Assessing Global Real Estate Investment Risks

Assessing Global Real Estate Investment Risks

Political and Regulatory Risks

The political landscape significantly influences real estate investments. Factors to consider include:

• Openness to private business enterprise: A country’s commitment to free markets affects investor confidence.
• Rigidity of labor markets: Stiff labor regulations can hinder tenant operations and growth.
• Nature of labor: Consider whether the labor force is seasonal or long-term, which impacts operating costs.
• Consistency and predictability in application of laws: Stable and consistently enforced laws are crucial.
• Restrictions to international trade: Tariffs and trade barriers can affect the overall economy.

Political stability is vital for sustained real estate growth.

• Democratic environments may offer economic freedom but can be slow to react.
• Authoritarian governments might implement long-term plans more quickly but represent special interests.

Analyzing Political Stability:

1. Consult information and rankings from firms specializing in political risk analysis.
2. Monitor Foreign Direct Investment (FDI) growth as a percentage of GDP; this indicates international investor confidence.

Corruption Risks

Varying business practices and weak legal enforcement can lead to corruption, including:

• Bribery of public officials
• Kickbacks in public procurement
• Embezzlement of public funds
• Political scandals

Managing Corruption Risk:

• Utilize corruption indices from global banks and independent agencies.
• Assess the risk of contract repudiation and the government’s history of breaching contracts without penalty.

Economic Stability and Growth Risks

Analyzing a country’s financial health is analogous to analyzing corporate financials. Key indicators include:

• Revenue Structure: Understand the source and structure of government revenues (taxes, commodities, land rights).
• Fiscal Balance: Determine if government revenues exceed expenses. How will deficits be financed?

Table 1: Basic Indicators of Economic Structure and Growth Potential

Economic Structure:

• Origin of GDP (% in agriculture, manufacturing, services)
• Expenditure on GDP (% from private consumption, government, fixed investment, imports/exports)
• Dependence on exports (% of GDP, trading partners, export types)
• Size of import market, trading partners, import types
• Availability of natural resources and dependency on other countries

Fiscal Structure and Public Finances:

• Sources of government revenues
• Fiscal balance (% of GDP)
• Current account (% of GDP)
• Public debt (% of GDP)
• Debt service paid (% of GDP)
• Cost and maturity of public debt
• Borrowings from international organizations (IMF)
• Foreign exchange reserves (% of GDP)
• Foreign exchange reserves/short-term debt or gross external financing requirement
• Foreign direct investment trends and size

Demographic Structure:

• Age structure of population and ratio of working to non-working
• Dependence on in-migration and remittances

Basic Economic Growth Trend Indicators:

• GDP growth
• GDP per capita (PPP adjusted)
• Unemployment rate and employment growth
• Retail sales growth
• Industrial production
• Size and growth in middle-income households
• inflation❓ (and government target)
• Government bond rates (short & long term, denominated in local currency?)
• Monetary policy/money stock (M1, M2 growth)
• Exchange rate

Aging populations in developed markets can strain economic growth and fiscal balances.

Governments with low debt, low financing costs, substantial reserves, and fiscal surpluses can better withstand external shocks. Assess their historical ability to manage❓ such shocks.

Monetary Policy and Capital Market Structure Risks

A sound monetary policy and stable banking system are crucial. Key considerations:

• Who drives monetary policy?
• What are the monetary priorities?
• How is monetary policy implemented?
• Is there an inflation target, and is the central bank independent?

The local banking system impacts mortgage markets, tenant growth, and interest rate volatility. Evaluate:

• Bank ownership (government, local, international)
• Lending volumes to the private sector
• Consistency of lending and reporting policies with international standards
• Size of non-performing loan portfolios
• Existence of functioning stock and corporate bond markets

Legal and Tax Environment Risks

Investor rights, shareholder protection, legal enforcement, judicial efficiency, and the rule of law vary across countries.

• Some countries restrict foreign ownership.
• Foreclosure laws, processes, recovery times, and amounts vary.
• Rental contracts may be more flexible in some countries.

Expropriation:

• Government seizure of private property is a risk.
• Land-use rights for cleared (expropriated) land are less risky than those for uncleared land.

Tax Structures:

• Tax efficiency may dictate investment through debt, public entities, or minority ownership.
• Taxes impact income versus capital-gain components.
• Repatriation of funds may be taxed.

Tax implications influence deal structure, investment type, and after-tax return expectations.

Local Partners and Competitors

Informational disadvantages can arise from spreading too thinly across markets.

• Experienced local talent is crucial for understanding local language, culture, and conventions.
• Ensure local partners operate and report by international standards.

Exit Strategies:

• Understand potential buyer motivations.
• Consider the different interests of cross-border buyers (sovereign wealth funds) versus local buyers.

Transparency Risks

Real estate market transparency is essential. Key elements include:

• Availability of market trend indicators: Size of the institutional market, new construction pipelines, pre-leasing, demand, occupancy, rental rates, sales prices, yields, identity of owners, operators and tenants.
• Availability of benchmarks: Allowing investors to compare their investment performance.
• Standardized measurements and reporting: Agreement on standard ways to measure and report real estate performance.
• History, timeliness, depth, and frequency of reporting: Data should be reported frequently and with sufficient detail for a long enough historical period.
• Existence of public markets: Public equity and debt markets enhance transparency.

Local Standards and Language Risks

Languages, standards, and measurements vary by country. For example, rent terminology❓ has a wide range of terms such as net rents (typically excluding utilities, CAM, taxes and insurance) or gross rents (typically including utilities, CAM, taxes and insurance).

Rental standards:

• Prime rents: Typically average rents for top buildings, but definitions vary.
• Inclusions: Understand whether expenses are included in prime rents.

Table 2: Comparing Net-Rent Growth to Gross-Rent Growth

Capitalization Rates (Cap Rates):
*Can be misleading due to differences in the way rents and expenses are calculated.

Cap rates should be analyzed as cash yields rather than income yields.

Product Quality

Building standards vary significantly. Limited financing in emerging markets can affect construction quality and ownership structures.

Underwriting Risks

Underwriting standards (discounted cash flow, yield analysis, replacement cost, sales comparisons) are generally similar across countries.

• Lease structures and return expectations vary by country.
• A clear exit strategy is critical.

Lease Structure Risks

Lease structures vary significantly, impacting the risk structure of investments.

Table 3: Comparison of Office Lease Terms by Country

Shorter and easily breakable leases increase risk. Some leases may be denominated in foreign currencies.

Hurdle Rate Calculation

Hurdle rates can be viewed as three components:

1. Government Risk: Estimated as differences in long-term government bond rates or sovereign bond credit ratings.
2. Real Estate Risk: Generally between bond and stock market risk premiums, reflecting the structure and maturity of the real estate market.
3. Deal Risk: Includes occupancy and leasing assumptions, new construction, and leverage metrics.

Execution Risk, Liquidity, and Exit Strategy

Exit strategy execution varies by country due to market size, structure, and investor objectives. Consider the stability and growth of local public markets.

Portfolio Strategy and Risk

Top-down portfolio strategy, allocation, and risk exercises can be applied to cross-country portfolios. Multi-country portfolios introduce new metrics like currencies and sovereign risks.