Pru Real Estate Cranks Up The PR Machine, but why?

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….

With US REITs Overextended, Consider this Latin America Real Estate ETF

With US REITs Overextended, Consider this Latin America Real Estate ETF

With U.S. REITs Overextended, Consider This Latin America Real Estate ETF

With attractive REIT opportunities drying up in the U.S., the time is ripe for investors to look overseas, particularly in Latin America, for ETFs providing exposure to emerging market real estate.

These high-yielding, attractively-valued assets are also slated to experience meaningful appreciation given a flurry of tailwinds expected to impact their respective countries. But before we get into why this space presents such a compelling opportunity, we need to take a closer look at the real estate picture here at home.

U.S. REITs Overextended

Real estate investment trusts (REITs) have experienced a sharp rise in demand as a result of their attractive dividend yields and the general appreciation of real estate values over the last five years. Investors have done well to jump on the REIT train with annualized appreciation that has outpaced overall equity returns. However, as the Federal Reserve moves closer to the next Fed Funds interest rate hike against a backdrop of historically high valuations for income-producing real estate in the U.S., are we nearing an inflection point?

Real estate was reclassified last August into its own sector under the Global Industry Classification Standard. With REITs and real estate operating companies no longer grouped into the broad Financials Sector, investors can now properly benchmark companies as well as funds and different industries.

The sector change was long overdue for the $1 trillion REIT category, however, investors must now grapple with the fact that U.S. REIT valuations are at historic highs and are increasingly sensitive to expectations surrounding U.S. rate increases. For example, the widely tracked MSCI U.S. REIT Index fell as much as 5.5 percent when investors fretted over the chance of a Fed rate increase at the September Federal Open Market Committee meeting. But when the committee elected to not raise rates, U.S. REITs promptly recovered nearly all of those losses in the following week.

Given their close tie to U.S. rate policy, the value of U.S. REITs will likely fall when interest rates eventually rise. The good news is we do not necessarily believe investors are going to lose money on a total return basis since the pace of rate hikes is expected to occur over years, not months. However, further appreciation is likely capped and the prospect for dividend growth appears very limited.

Like bonds, many experts believe U.S. REITs are priced for perfection as a result of investor demand for yield, the lack of “risk-free” investment choices and limited global economic growth. Real estate historically has provided investors with both income and appreciation potential. Income is a function of rents, and appreciation is a function of both economic growth and interest rates. In an expansionary economy where growth is robust, the impact of rising interest rates may be offset by strong growth and higher rental rates. But in a low-growth economy, the impact of interest rates is amplified.

What does this mean for the investor who values the predictable income associated with REITs and real estate in general? Does ridding the sector from your portfolio make sense given the current macro environment and medium-term expectation for interest rate changes? We believe the answer is no.

Emerging Market REITs to the Rescue

Real estate is an important low beta source of attractive risk-adjusted yield. But, like a bond portfolio, real estate exposure should be balanced between developed and emerging market (“EM”) real estate, a market which remains in growth mode on the back of favorable demographics and attractive valuations.

U.S. REITs are anything but cheap. The top 10 largest U.S. REITs, with a total market capitalization of nearly $300 billion, currently trade at an average price-to-earnings multiple of 33x, compared to the S&P 500 which trades at 24x earnings. On a price-to-sales basis, the top 10 U.S. REITs trade at an average of 10x sales and 4.5x price-to-tangible book value. Like bonds, the quest for yield has stretched U.S. REITs to historically high premiums over the broader equity market.

On the other hand, EM real estate, Latin America in particular, remains attractively discounted and offers dividend yields that are often superior to U.S. REITs. Notably, interest rates in Brazil are at 10-year highs with REITs yielding 10 percent or more, and many experts believe the central bank will begin cutting interest rates by the end of 2016. If this happens, real estate values will likely rise. Brazilian REITs are cheap, trading at less than book value and price-to-earnings multiples of around 12x, which is in line with the broader local equity market. Mexico REITs also offer attractive dividend yields in the 5 to 7 percent range and trade at roughly 15x price-to-earnings and 0.85x book value.

