by Garth Wilson,
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on the net: http://www.dunbar.co.za
SOUTH AFRICA, Oct 13 — With opportunities abounding in Real Estate markets across the globe, why would a commercial real estate investor even contemplate investing in an unknown market let alone an Emerging Market?
Apart from fear of the unknown, investors seldom research the huge differentials between their security blanket market and that of other markets. Also often overlooked is ROI vs ROE, the former been based on the Net Operating Income of the Property measured against the Purchase Price and the latter being the Net Income after Finance Costs measured against the Equity Contribution from the investor. We use South Africa as an example as this is a market we know intimately although this is one of many to contemplate.
W
ith opportunities abounding in Real Estate markets across the globe, why would a commercial real estate investor even contemplate investing in an unknown market let alone an Emerging Market?
Apart from fear of the unknown, investors seldom research the huge differentials between their security blanket market and that of other markets. Also often overlooked is ROI vs ROE, the former been based on the Net Operating Income of the Property measured against the Purchase Price and the latter being the Net Income after Finance Costs measured against the Equity Contribution from the investor. We use South Africa as an example as this is a market we know intimately although this is one of many to contemplate.
So what are these differentials?
Well for one, there are the technical differences in the lease structures. Whilst in the US, leases can run up to 25 years or longer with periodic rent reviews, in South Africa it is common for leases to range between 3 years and 10 years, however, the rentals escalate every year at a preset percentage, usually between 8% and 10%.
Secondly, there is the significant interest rate differential. US interest rates on borrowings are around the 5% mark whereas in South Africa current interest rates on borrowings are around 13%.
Thirdly, there is the colossal differential in yields or cap rates. US cap rates for quality investments can be around 6% whereas in South Africa, quality starts off at around 10% and peaks at around 11.5%...most stock at higher cap rates are often sub-standard investments.
Lastly, exchange rate differential which brings into play currency risk…should the Emerging Market currency depreciate against the Dollar in this instance, the investor will start generating less returns in Dollars. This is a very real risk and for risk averse investors, a currency hedge is imperative…we recommend a hedge for up to 10% depreciation on the currency in which the real estate is located.
So what does all this data translate to? Well, permit us to use an example supported by the numbers contained in this link below.
Imagine investing in quality CRE at a yield of 11% and obtaining fixed rate funding at around 5% (say 4% on finance and 1% for the currency hedge) over a 10 year term.
Between years 3 and 5, the ROE surpasses the ROI with a significant leap in ROE after finance is settled because the investor is not using his own capital to pay the finance installments…the property rentals perform this function.
In this example, the South African rentals will continue to escalate, all things being equal, whilst in the US, rental reviews are periodic. In Rand terms, ROE will be over 300% after 20 years whilst in Dollar terms ROE will be some 275% given a 10% depreciation in the Rand with a currency hedge in place.
So why on Earth would one NOT invest in Emerging Market CRE?
Note:
The financial model per the link is very simplistic...it merely illustrates the differentials contained herein and is not designed to measure other risk factors in real estate that are common to all markets.
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