, he said, the potential for investment in India may not be realized. Moreover, it’s not clear what an outside developer could bring to the market, he added. “You need to look for opportunities that need servicing” in order to add value in any market.

For all development projects, the participants generally agreed it is critical to have a local partner and a team on the ground –although that need is perhaps even more acute in India and other markets where a lack of infrastructure impedes easy access to construction sites for foreigners. In those cases, it’s imperative to make the effort to visit any project sites in person. “You’ve got to see the assets in India,” said Richard Johnson, CEO of Standard Chartered-Istithmar Real Estate Fund Management in Singapore. “You need to see what they’ve built.” Follow-through isn’t always up to Western standards, he noted. “I’ve been to apartments where the three steps leading to the front door aren’t there.”

Russia, too, should merit high marks as an investment destination, with its massive oil reserves and increasingly wealthy consumers. Mark Weiss, president of JER Investors Trust, which has private equity funds in Russia and Georgia, noted that real estate development in Russia has not caught up with its growing middle class. He spoke about an “Ikea-like” store he visited outside of Moscow that had “100 registers, all with lines 10-people deep.” With that kind of opportunity, you would think there’s tremendous potential for retail development. The problem, he said, is funding. “We do development projects and the first thing to go during a financial crisis is funding for development deals. There is no lending going on in Russia.”

But the fundamental issue preventing many investors from going to Russia and many other markets, Zell said, is rampant corruption. “In Russia, they just steal your company,” he noted, relating a story about one firm that was taken over by the Russian tax authorities, leaving its foreign owner with no legal recourse. “It’s one thing to trade growth for rule of law, but another thing to trade growth for kleptomania.”

Common barriers
Corruption and lack of transparency ranked high on participants’ lists of reasons to avoid particular markets. “Life is too short” when there is much that can be  accomplished elsewhere, said Eyal Ofer, chairman of Ofer Global Holdings in Monaco, which has investments in Eastern European countries. Unlike Russia, he noted, the countries he is investing in “are civil societies, reconstituting old European laws.”

Another main obstacle is red tape. Vietnam, for example, has been on real estate investors’ radar screens for some time, but despite its growth potential, “it is totally crippled by its bureaucracy,” Ofer said.

For Zell, the key issue is the ability to achieve scale. Africa, for example — outside of Egypt and South Africa — has great potential for development, “but there’s no infrastructure, and no talent to recruit. Distance is a deal-breaker, and you need to be able to develop on-the-ground power to run the business effectively.”

Although several untapped markets may look attractive, at present there is enough to do in those markets that are open to and support development activity — such as China and Brazil. “Who wants to take their money where they aren’t wanted?” Zell asked. “I don’t see any reason to invest in a market unless I see sufficient premium to reflect the complexity and effort.”

Author: knowledge@wharton.edu