In this exclusive interview with Dr. David Lynn, a highly regarded author and real estate investment expert, Emerging Real Estate Digest explores the evolving landscape of emerging market real estate investing. Among other texts and articles, Dr. Lynn is the author of "Emerging Market Real Estate Investment," considered by many the authoritative text on the topic for institutional investors and entrepreneurs. This informative interview offers valuable guidance for investors considering opportunities in commercial real estate in the emerging markets.
Emerging Real Estate Digest had the privilege to speak with Dr. David J. Lynn, a well-known author of several published books, including one Published by Wiley in 2010 entitled, "Emerging Market Real Estate Investment" which should be of particular interest to our readers.
Below are the answers to these three questions:
Please describe the evolution of how Western investors have viewed and approached emerging market real estate investing over the years until now.
What are the top two differences between investing in real estate in emerging markets compared to a similar property located in America?
What does the future of emerging market real estate investing look like and what should investors be watching?
You may find Dr. David Lynn's impressive bio at the end of this article.
This is not an advertisement and there are no financial incentives involved. We thank Dr. Lynn for graciously sharing his views with our special audience!
Summary of "Emerging Market Real Estate Investment" the Book
Dr. Lynn focused the analysis on real estate investments in China, India, and Brazil and attempted to provide a framework for understanding those dynamic markets. His approach is practical and aimed at institutional investors and entrepreneurs, not those sitting in ivory-tower perches. A nice summary is provided by then Managing Partner of Real estate for Apollo Global Management, Joseph F. Azrack:
“David Lynn has set the bar with respect to real estate investment in the most compelling emerging markets. Lynn provides a framework for thinking about highly dynamic markets characterized by youthful populations, extraordinary demand, capital inefficiency and, most importantly, aspiration. This book will enlighten institutional investors and entrepreneurs alike. I look forward to another work by David Lynn addressing the frontier markets.”
Question 1: Please describe the evolution of how Western investors have viewed and approached emerging market real estate investing over the years until now
I suppose there are several major phases. Phase I might be described as the Age of Exploration. European explorers starting in the 1400s began to explore the coast of Africa, trading for spices, woods, gold, and precious gems. Soon Portugal then Spain were establishing permanent trading stations in far-off locations. Perhaps these can be considered the first emerging market investors since the ancient times. Then Colonialism developed and European nations were trading, claiming and investing in large parts of South America, Asia and Africa. Investments were made in farms and plantations, mines, forests, and soon infrastructure to serve these investments—roads, bridges, railroads, schools, government buildings, governmental/social buildings, ports and in the latter 19th century, processing and manufacturing facilities. The beginning of the 20th century saw globalization in full swing with significant capital going into emerging markets. Emerging markets were rapidly growing with Colonization and globalization up until WW I. EMs began to develop markets and they were industrializing, albeit not at the same level as Western countries. WW I created a slowdown in EM investment as the Western powers focused inwardly on the war and many were in debt or short of capital for outward expansion or investment. EM investment resumed its rapid pace in the 1920s until the Great Depression, which again led to a slowdown and pullback of EM investment once again.
While traditional EM capital flows were largely directed toward US and Western European opportunities, in the last 25 years, substantial interest has developed for markets in Asia. More recently, investment has been growing in Latin America, Eastern Europe and Russia.
Although most capital currently going into EM real estate has an “opportunistic” risk/reward structure, we expect that, over the next few years, “value-added” and “core” strategies will follow as comfort with international real estate grows and reduction in portfolio risk becomes more attainable.
Investing in EM real estate can provide the investor with the following:
Earn higher returns
Increase diversification
Expanded real estate universe
Higher returns
Many EM countries produce greater total returns than the US in most years, albeit usually with great volatility. Emerging markets are much less competitive so the cost of capital and returns are higher. Equity (and debt) is not as prevalent, thus investors can command a higher rate of return. Higher returns are often driven by higher growth. Asked why he robbed banks, the famous bank robber Willie Sutton replied that’s where the money it. Similarly, real estate investors go where there is growth as high growth tends to result in higher returns. Higher economic growth rates have been found in developing rather than in developed economies for several decades, and I believe that this trend will continue in the near term. In faster-growing economies, the demand for new buildings and facilities should expand proportionately. In some cases, such as India and Brazil, there is significant pent-up demand in several sectors. As a result, investors should expect more development opportunities coupled with the need for additional inbound foreign capital in these countries. Each country is likely to develop its own stock of investment-grade real estate to meet the needs of its expanding economy.