Apart from the impact of rising U.S. interest rates on domestic REITs, investors should pay close attention to their revenue growth. Analysts expect the top 10 U.S. REITs to see a decline in revenue over the next 12 months. On this factor alone, we believe diversifying into Latin American real estate is warranted. In contrast, Latin American REITs are expected to grow revenue by nearly 30 percent in 2017.

When we launched the Tierra XP Latin America Real Estate ETF (LARE) last December, one of the main goals was to provide investors with diversified access to this expanding asset class. In addition to the inherent benefits of diversification, balance and transparency, the LARE ETF seeks to maximize dividend yield and growth potential by tracking the Solactive Latin America Real Estate Index (LAREPR). LAREPR contains more than 60 components from Mexico, Brazil, Argentina and Chile. Our 20 years of experience working in real estate private equity in the region taught us that regional diversification, combined with the above average yields associated with real estate, is an excellent way to compound capital.

But Latin American real estate isn’t just cheap and high-yielding; it is an excellent risk mitigation tool for broader EM exposure as well. Based on our analysis, the LARE Index exhibits lower volatility than the broad MSCI Emerging Markets Index and significantly less volatility than Brazil and Mexico. Finally, the LARE Index is tracking a dividend yield north of 5 percent on a forward basis which is more than 3x the projected dividend yield for many EM indexes that serve as reference for widely owned EM ETFs.

One potential strategy an investor could employ is to add exposure to the Latin American real estate sector via the convenience of a U.S.-listed ETF to an existing U.S. REIT allocation. The resulting impact would increase exposure to growth potential, diversify sources of dividend yield and offset any potential pullback in U.S. REIT values, without adding unreasonable risk to the overall portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

TheStreet – Sep 2016

Why is Latin America the Next Hot Investment?  What makes Latin America, an area rife with political uncertainty and economic concerns, such a hot investment space? It’s all about timing.   Chris Ciaccia Follow Sep 27, 2016 4:21 PM EDT Latin America has experienced tremendous volatility in recent years, but the region is emerging from the fallout of political scandals, […]

Benzinga – Sep 2016

Avoid Fed Shenanigans With This Real Estate ETF

Benzinga – Aug 2016

Meet This Year’s Best Real Estate ETF

Meet This Year's Best Real Estate ETF

The Federal Reserve’s refusal to raise interest rates to this point in 2016 coupled with investors’ seemingly unquenchable thirst for higher-yielding assets have created a perfect storm for real estate stocks and the corresponding exchange traded funds.

Additionally, real estate stocks and ETFs are getting increased attention ahead of the move, happening at the end of this month, that will see the group depart the financial services sector and become the 11th GICS sector. Obviously, those factors are benefiting US-focused real estate ETFs, but this year’s best-performing real estate is an emerging markets fund.

That honor goes to the Tierra XP Latin America Real Estate ETF LARE 0.33%, which as of August 9, is up 36.6 percent year-to-date. Said another way, LARE has posted better than double the returns offered by the largest U.S. real estate investment trust ETF.

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LARE debuted in December and tracks the Solactive Latin America Real Estate Index.

“The Solactive Latin America Real Estate Index screens for all listed equities with primary listings in the Latin America region and which derive substantially most of their income from real estate and real estate services. The Index then uses dividend yield, market capitalization and liquidity in the underlying shares to determine weights. The Index is rebalanced quarterly,” according to Tierra Funds.

With Brazil being one of this year’s best-performing markets, emerging or otherwise, LARE may garner comparisons to traditional Brazil ETFs. However, such comparisons are inaccurate. Brazil and Mexico, Latin America’s two largest economies, combine for 96 percent of LARE’s weight, meaning the ETF is more a dual country/regional fund than a single-country ETF.

Said another way, with Brazilian stocks hot, LARE is not going to outperform a traditional large-cap Brazil ETF. Simple math confirms as much, but that doesn’t diminish LARE’s opportunity set. Certainly not at a time when yield is a primary concern for many investors.

For those that insist on labeling LARE as a Brazil ETF, notable are the facts that as of August 9, LARE is showing volatility that is about half that of the largest Brazil ETF and a dividend yield that is more than 340 basis points higher. Speaking of yield, LARE’s dividend yield is 5.58 percent, which is far superior to what investors will find on standard U.S. REIT ETFs.

Likewise, combining the dividend yields on the larges Brazil, Mexico and Latin America regional ETFs generates a number that is below LARE’s yield.

Year-to-date, LARE has outperformed all other LatAm ETF strategies with the exception of the benchmark Brazil ETF and the lone Peru ETF.

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Forbes – Feb 2016

Why Latin America Is The New Hot Spot For Investors

Investors who feel they’ve been booted out of the U.S. real estate market (and the rest of the developed world for that matter) may want to consider doing the cha cha cha in Latin America. Exchange-traded fund industry newcomer Tierra Funds believes Latin America is the new hot spot for real estate investors.

Tierra Funds rolled out the first ETF investing solely in real estate investment trusts (REITs) and real estate operating companies (REOCs) in that region. Tierra XP Latin America Real Estate ETF (LARE) debuted in December with about $2 million in assets.

 

James Anderson is the managing principal of Tierra Funds based in Devon, Penn. He explains why real estate investors should venture to Latin America.

Key Growth Areas

Ho: Why did you launch this ETF?

Anderson: A few years ago we predicted that global private equity would be supplanted by local pension capital as the primary source of financing for both real estate development and long-term investment in the asset class. This is exactly what has happened since 2009 and has no end in sight. The Tierra XP Latin America Real Estate ETF (LARE) is simply a response to evolving market conditions in Latin America and a solution for both institutional and individual investors to gain exposure to this key growth sector.

LARE is the first listed vehicle to offer diversified and unique access to the $60 billion+ public real estate industry at a reasonable cost and with the ability to capture attractive dividend yield without sacrificing growth prospects. More than 80% of the 52 components represent new access – meaning they are unavailable through competing products. Approximately 55% the components are real estate investment trust (REIT)-type equities, which by law must distribute all of their pre-tax income to the investor.

We expect the REIT market to grow significantly over the next five to 10 years as the local capital markets become the go-to place for real estate financing. We designed the multi-factor index around our 20+ years’ experience on the institutional private equity side of the business. In choosing the ETF wrapper, one of our goals was to democratize access and allow the individual investor to invest in a strategy designed for institutions.

My partners and I have been active in the Latin America region since the early 1990s. Apart from being a specialist in the region, we also tried to inject our real estate private equity experience into the product. One of my partners is a Rio de Janeiro-based portfolio manager. My other partner and I began our careers in Mexico City in 1993.

To be honest, the turn toward local public market financing since 2009 is a development we would have never thought possible back in the mid-1990s. But when one steps back, it’s just standard, predictable capital markets evolution.

Investment Strategy

Ho: What is the investment strategy for your ETF? How do you go about picking the holdings? What are the rules for reconstitution?

Anderson: LARE is a passive product and seeks to track the Solactive Latin America Real Estate Index, which currently has 52 components. Brazil is weighted 58%, Mexico is 39% and Chile is a little less than 3%.

REITs comprise about 55 % of the portfolio with the balance being developers, owners and service providers. This is the growth piece. The index methodology screens more than 150 listed real estate equities in the region and ranks them against the population set based on dividend yield, market cap and liquidity at each quarterly rebalancing.

The index includes most major public real estate owners and operators, developers and real estate services. It’s a diversified and balanced slice of the entire industry.

Rapid Growth Projections

Ho: What catalysts will drive performance in the industry? What are their projected sales and earnings growth?

Anderson: On a trailing basis, LARE trades at 16.6 times earnings as of Jan. 28. We project a 14.8x forward price-to-earnings (P/E) ratio – or about a 10 % discount. Overall, revenue growth is projected to be flat in 2016. But earnings are set to grow 28 %.

So what we have is a basket of diversified real estate companies that, in aggregate, have cleaned up their balance sheets over the last three years and are growing earnings in a flat sales growth environment. There is tremendous built-in operating leverage when overall growth picks up.

Notably, it’s important to mention projected revenue growth for Mexican REITs is 21% , which comprises 23% of the overall weights.

LARE is a regional product with exposure to Brazil, Mexico and Chile (which are tracked by iShares MSCI Brazil ETF (EWZ), iShares MSCI Mexico ETF (EWW) and iShares MSCI Chile ETF (ECH), respectively.)

Growth catalysts differ by country. Brazil, for example, is entering its third year of recession. Forward performance is largely dependent on improvements in the overall economy, which we think are underway. Since the market is a discounting mechanism, which prices in future earnings, investors are starting to put money to work there on expectations that Brazil’s economy will bottom during 2016 if it has not already.

In the second half of 2015, Brazil’s current account surplus grew to more than a 5% rate, cutting the current account deficit in half compared to 2014. Brazil’s gross domestic product (GDP) in 2016 is projected to fall 2.5%. However, this is an improvement compared to the 3.7% contraction in 2015.

The central bank has aggressively raised interest rates in the face of high inflation, which was brought in large part by transportation and fuel price increases last year. Real estate and assets, in general, are very discounted, with real estate trading close to half of book value.

An investor in LARE can have access to Brazil REITs with unleveraged yields of 10% to 15%, trading at a 40% discount to book value and a forward seven times P/E. That is dirt cheap for commercial real estate with stabilized lease cash flows.

Mexico and Chile continue to be favored by foreign investors. Mexico tracks the U.S. economy very closely and is going through a real estate renaissance fueled by low-interest rates, stable growth, low inflation and a growing middle class. The rise of local pension capital will also continue to be a major driver of real estate development.

 James Anderson is managing principle at Tierra Funds. (James Anderson)

James Anderson is managing principle at Tierra Funds. (James Anderson)

On the downside, Mexico is not cheap. Its benchmark index trades at an approximate 20% premium to the S&P 500 (SPY). But it is growing faster than the U.S. However, Mexico REITs are quite attractively priced, trading at 14 times trailing earnings with a projected 13.5 times earnings on a forward basis, or a 25% discount to the Mexico benchmark (iShares MSCI Mexico ETF (EWW)).

If we step back, Brazil is a discount, get-paid-to-wait story. And Mexico is a GARP (growth at a reasonable price) story. By combining Brazil’s high yield with Mexico’s growth, an investor has the best of both worlds inside the convenience of the ETF structure.

Broadly speaking, demographics favor real estate across the board in both Mexico and Brazil, including residential, commercial office, retail and industrial. There is a long runway regarding housing needs, retail, industrial, etc. That isn’t going to slow for many years.

The real determinant in the short run is macro conditions. Economic growth can reignite just as quickly as it drops off. We have witnessed this phenomenon many times. The key is to buy into assets when they are cheap.

Bargain Valuations

Ho: How do their current valuations compare to historical and the S&P 500 (SPY)?

Anderson: Long-term comparisons between the S&P 500 (SPY) and public real estate are difficult since many companies in LARE have only been publicly traded since 2010. LARE began trading publicly in December 2015. But we do have live index data back to September 2015 and two years’ of third-party back testing.

The major impact over the last two years on index performance was currency. And this has been a global emerging market theme. Brazil’s currency has declined more than 35% and Mexico’s is down about 30% (against the U.S. dollar).

In 2014, Brazil REITs were trading at 15x to 17x trailing P/E vs. 10x currently. Mexico REITs are a harder comparison since many of them went public throughout the last three years. But regarding price to book value, Mexican REITs currently trade at 0.9x book value, which is more than 30% below where they debuted on public markets. The attractiveness of the discounts, we feel, is one of the most compelling aspects of LARE.

Ho: What is the historic performance of the underlying strategy or index?

Anderson: Regarding performance since September 2015, which was the period just after the sharp August sell-off, LARE has outperformed not only the Brazil and Mexico benchmarks (iShares MSCI Brazil ETF (EWZ) and iShares MSCI Mexico ETF (EWW)) but also the global emerging markets benchmark (iShares MSCI Emerging Markets ETF (EEM). Notably, LARE exhibits much lower volatility than Brazil (EWZ) and very similar volatility to Mexico (EWW) and the global emerging market benchmark.

