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Emerging Markets Turnaround?

Global REIT funds take big hit, but offer long-term benefits

Global real estate funds have suffered several difficult years, posting negative returns and disappointing investors. With funds trading at least 20 percent off their peak pricing for 2011 and posting negative returns ranging from nearly 7 percent to more than 28 percent, industry experts suggest that investors who are looking to diversify their real estate portfolios and to position themselves for an improving global economy should consider investing in global real estate funds.

“If you look at future economic growth and real estate demand, the opportunities are better in emerging markets than here in the U.S.,” says Tom Roseen, a research analyst with Lipper. “It makes sense that global real estate funds are an attractive place for investors over the long haul.”

Relying on Development Activity

Obviously, global real estate fund performance varies based on the composition of the REITs and listed property companies within the fund. What may be less obvious is how REITs and listed property companies across the globe are impacted by regions in which they operate.

While each country has its own specific legislation regarding REIT structures and listed property companies, these companies also are differentiated by their investment strategies, which vary dramatically depending on whether they're based in the United States, Europe or Asia-Pacific. (With the exception of Brazil, there are few publically-traded real estate companies in South America.)

For example, U.S.-based REITs tend to generate the bulk of their income from existing properties with only a small portion of their investment activity focused on development. The reasons for this are two-fold: One, the U.S. is a relatively mature commercial property market with limited development opportunities; two, development is considered a risky endeavor, and investors tend to shy away from REITs that are overly focused on development.

In contrast, REITs and listed property companies based in Asia-Pacific are heavily focused on development. With robust population growth and a burgeoning middle class, opportunities for new development projects are plentiful and varied across multiple property types, from hotels to high-rise residential properties.

Since development tends to provide juicier returns, it makes sense that Asia-Pacific REITs and listed property companies posted better returns during the most recent real estate boom. The flip side is that when the regional and global economies are weak, development activity moderates, which significantly impacts the investment performance of the companies that rely on development.

European REITs and listed property companies traditionally have not focused on development, primarily because most Western European countries have little developable land and limited demand. The opposite is true for Eastern Europe, particularly Russia, the Czech Republic and other former Soviet bloc countries.

However, the risks of developing in these countries are significant. Although a handful of REITs and listed property companies have dipped a toe in these emerging European markets, most of them tend to shy away from countries that still operate under archaic and convoluted property laws. Moreover, opportunities to develop in Europe have been mitigated by the region's economic troubles, which seem to be escalating rather than waning. That translates into depressed returns for European REITs and listed property companies.

Exposure to Emerging Markets

Over the past decade, commercial property developers and owners have been buzzing about emerging markets like the “BRIC” nations of Brazil, Russia, India and China. These markets, with their burgeoning middle class, tend to be chronically underserved for both residential and commercial property.

Global real estate funds benefited from the excitement surrounding emerging markets. Lipper's data shows that global real estate funds posted a 10-year total return of 8.45 percent — outperforming most major indices.

A recent whitepaper by global fund manager Cohen & Steers, “Emerging Markets Real Estate Securities: Risk/Return Profile and Asset Allocation,” found that adding emerging market (EM) real estate securities can enhance a portfolio's risk-adjusted return characteristics. Scott Crowe, global portfolio manager with Cohen & Steers and author of the whitepaper, calculated that a portfolio that included a 10 percent allocation to EM real estate securities would have returned 1.1 percent per annum more than a portfolio excluding this allocation over the 10-year period ended Dec. 31, 2010.

However, the global real estate funds have taken big hits since the global credit crisis and the subsequent global recession. The five-year total return for Lipper's global real estate funds was -5.41 percent.

“The global markets have been crushed, particularly the real estate sector,” Roseen says. “In addition to concerns about Europe's economy, investors also are discouraged by the lack of real estate activity in Asia.”

In fact, fund performance throughout 2011 has been downright ugly. As of Sept. 22, global real estate funds had a total return of -13.88 percent, according to Lipper.

Even the best performing fund, DFA Global Real Estate Securities Portfolio (Ticker: DFGEX), still posted a negative total return of 6.94 percent. The worst performing fund, Alpine Emerging Markets Rl Estate Fund (AEMEX), posted a total return of -28.12.

Despite their less-than-stellar performance, global real estate funds still have managed to significantly outperform their international counterparts, primarily because of their exposure to domestic REITs and other real estate stocks, Roseen notes.

“Domestic exposure has mitigated losses for global funds versus pure international funds,” Roseen explains, pointing out that international real estate funds posted a year-to-date loss of -19.11 percent (as of Sept. 22). Interestingly, the 10-year total return for international real estate funds — 8.89 percent — is better than average return for global real estate funds for the same period.

Strong Earnings Potential

While the global economy continues to cause concern, most real estate experts agree that the worst is over. That means improving property fundamentals across the globe and better financial performance from listed property companies and REITs.

“There are many countries that are on the cusp of major wealth creation,” says Brad Case, senior vice president of research and industry information for the National Association of REITs. “If you are confident that the economy will improve, you want to be investing in global real estate funds now when the price is low and strong earnings growth is in the future. You want to invest before that wealth creation takes place. The biggest mistake you can make is to wait until the recovery is already under way and miss out.”

Crowe wrote in the Cohen & Steers whitepaper that “growth potential is higher for EM real estate securities than for either developed property or broad equity markets.” He concluded that 10 percent to 20 percent of an investor's overall real estate investment portfolio should be allocated to EM real estate securities, subject to individual return and risk requirements.

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