Investors can also achieve higher returns due to advantages in knowledge, expertise and information. Emerging market real estate investing creates the opportunity to transfer the knowledge of real estate management and investment acquired by individuals and firms in developed markets to emerging markets. The widespread desire by a number of countries to create structures similar to the real estate investment trust (REIT) structure in the US is an example of knowledge transfer of an investment vehicle in the real estate industry. We believe that knowledge transfer is a powerful return enhancement technique. Investors may benefit from a knowledge and skill advantage in emerging markets. We can bring techniques, relationships, capital markets capability, etc.
Diversification
A common measure of risk for an individual asset, such as real estate, is the standard deviation of returns for that asset. This risk measure can be partitioned into two parts, systematic or market risk, and unsystematic or property-specific risk (also called idiosyncratic risk). By investing in multiple properties, rather than just one, the standard deviation of the portfolio of properties declines from that of the individual asset, meaning that the multi-property investment is less risky.
The same benefits of diversification apply when a new asset class is added to a portfolio. Adding real estate to a stock portfolio will reduce portfolio risk. The greater benefit is obtained from lower correlation between the two assets. When the portfolio perspective is that of a global investor, then all real estate in all forms in all markets could potentially be placed in the portfolio. It is highly unlikely that the optimum portfolio for this investor would actually comprise only real estate from one country as this scenario would not capture diversification benefits. While any attempt to obtain an optimum mix of assets from a modern portfolio theory perspective might result in a preference for a concentration of assets in some subset of countries, the likelihood of a single country as the only source of real estate assets for inclusion in the portfolio is nearly zero.
Expanded investing universe
Consideration of international real estate greatly increases the opportunities to achieve alpha. For example, the investor may desire to invest in central business district (CBD) office buildings in supply-constrained markets. In developed economies, supply-constrained markets do exist but they are finite, and other investors pursue the same strategy, pushing up prices and lowering returns. By increasing the universe to international real estate and finding supply-constrained CBD office buildings in other countries, the investor can continue to pursue the desired strategy.
The ability to engage in international real estate investment is made easier by the continually expanding universe of investment-grade real estate throughout the world. The estimate of the global stock of investment-grade real estate is now $17.8 trillion, with $4.6 trillion, or 25.7%, in the US. In other words, most real estate suitable for the portfolio of an institutional investor is now in countries other than the US.
Globalization of economic activity has accelerated the development of commercial real estate over an ever-widening array of countries. The process should continue as more countries are added to the list in the future. The market share for smaller countries on the current list will likely expand at the expense of developed economies.
Also EM provides the opportunity to expand into sectors that are still nascent or growing while in developed countries those very same sectors may be stagnant or shrinking, like for example the retail and office sectors in the United States. While arguably the US is over-retailed, many EM countries are growing wealthier and are under-retailed.
Question 2: What are the top two differences between investing in real estate in emerging markets compared to a similar property located in America?
Certainly, there is greater risk investing in emerging markets. There are two basic types and those are country risk and political risk, although those aren't the only risks.
Country Risk
Country risk is the risk that cross-border cash flows will not be realized because of disequilibrium between the domestic platform and that of another country. Given this potential concern, one may require higher returns from an investment as an offsetting factor. Factors that influence country risk can be partitioned a number of ways. Country risk can be broker down further into political risk and economic risk.
Political Risk
Political risk is concerned with government structure, policy, leadership and stability, conflicts, tensions and war, political parties and bureaucracy. A measurement of political risk would attempt to capture the degree of movement along the continuum of political freedoms that lead to stable environments over time. Much of the research to date has tended to use qualitative factors in such measurement. Countries in the Middle East and China for example are now experiencing higher political risk.
