Euromoney: ADIA lifts the lid on emerging real estate

Euromoney, April 2015

Emerging market real estate is sometimes seen as the playground of speculative capital: the soar and plunge of apartments in Shanghai, Sao Paolo or Dubai, a regulatory arbitrage here and a fleeting new opportunity there. But what about the investors who are in it for the really long term – the professionals who can ride out the peaks and troughs and look for what the asset class can represent if approached properly?

There are plenty of them. Last year Blackrock surveyed 169 of its largest institutional clients, with $8 trillion in assets between them, about their investment intentions for 2015. Real estate, with 61% of respondents saying they would increase their allocation, was by far the most popular asset class, with most of the capital apparently coming from selling out of fixed income. The same survey found increasing appetite for emerging markets. Invesco, in its own study of sovereign wealth fund investment appetite, found real estate the second highest area of focus last year, and is preparing its findings for 2015. “We do think that real estate, and certainly within the context of emerging markets, is going to continue to be quite significant,” says Nick Tolchard, Head of Invesco Middle East. And Guggenheim Investments (see box) says emerging markets real estate has expanded from 2% to 11% of listed global real estate in the last 14 years.

The longest-term investors around are the bigger sovereign wealth funds, and they approach real estate with a level of sophistication that can scarcely be matched anywhere in the institutional world. Funds like the Abu Dhabi Investment Authority and Global Investment Corporation of Singapore are among the biggest real estate investors in the world in their own right, even though neither one puts more than 10% of their total assets into it.

To understand how they view emerging market real estate, you first have to understand how they approach risk and the overall portfolio. At ADIA, for example, a look at their public data will tell you that real estate must fit between a band of 5 to 10% of the portfolio, and that emerging markets (which don’t include developed Asia) can account for between 15 and 25% of the overall fund. But looking at it through such strict parameters doesn’t really reflect how the fund sources assets.

“We monitor risk at both the asset level and the portfolio level,” says Bill Schwab, global head of real estate at ADIA. “While we aim to balance our risks regionally, and across sectors, it’s important that we also retain flexibility and avoid being too prescriptive.” If a top-down review of an emerging market was to tell them, for example, that they should have 5% of the portfolio invested there over a longer-term investment horizon, it’s usually not a problem if the actual allocation is a bit higher or lower at certain points of the cycle. “It may be that a bigger exposure makes more sense at certain times, or alternatively we may feel that the opportunities in a market are not sufficiently attractive and we would rather wait.” ADIA does have indicative portfolio projections which go out through 2030, “because they give us a frame of reference. If we can justify deviating from those because of our assessment of investment risk at the asset level, then we may choose to do that. Our risk discipline at ADIA is both bottom up and top-down.”

So although ADIA’s real estate team divides the world into four segments – three geographic regions, plus hospitality globally – any one investment involves comparing that asset’s risk and return in comparison to any other potential investment worldwide. Real estate is governed by a 20-strong internal executive committee, and not just portfolio specialists: the real estate group’s CFO and operations functions are represented, among others. So if ADIA was looking at, say, a buy-and-develop Chinese office building, “the internal discussion would revolve around how the investment risk compares against competing opportunities in, say, existing warehouse assets in Brazil, or a residential renovation project in Paris,” says Schwab. “Our emphasis is on finding relative value wherever it exists.”

With all of that said, asking whether ADIA is overweight emerging markets real estate is clearly the wrong question; there are countless asset-specific considerations under the surface. But “we like the long-term growth opportunities that you generally see within emerging markets,” says Robert Walker, head of Asia Pacific in ADIA’s real estate division. “We like emerging markets as an institution, in the sense that we can feel good about longer-term growth prospects. Of course there will be teething problems as those markets and economies emerge and go through cycles. But we tend to look through that, because of our longer term view: what we’re good at, as an organization, is being patient and prudent.”

