Are the Foundations Solid for
Emerging Market Real Estate?
J.P. Mei
Stern School of Business
New York University
Are the Foundations Solid for Emerging Market Real Estate?


The dramatic downturn in the Asian property market has led many investors to question the wisdom of long-term investment in emerging market real estate, especially in Asia. Those who proclaimed the Asian economy a miracle a year ago now call it an Asian mirage and vowed never to invest a penny in Asian real estate again. It is worth noting, however, similar views were also held on New York real estate just a few years ago. Thus, in the midst of an Asian property market crisis, it is important to re-examine the fundamentals of emerging market real estate. In this study, we will try to separate the long-term trends from the short-term fluctuations of the market and offer some suggestions for the long-term investor.


 The Foundation Is Still Quite Solid


It is well known that the two main engines of real estate market are population and economic growths. Based on data from the World Bank, emerging markets have 85% of the world population and many of them are expected to grow at several times the growth rate of the U.S. economy. As shown in Figure 1, the population growths of Hong Kong, Indonesia, Malaysia, and Thailand are many times that of Japan. Thus, Unlike the Japanese real estate market, which has been suffering from over-valuation and a slowdown in both economic and population growths, the Asian property markets are only suffering from over-development but still enjoy high population growth. Moreover, despite the fact that these economies may go through a period of painful adjustment, economic growths are expected to pick up once the structural reforms proposed by the IMF are made.

Rapid population growth coupled with economic growth has several important implications for real estate market. First, demographic factors in emerging markets are likely to create a strong demand for housing. According to Jim Rohwer in his book, Asia Rising, "Of the 3.3 billion Asians alive in 1995, some 1.7 billion, or around 52 percent, are under the age of 25. Only 35 percent of Americans and 28 percent of Germans are that young." Over the next 20 years, most of these 1.7 billion people will find jobs, get married, and start families. Twenty-five years ago the young families might have chosen to squeeze into an apartment with their parents. With increasing income, however, they will probably prefer to live on their own. This suggests substantial increases in demand for affordable housing by the young families in the future.

Figure 1: Comparison of Population Growth














Data Source: World Bank "World Development Statistics", 1995


Second, rising population is causing a serious housing crisis in almost all of the major cities in developing nations. For example, according to official Chinese statistics, the average living space for a family of four in Shanghai was about 400 square feet in 1995. For many families, there is only one bedroom so that parents have to sleep in the same room with their grown children. With the exception of some new high-rise apartment buildings in major cities, many apartments do not have private amenities, such as toilets, running water, and stoves. The situation is even worse in Bombay. More than half of its 14 million residents live on the street or in slums with no access to running water or electricity. A family of six would be considered very lucky if they could live in a 280-square foot public housing unit. There is no doubt that, with increased income and a free housing market, residents in emerging markets will spend a significant amount of money to improve their dreadful housing conditions.

Moreover, massive urbanization caused by rapid industriali-zation and poor infrastructure (roads, electric and telephone service, etc.) will also have a positive impact on urban property market. According to the United Nations study presented in Table 1, by the end of 2015, nine out of the ten largest cities in the world will be in emerging markets and none of them will be in the United States. Massive migration from rural areas to urban centers will exacerbate housing problems in these cities. As shown in Table 2, Thailand and China's rural population accounted for 81% and 72% of the total population. But this large rural population is on the move. The urban population is expected increase quite rapidly from 1992 to 2000. For example, it is estimated that about 100 million Chinese migrant workers will be working in cities in 1998. Many emerging markets are already densely populated. India, for example, has almost 10 times the population density of the United States. South Korea is even more densely populated. Any further migration to cities would make urban land an increasingly scarce resource. Of course, population density is not the only factor affecting real estate market. Other factors, such as existing property supply and their pricing, interest rates and alternative investment opportunities.



Table 1
United Nations Estimates of the World's Largest Cities in 2015

(Million Inhabitants)


Projected Implied

Population Population Growth

Rank City Country    1994        2015   1994-2015


1 Tokyo Japan              26.5     28.7          8%

2 Bombay India             14.5     27.4       89%

3 Lagos Nigeria               9.7     24.4     152%

4 Shanghai China           14.7     23.4       59%

5 Jakarta Indonesia        11.0     21.2       93%

6 Sao Paulo Brazil         16.1     20.8       29%

7 Karachi Pakistan          9.5     20.6     117%

8 Beijing China              12.0     19.4     62%
9 Dacca Bangladesh        7.4     19.0   157%

10 Mexico City Mexico 15.5 18.8 21%


Source: Urban Agglomerations 1994, United Nations Publication.