Corruption
Investors should be aware of higher levels of corruption in many EM countries. US investors in particular cannot engage in corrupt practices including bribes. Real estate can be a hotbed of corruption in many countries and the inability to engage in these practices can obviate a real estate program or deal.
Economic Risk
Economic risk is concerned with the stability of exchange rates and the performance of the economy. The measurement of economic risk is more quantitative, and insight can be obtained from factors such as output growth, inflation, debt, current account balances and exchange rates. Focusing more directly on business and real estate transactions, factors to be considered include contract law and enforcement, the nature of property rights, ability to meet financial obligations, bankruptcy laws, and methods for handling defaults. Related to economic risks are simply the cultural differences of doing business and investing in a different country. This can lead to confusion and different expectations. In most developed countries, the legal agreement is paramount and must be followed to the letter. In some Ems, legal agreements may hold less importance and not strictly followed.
Perhaps the single best indicator of the level of country risk is the level of income received by each citizen. As per capita income levels increase, the pressures for political change are likely to be reduced and economies flourish, producing a decline in country risk for the cross-border investor.
The absolute level of gross domestic product (GDP) is also an indicator of reduced country risk, even after adjusting for the factor of high per capita income. All things being equal, larger economies are less risky economies. As economies expand, the level of country risk generally declines. Sound monetary policy, resulting in low levels of inflation, is also a feature of countries with a lower level of country risk. By contrast, rapidly expanding money supplies and persistent high levels of inflation result in heightened pressures for currency devaluation.
One strategy that reduces country risk is to monitor the movement of the markets and economic structures toward free and competitive markets. The Fraser Institute of Vancouver, British Columbia, annually rates the economic freedom of countries, taking into consideration five major areas: size of government - expenditures, taxes, and enterprises; legal structure and security of property rights; access to sound money; freedom to trade internationally; and regulation of credit, labor and business. As a final outcome of their assessment process, the Economic Freedom of the World (EFW) rating is produced, measured on a scale from 1 to 10 with the higher value indicating the greater freedom.
Currency Risk
The potential movement of exchange rates in EMs during the holding period of an investment definitely adds risk to the investment in another country should the currency of the country where the asset is located devalue. When the various dimensions of country risk are identified, then strategies can be employed to mitigate that risk. Some will be partial solutions while others might render the particular risk neutral.
In an ideal risk-neutral situation, the exchange rates between two countries would remain unchanged during the life of an international investment. While such a perfect relationship is difficult to find over extended periods of time, there are ways to deal with the problem.
Hedge the currency. Examples of hedging devices include both forward contracts in the currency and currency swaps. Unfortunately, these methods to hedge risks are available on a limited basis, usually for the major currencies of the world, and have a cost associated with their use. The dollar, yen and euro are easily hedged for extended holding periods as these are the most actively traded currencies. However, the same cannot be said for currencies of developing and transitional economies where the risk of currency movement is the greatest.
Use leverage. Borrow funds in the target country to purchase the real estate asset in that country. The debt will be denominated in the same currency as the held asset and the risk of differential currencies on that portion of the investment is neutralized. In order to utilize this strategy, there must be capital available in the target country. While the capital markets of emerging economies are improving, there remain many countries with limited ability to support this strategy.
Invest in markets where real estate leases are dollar- or euro-denominated. With the growth of multi-country trading zones and the increased activity of multinational firms, this strategy is becoming more widely available. The currency risk is transferred from the owner of property to the tenant.
When the country risks are perceived to be high, a strategy of making only short-term investments can mitigate some of the risk. In the short term, the direction of the economy is much easier to forecast. In a like manner, the effects of political change are more visible over a shorter time horizon. As a result, short-term currency movements are more predictable since they are often tied to short-term economic and political health.
Given the wide variety of local practices and procedures for engaging in business and real estate transactions, the selection of a local partner for participation in a joint venture can serve to mitigate much of that risk.
Staying with the theme of “using local knowledge,” many financial services companies have global operations. In the process, local operations for banking and insurance have been acquired and incorporated into the firms. These units are, in turn, a source of local knowledge for the institutional investment arms of the consolidated company.