ADIA’s most natural peer in this area is Government Investment Corporation of Singapore, considered to be one of the most sophisticated and powerful real estate investors in the world, though real estate only accounts for a 9% to 13% allocation according to GIC’s stated targets (what it calls its policy portfolio), and in fact when last disclosed on March 31 2014 stood below that range, at 7%. GIC Real Estate is one of three asset management companies that serve as wholly-owned subsidiaries for the overall fund, and it has its own board; GIC Real Estate’s president, Goh Kok Huat, is also COO of GIC in its entirety. The GIC fund overall has had a stated intention to increase its exposure to emerging markets, and indeed, North Asia assets have grown from 13 to 14% over the last two reported years, with Latin America steady at 4%, and a fair portion of the ‘others’ category likely to represent the emerging world too.

“We are one of the few institutional real estate investors who can invest across the capital structure, in both the public and private universe,” says Chris Morrish, regional head for real estate for Europe. “This gives us the flexibility to pursue value opportunities in different ways in different markets and in different parts of the cycle.”

In practice, this has often meant emerging market investment. For example, in December, GIC (through an affiliate) agreed to buy Eco Sapucai, an office building in downtown Rio de Janeiro, following on from GIC’s decision to open a Sao Paolo office. In October it formed a strategic partnership with, and bought 20% of, Ronesans Gayrimenkul Yatirim (RGY), a Turkish real estate group, including a Eu250 million capital injection from GIC. India has been particularly active: through its Reco Berry affiliate, GIC agreed to buy up to 39.2% in Nirlon, the owner of a large IT office park in Mumbai, in December, and will make an open offer for another 28.4%. It has set up a joint venture with Vatika Group, a developer, to build two residential projects in the state of Gurgaon, and a joint investment with Brigade Group to invest in residential projects in South India. Announcing the Vatika tie-up in December, Loh Wai Keong, co-head for Asia at GIC Real Estate, said: “GIC is confident of India’s growth potential over the long term.” (ADIA, too, has at least twice been reported to be in partnership with Indian real estate developers in the last six months, though the fund says these reports are wide of the mark.)

From what we know of GIC’s investment approach, it appears similar to ADIA: investment in both private bricks-and-mortar assets and public equities such as REITs, all property sectors including office, retail, residential, industrial and hospitality, under guidelines heavily dependent on risk assessment, with active management of assets to generate income and improve value, including through tenant management, market positioning, leasing and capital improvements.

What stands out about GIC’s emerging market real estate investments is that many of them involve partnerships. “Our long-term orientation is often attractive to real estate players seeking partners, especially private companies who share such a perspective,” says Morrish. “Good examples are our recent investments in RGY and Gmp [the Spanish property group in which GIC bought a 30% stake in October], leaders in their respective markets who inevitably have better access to opportunities than we do as well as on-the-ground expertise to exploit such opportunities.”

Partnership is an interesting idea. It has its strong and weak points. “The first thing that comes to mind would be about control,” says Walker. “That is something we spend a lot of time thinking about. We like to maintain control over our capital.” Schwab explains this as a matter of caution. “ADIA is a prudent investor by nature, so it’s important that we have enough control to be able to take action to protect our positions, if and when required,” he says.

Nevertheless, ADIA frequently works with a variety of operating partners on its investments and is comfortable with delegating day-to-day management. “But to be successful, it’s critical that we stay well informed and have the in-house experience that will enable us to visit a project and know what is driving its performance, both in the right or wrong direction, and make recommendations,” says Schwab. In order to do so, ADIA needs a strong real estate team, able to work well with its investing partners. “As real estate is a local business, our ability to execute a deal in the most effective way is often improved if we team up with an experienced local operator instead of trying to do everything on our own.” Walker says partnership can take the form of a joint venture, fund-of-one structure, or platform.  “We are partners with a number of big institutions, whether sovereign funds or otherwise,” says Schwab, “But our usual preference is to work with only one partner rather than with groups in an investment.” He says the number of sovereign funds with a high level of in-house capability is increasing.  “We are seeing a number of them looking to hire and build out their teams.”