There is ample evidence that a scarcity of urban land has already made emerging market cities some of the most expensive places in the world to live and do business. According to a New York Times study in July 1995, the rent of a decent two-bedroom apartment was $1,500 per month in Buenos Aires, $5,000 in Moscow, $6,300 in Shanghai, $7,100 in Hong Kong, and $7,800 in Bombay. The notoriously high rents in New York ($2,300) were actually quite a bargain by emerging market standards.

Table 2
                  Total        Density               of Total Population
            Population      (people per     Urban  Urban     Rural
 Country     (million)     sq. km.)        1992      2000     1992
Argentina       34          12                   87        89          13
Brazil           164          18                   76        81          24
China        1,215         120                  28        35         72
Chile           14            18                    84        85         16
India          928           264                  26        29         74
South Korea     45      437                  77        86         23
Malaysia        20          55                   51        57         49
Mexico          89          43                   74        78         26
Philippines     68         210                   51       59         49
Thailand        61         111                   19        22         81
United States  265          27                76        78         24
Source: Urban Agglomerations 1994, United Nations Publication




Finally, real estate should profit handsomely from rapidly rising real wages. Property construction is very labor intensive, and the cost of construction labor is rising rapidly in many countries. Between 1991 and 1993, the cost of labor rose 50 percent in China, 22 percent in Mexico, and 20 percent in Korea in dollar terms. Given this rapid rise of real wages, an office building that costs US$200 million to construct today may cost twice as much in less than five years. If the market value of the building reflects its replacement cost, an investor today could reap a capital gain of 50 percent in five years simply by taking advantage of rising labor costs.


Emerging Market Real Estate as a Long-term Investment


The above long-term fundamentals have contributed to quite generous rates of return for emerging market real estate over the past -- rates that are comparable to those from common stocks and well above real estate returns in most developed countries (see Figure 2). While the generous returns in Figure 2 may contain a speculative bubble and are unlikely to be sustainable in future, we believe that the positive long-term fundamentals will continue to help patient investors achieve adequate risk-adjusted returns.

Equally important, real estate is an excellent vehicle to provide the benefits of diversification. It does this in two ways. First, real estate returns have a relatively low correlation with other assets, such as stocks. Second, real estate returns in one part of the world are generally not correlated with those in others. As shown in Figure 1, during the 1988-94 period, when the west and Japan were suffering through one of the worst real estate slumps in history, Asian markets were enjoying a magnificent

Boom. The average correlations between the U.S. and five Asian real estate markets in a study by Quan and Titman were actually negative during the 1988-1994 time period they covered. Thus, putting some share of your portfolio into emerging market properties can reduce the overall risk of your investment program.

And there is an additional advantage. Real estate has been a fairly dependable hedge against inflation in many emerging markets. During periods of double-digit inflation in Hong Kong and other parts of Asia, real estate returns were considerably higher than the rate of inflation, and even higher than the returns from the broad stock market indices in several countries.

Figure 2


Source: Quan and Titman, Commercial Real Estate Prices and Stock Market Returns: An International Analysis, 1996.


All of these real estate investment factors -- generous rates of return, risk reduction through diversification, and hedge against inflation -- make emerging market real estate attractive. Moreover, in late 1997, many real estate companies have plunged more deeply than other blue-chip common stocks in emerging markets, especially in Asia. Equity markets fell a staggering 60 percent (in dollar terms) in Thailand and Malaysia, while declines in Hong Kong, Indonesia, South Korea, and Singapore, have exceeded 40 percent from their peak. Provided these countries take the firm steps to further reform their economy, the crisis in 1997 may prove to be a rare buying opportunity for long-term investors.

In summary, with continued economic growth and favorable demographic trends for the next 20 years, we believe that real estate is still a viable investment asset class for long-term investors. That said, we also like to address some of the risks involved in emerging market real estate investment.


Risks in Emerging Market Real Estate


Investors in emerging market real estate incur many risks, such business risk, political risk, and the risk of speculation. The main source of emerging market real estate risk is speculation. Most real estate developers are prone to excess. During the 1980s, there was excessive development all over the world -- Tokyo, London, California, Hawaii, Texas, and New York. The favorite game was always to see who could build the tallest office tower in town or the most luxurious apartments or hotels in the area. While the party lasted, it was fun for everyone; when it ended, bankers and investors were stuck with huge bills. Over-building in Japan caused Tokyo real estate prices to plummet by two-thirds to three-fourths from their peak in the late 1980s. Wild speculation and excess building in Texas led to the failure of hundreds of savings and loans.