Question 3: What does the future of emerging market real estate investing look like and what should investors be watching?
The world is ever shrinking and integrating. Some may not like this and are against globalization of any kind including capital investments in real estate. It is easier to communicate, travel and do business in an increasing number of countries.
The US, while large economically, represents less than 5% of the world’s population. We are a mature country and most of the economic and population growth in the world is happening in emerging markets.
EM real estate investment increases risk-adjusted returns and the diversification of a portfolio. Investment-grade real estate is dispersed around the globe and should become more so. Economic convergence is likely to increase information about and the demand for international real estate.
Investors should look for EMs that are growing rapidly, have lower corruption, have growing per capita wealth, large market, a good working environment with regulations and laws that are conducive and protective to the foreign investor.
Dr. David Lynn's Bio
David Lynn, Ph.D., MBA, MS, CRE is an institutional real estate leader, investment expert, portfolio manager, and strategist, with deep expertise and an outstanding track record in private equity real estate, with an emphasis on healthcare real estate. David began investing in healthcare real estate in the mid-1990s.
He is the founder and CEO of Unity Medical Properties (UMP). UMP is a focused private equity real estate firm investing and managing medical buildings around the country. He founded and served as President of White Oak MOB REIT, where he built a national medical building portfolio and operating company, delivering outstanding, top 5% NCREIF performance. Previously David was founder and CEO of Everest Healthcare Properties, LLC in 2014. He created a portfolio of institutional medical buildings across the country and sold the firm to a leading Fortune 500 multinational firm achieving excellent (top quartile) returns and winning “Best Equity Deal of 2019” awarded by Real Estate Finance and Investment.
Prior to establishing Everest Healthcare Properties, LLC, he was the CIO, Executive Vice President, and Head of Portfolio Management for Cole REIT and Cole Investments. As key leader of the Executive Team, he managed the investment functions for a multi-billion-dollar portfolio of private and public real estate funds. David developed and executed strategic plans and played an integral role in deal structuring, negotiations, and delivering tactical direction for acquisitions, dispositions, and fund management. He and team took the flagship portfolio public in a highly successful $12 billion AUM REIT IPO in 2014 (COLE REIT).
At ING Clarion, David was the Managing Director/Partner and Head of Global Real Estate Investment Strategy and Research leading investment decisions and strategies for the $130 billion dollar AUM platform. David was the key architect in transforming the firm from a bottom-quartile performer to a top-quartile performer. He served on the Investment Committee, the Management Committee and the Global Asset Allocation Committee formulating strategies, managing firm-wide investment processes, underwriting, transactions and making critical decisions on funds, REITs, strategies, and transactions that led to massive performance improvement and increased stature and perception of the firm in the institutional investment world.
Prior to joining ING Clarion, David was the Global Head of Strategy and Research with AIG Global Real Estate (AIGGRE), where he led global investment strategy, creating and implementing successful strategies in the primary and niche real estate asset classes and in major countries and markets globally. He pioneered and implemented emerging strategies and new major and profitable markets for AIGGRE. He also served as Senior Director of Development with AvalonBay REIT, Inc and Vice President for International Real Estate Investments for the Keppel Corporation in Singapore.
He has written over 90 articles and published (John Wiley & Sons/Fabozzi/PEI) six critically praised real estate investment books utilized within the industry and universities including Real Estate Mathematics, Active Private Equity Real Estate Strategy, Emerging Market Real Estate Investment, The Investor’s Guide to Commercial Real Estate.
David holds degrees from MIT, Cornell, Berkeley and the LSE. He received his Ph.D. and Master of Science in Financial Economics, from the London School of Economics. David earned a Master of Business Administration (MBA), and Sloan Fellowship, from the Sloan School of Management at MIT as well as a Masters in Urban Planning and Real Estate as a Cornell Professional Scholar at Cornell University. David received his bachelor’s degree in Architecture as a Bank of America Scholar at the University of California at Berkeley.
Other titles by Dr. Lynn:
