Elevate Your Portfolio
John Paul Lech, Lead Manager of the Matthews Emerging Markets Equity strategy, explains the potential value that unique real estate equities can offer emerging market-growth portfolios.
The real estate sector may contain good options for equity investors searching for insulation from heightened market volatility, supply-chain disruption and the unfolding inflationary environment. To start with, real estate can and has performed well in inflationary climates by retaining value and providing income. And while most publicly traded real estate options are relatively undifferentiated developers—which are cyclical and lack durable competitive advantage—there are a select group of world-class real estate businesses that offer more. Finally, certain real estate businesses have been less impacted by the geopolitical factors and supply chain disruptions that have been a drag on some other sectors.
Types of real estate-equity investing
Investors have typically viewed real estate within a broader asset allocation alongside equities, cash, fixed income and alternative investments. And while most types of real estate are probably better held directly or in specialty vehicles, investors can get exposure to high-quality businesses in the public markets. From an equity investor’s perspective, the first thing to grasp is the breadth of the sector. It ranges from traditional development-oriented businesses often involved in local projects where future returns are determined by property sales, to specialized real estate asset managers with recurring cash flow.
The development business is most prevalent in emerging markets. It typically acquires land, entitles it, plans a project and then either sells or holds onto the completed project. The working capital cycle can often last years. Margins are often high for successful projects and disastrous for bad ones. On the face of it, the key to success for these types of business is having an advantage in either land acquisition, construction, marketing or cost of capital. However, it’s questionable as to how durable these advantages actually are. And many of them, like access to land, may be influenced by government. Companies whose advantage is proximity to government often see their advantages fade if they fall out of favor or the government changes.
Visibility and flexibility
A smaller subset of real-estate businesses are less about development and more about recurring income. These business models are quite diverse and may range from those that actually own lots of real estate to essentially third-party managers.
Businesses that own or operate real estate differ greatly in their operational intensity. Some are almost akin to fixed income with relatively predictable and long-term distributions of cash and others are operationally intense and have greater upside potential but also more volatility or risk.
Similar businesses are influenced by geography as well. For example, office buildings, warehouses and logistics facilities tend to have shorter lease terms in most parts of Asia when compared with the U.S. This can allow leases to be adjusted upward more frequently in periods of rising prices, which can potentially provide more upside in inflationary environments but less visibility and defensiveness in a down market.
What to look for in real estate within an equity portfolio
For the Matthews Emerging Markets Equity strategy, we look at the real estate sector essentially as we do other sectors where our philosophy guides us. First, we look at durable competitive advantage. In real estate, this often is about scale, relationships, insight and portfolio breadth. Owning a warehouse sounds simple but it needs to be managed efficiently with the access and ability to serve large and complex clients, and a pipeline of potential assets to grow the business. Partnerships with global firms are often critical.
We also look for a history of capital allocation. Some operators are very good and some are extremely poor. Good companies are often able to manage their portfolio over time recycling capital from lower returns or mature projects to ones with more upside. Poor companies often ride a cycle until their luck runs out. Like other sectors, the real estate sector suffers from a degree of imprecision. It’s possible for a business to be classified as real estate without owning much in the sense of real assets. Real Estate Investment Managers (REIMs), for example, are often capital-light businesses that don’t own assets but receive fees based on either the value of assets managed or on the value of certain contracts. While these businesses don’t own assets, their fees are still tied to rents, meaning they still can offer a degree of inflationary protection.
As we look across markets, the prospects for real estate vary widely. Residential real estate in China, for example, is clearly going through some challenges, which mostly impacts developers. The government is trying to reduce indebtedness among some developers and at the same time home sales have weakened. As a result, defaults and consolidations are occurring. Developers aren’t really differentiated in terms of sustainable competitive advantage and consequently we have never owned these businesses in any regional market.
We are more focused on the growth opportunities provided by solid, income-orientated real estate firms, with a particular focus on industrial, logistics and commercial portfolios. We believe these opportunities exist in many markets including Mexico, Singapore and the Philippines where our current positions are listed. One strength of commercial real estate, for example, is that it can’t be disrupted in the way industries can. For example, the shift to online retail sales hasn't meant less real estate. Online sales require fewer stores but necessitate two or even three times the logistics and warehousing space.
Looking ahead, the only thing we know is that the next few years are going to be different than the last few. The next investment cycle may feature quite a different backdrop of interest rates, capital availability and inflation to what we have been accustomed to in the past decade. Targeted exposure to specific real estate business models in emerging markets could offer an extra growth dimension with inflation protection and predictability from an overlooked—and often misunderstood—sector in these challenging times.
John Paul Lech