Sovereign funds try to build teams with a diverse range of skills. At ADIA, some are development managers who have spent their careers in construction management before joining the fund. Some are former hotel operators, logistics specialists, people who have operated real estate businesses, or have been in charge of asset management and property management. This in-house expertise “gives us valuable insights into how our assets are being managed, and allows us to identify any issues quickly,” Schwab says. The only exceptions to this are in some of the more niche sectors and smaller emerging markets. “But we believe it’s important to include these less mainstream areas in the portfolio, not just for diversification, but because they contribute to our bank of internal experience and knowledge. This is, by necessity, an ongoing educational process, and central to our ability to remain a relatively unconstrained investor as markets and sectors evolve over time.” In order to ensure its senior team members retain a well-balanced view of investment opportunities, ADIA has its investment managers travel outside their own region several times a year; Walker, for example, is responsible for Asia, but might be sent to Sao Paulo or New York to express an opinion on other potential projects, in order to ensure that everyone understands how the opportunities they see in their patch stack up globally.

Investors are united in their conviction that getting out is as important as getting in. “It’s absolutely critical, the second thing we tend to ask,” says John Saunders, head of Asia Pacific real estate at Blackrock, which has $24 under management in real estate worldwide.. “The three things in order, are: are we paying the right price going in; who are we going to sell to; and if it’s so great, why are they selling it in the first place?”

While sovereign funds may have longer time horizons – Saunders says Blackrock “will take a four to six year view on most things,” whereas ADIA, for example, reports only 20- and 30-year returns and manages accordingly – it’s not the case that they are purely buy and hold. They have the same concerns about an exit as anyone else. In ADIA’s case, the real estate portfolio is a mix of what Schwab calls long-term holds and those that may be sold more quickly, perhaps because they have a shorter cycle of appreciation likely to be followed by a correction. “We recognize that it can enhance our investing performance to have both types of assets in our portfolio,” says Schwab.

Funds like GIC and ADIA are big enough to influence the asset classes they invest in. Still, the fact that sovereign funds are becoming more active and sophisticated in emerging real estate doesn’t necessarily mark a sea change in the way the whole asset class behaves. “If your angle is: have the markets become more sophisticated because sovereign wealth funds and direct pensions have come in, well, the market was already quite sophisticated,” says Saunders. “There’s a myth that good old Asia is a lovely place but way behind the west in terms of real estate sophistication. That might have been the case 20 odd years ago, but the market has for some time been populated by highly sophisticated investors who frankly know exactly what they’re doing.”

Certainly, nobody today would try to paint Asian real estate as frontier; that’s probably an accolade that falls instead to Africa, and that does have its admirers. 90 North Group, for example, is a real estate investment adviser which helps to put institutional investors into real estate assets, generally in a Shariah compliant way. To date, all its investments have been in the US, UK and Europe, but it is about to make its first emerging market deal, not in Asia or Latin America or even Eastern Europe but in Morocco. The developed world nations “will remain our core markets, because they can deliver capital returns in places investors know and feel comfortable with, with tenants they know well, and can give a yield while preserving wealth. That investor doesn’t need to go to emerging markets at the moment,” says Nicholas Judd, one of the group’s founders. “However, we have been asked by various investors whether we would look at investments in Africa. I’m not sure they are going to deliver returns above and beyond what you can currently get in the UK and US right now, but they represent interesting diversification for investors.”

It’s difficult, though: Judd says many investors would like to buy logistics assets near African ports, but that the land prices in the areas where those projects would make sense are so high that it becomes impossible to build them. “Until the land market becomes more liquid or rational in emerging markets, in the right locations, there are issues about how a real estate market can develop.” The fact that the fund has hired Toby Selman, a founding manager of Raven Russia, which built a US$1.5 billion logistics asset portfolio in Russia, suggests that it does see a future in emerging market real estate.