LARE price return (PR) and LARE total return (TR), despite having a 58% Brazil weighting, dramatically outperformed the Brazil benchmark, iShares MSCI Brazil ETF (EWZ). The Index has a trailing yield of approximately 7.2%, as of Jan. 27, which is a pretty compelling get-paid-to-wait proposition.

Ho: How do you expect your ETF to perform over a bull and bear market cycle?

Anderson: We’ve been involved in the Latin America real estate industry for almost 25 years. We’ve been through multiple cycles, including the 1994 Tequila Crisis, the 1998 Asia Crisis and the 2003 Brazil Crisis.

Real estate, next to cash, is a sweet spot for local investors and tends to act as a safe-haven asset. We believe this is one of the reasons why real estate equities are less volatile than overall equities.

Anecdotally, you could have purchased new Class A office space during the depths of the Mexico Tequila Crisis in 1995 for about $100 per square foot. Today, Class A office space trades at around $400 per square foot. This is over a period where the Mexican peso lost more than 80% of its value versus the U.S. dollar. In nominal terms, that’s more than 700% appreciation.

For the long-term investor, real estate should provide a cushion against volatility while paying an attractive dividend. In bull periods, real estate is a natural beneficiary of stronger capital investment and growth. But the trade-off is you aren’t going to get the same rip higher when everyone decides that EM is the place to be. That said, minimizing losses is one of the key determinants in long-run asset appreciation.

Ho: Why should investors invest in your ETF? What purpose would it serve in their portfolios?

LARE is an ideal complement or proxy for emerging markets exposure that may provide a substantially more attractive current dividend yield with broad exposure to all economic sectors – consumer, industrial and commercial. We also think LARE is a compelling addition to an income portfolio overall.

For example, LARE, alongside the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), would add material income plus growth potential at roughly the same volatility. Many consider real estate to be a bond-like asset with some of the growth potential of a traditional equity.

Finally, emerging markets real estate (Guggenheim Emerging Markets Real Estate ETF (EMRE), contrasted with developed markets (iShares International Developed Real Estate ETF (IFGL), is growing operating cash flow. Developed market real estate (IFGL) in general is either selling assets or borrowing to pay dividends. Payout ratios among some of the leading U.S. REITs are well above 100 %. Latin America REITs have payout ratios of roughly 60 %.

Investment Risks

Ho: What are the investment risks that investors should consider?

Anderson: Investors should always consult with their financial advisor prior to making investment decisions as well as read an investment’s literature. Ours is available at www.tierrafunds.com. Major risks in our opinion, are a continuation of the U.S. dollar strengthening and a deterioration of economic fundamentals in Brazil.

The trade weighted dollar has rallied about 30% since 2014. Being long U.S. dollars is now a very crowded trade. In fact, since the Federal Reserve hiked interest rates in December, the dollar has actually stabilized, which suggests we may have seen the brunt of dollar strengthening – a little bit of buy the rumor, sell the news.

Given the impact of the stronger dollar, I can also imagine the Fed holding off on further rate hikes for at least the first half of 2016, if not longer.

On the Brazil front, we are really starting to see constructive signs that the economy is stabilizing. The main issues are their current account deficit and inflation. 2016 is projected to have the first annual surplus since 2014.

Inflation remains hot but many believe it is set to stabilize and drop as we get further into 2016 and government controlled price increases last year were a major contributor to the spike in the indicator. Since Brazil’s central bank began hiking interest rates two years ago, they are actually much closer to a cut in rates which should spark a rally in assets across the board.

Most have heard something about the political mess and the potential for President Dilma Rousseff to be impeached. While we are somewhat agnostic as to whether or not Rousseff survives her full term, we are increasingly convinced that this political paralysis can actually play into investors’ hands if we continue to see improvements on the economic front. A hobbled leader has little hope of pushing an agenda.

Also, don’t lose sight of the tectonic shift in the country’s desire to cleanse the political system of corruption. It is a major change in tolerance for what has been problematic for way too many years.

 

Ky Trang Ho founded Key Financial Media, which ghostwrites articles for financial services providers and business leaders. Follow me on Facebook, G+LinkedIn and Twitter.