So where are the emerging markets opportunities? Saunders at Blackrock – who invests purely in direct investment, with listed exposure being conducted through an entirely different team – favours China. “The credit crunch and lack of availability of funding is starting to see some interesting opportunities come out,” he says. “In China, we are particularly keen on the retail sector. The slowdown in China has clearly hurt the residential market and dampened demand for office to a degree, but from the portfolio we have, the retail spend numbers are still extremely robust.” Blackrock will gain exposure in direct real estate either through debt or equity. “We like to find a good piece of real estate, then tend to be fairly agnostic about the way we enter the capital stack.”

Like many institutional managers, Saunders believes one should look beyond China’s biggest cities. “There is a tendency to think about Shanghai, Beijing and maybe Shenzhen, and forget the rest,” he says. “One of our funds owns a building in Chengdu, and that has been an enormously successful centre. It has a very large and very young population, and we’ve seen great performance in terms of sales growth, rental growth, and general asset performance.

“The key to a good retail investment in China,” he says, “is to make sure you really understand the market in your catchment area. Who are you actually going to be selling to? How many are you trying to sell to, and are you selling the right thing? Across the region there is a temptation to get the very best brand names, put them in my store, and say: that’s done. But retail shopping centre management is very different to running an office portfolio. It’s intensive, scientific, and the mix needs to change pretty regularly.”

One major sovereign wealth fund has been looking at Chinese logistics, seeing in it high barriers to entry, a historical lack of supply of land, and considerable demand.

At the other extreme, Saunders has concerns about Hong Kong, partly because the peg from the Hong Kong dollar to its US counterpart removes any ability to control interest rates, and in practice is likely to mean that they effectively go up soon, at the same time that China is slowing.

Not everyone sees the appeal of emerging markets real estate at all. Norges Bank Investment Management, which runs the world’s largest sovereign wealth fund, has added real estate to its traditional debt-equity mix, with 5% of the fund targeted to be invested in this asset class. But, to date, it’s all been in the developed world. “Our strategy is to focus our real estate investments in a limited number of large global cities, where we invest in core retail and office properties,” says Line Haland Aaltvedt, advisor at NBIM. “We do not have any real estate investments in emerging markets.”

So, in the end, is ADIA overweight emerging market real estate? “We judge real estate investments on relative value, cyclicality of markets, their competitive advantages and attractive total returns. I see emerging markets as having more opportunities in that area,” says Walker. “We do look at them very carefully, and perhaps we look at them a lot, and maybe more than others, but at the end of the day it comes back to pricing.”

And that’s as close as you’ll get to a definitive answer on allocation from ADIA.

BOX: The Guggenheim view

Guggenheim Partners has its roots in the Guggenheim family, and remains connected to it. Its investment management arm, Guggenheim Investments, now operates as a mainstream fund manager as well as its role for the Guggenheim family office – and it turns out to be a pioneer in bringing emerging markets real estate to the mainstream.

In September, Guggenheim Investments launched the Guggenheim Emerging Markets Real Estate ETF, believed to be the first ETF to invest in the asset class. It does so by tracking an index custom-built for Guggenheim by index provider AlphaShares, run by Burton Malkiel, perhaps best known for his book A Random Walk Down Wall Street.

Why? “We looked at some of the major drivers around emerging markets, and the megatrends that we expect to be realised over the course of the next decade. The real estate market is going to be a beneficiary of those megatrends,” says William Belden, Guggenheim’s managing director for product development. “It is forecast that within the next five years, the global middle class is going to grow to over 3.25 billion people, and much of that growth we expect to see in emerging markets. That means consumerism growth too.” That, in turn, tends to bring increased participation in real estate, both residential and commercial. Combined with other well-known trends – increasing urbanisation in emerging markets, particularly China; increasing foreign direct investment; growing efficiency for real estate investment through REITS in Asia – it creates a compelling market.

The underlying index is passive, but rebalances, and at the time of writing included 146 constituents. As of mid-February, its top holdings were Emaar Properties, China Overseas Land, and Fibra Uno Administracion; China accounted for 18.43% of the fund, the UAE 15.01% and Hong Kong 12.56%.

Initial take-up has been slow, not helped by markets; total managed assets as of February 15 were scarcely $2.5 million. “But it’s early days,” says Belden. “We remain optimistic.”