Today, the real estate party has moved to the world of emerging markets. From Bangkok to East Berlin and from Shenzhen to Seoul, armies of construction workers are working on roads, apartment blocks, office buildings, shopping malls, and golf courses. While many of these developments have undoubtedly filled large demand gaps, excessive development has also produced a glut of vacant space and see-through buildings in many "hot" places. According to Shanghai government estimates, the office vacancy rate skyrocketed from 1 percent to over 50 percent in 1997, and rents have fallen by more than 40 percent in Shanghai. Similarly, over-development in Thailand triggered a financial crisis in the banking sector, which led to the sharp currency devaluation in 1997.

To reduce such speculative risk, we suggest that investors avoid the most lavish development projects. One useful measure for identifying speculative crazes in real estate is the ratio of market value of a property to what it would cost to replace the building. A high market-to-replacement ratio (much greater than one) means that it pays a developer to acquire land in the neighborhood and build a similar building. It implies increasing space supply in the future and more competition. Investors in buildings selling above replacement cost can get stuck with a double loss -- falling rents and falling market value of your property. On the other hand, investors buying during a real estate recession, when market-to-replacement ratios are much smaller than one, can get a double benefit. If space demand picks up, it means rising rents and increasing market value for your property. With the recent sharp decline in equity prices and a looming recession in many parts of Asia and Latin America, we can expect many properties will be put up for "fire sale" in the near future, with prices set below replacement costs.

One positive feature that somewhat mitigates the risks is that the property cycles in emerging markets are likely to be shorter than those in developed markets if these markets continue their high economic growth. For example, if Shanghai maintains its 15 percent growth rate in the absorption of space, then even with a 50 percent vacancy rate, it would still achieve full occupancy in four years. On the other hand, it may take a typical American city seven to ten years to fill a 20 percent vacancy if the local economy is only growing at 2 to 3 percent a year.

Another source of risk often cited is the changing business environment. Many observers have suggested that emerging market economies may get more suburban, as happened in the United States, leaving many downtown buildings with large amounts of vacant space. While this may become true in the future, we expect that it will take quite a long time because of the personal nature of business in many emerging markets. Given the poor transportation infrastru-cture for most emerging economies, downtown is still the most efficient place for doing business. While billions of dollars have been spent on the development of new suburban centers, such as the Pudong New Area in Shanghai, so far these suburban centers appear to be complementing the downtown facilities rather than replacing them.

In addition to speculative and business risks, political risk is also a major source of concern for investors. Given its immobility, real estate is most vulnerable to government expropriation and excessive taxes. To manage political risk effectively, it is important to know that it is usually made up of two components, country-specific risk and systematic risk. Country-specific risk, such as change in a nationís tax law or military coups, tends to happen independently across different countries. Thus, by constructing a well-diversified portfolio of real estate assets across many emerging market countries, these risks can be reduced. Systematic political risks tend to affect the returns of emerging as well as developed markets, and they can not be diversified away. For instance, the stability of China, Russia, and the Middle East has broad implications for world development. As a result, real estate assets with significant exposures to these risks should carry appropriate risk premiums.



How to Invest in Emerging Market Real Estate


Most individual investors lack both the expertise to evaluate emerging market property investments and the large sums required to purchase them. Moreover, poor liquidity and high transactions costs make it very difficult to turn property investment into cash if an emergency funding requirement arises or the investment prospects change. Thus, given the absence of emerging market REITs, property company stocks listed as American Deposit Receipts (ADRs) offer the only practical vehicle for individual investors in the United States to add some emerging market real estate to their portfolios.

There are a few dozen property and hotel company ADRs with good trading markets. Recently, many developers, such as IRSA and New World, have invested in Argentina, Brazil, China, India, Indonesia, Malaysia, and Thailand. Thus, investors can obtain property interests in emerging markets by just purchasing some of the property company shares. These shares are traded like regular stocks, and they are covered by many international accounting firms so that company financial information is easily available (For a complete list of property company ADRs and their valuations, see Malkiel and Mei (1998)).

It is worth noting that many emerging market equity funds already have some exposure to emerging market real estate, as the portfolios of these funds usually include some real estate securities. Global real estate funds, such as the Evergreen Global Real Estate Equity Fund, also have some exposure to emerging market properties. Thus, many investors will not need to purchase property company shares directly. But since this exposure tends to be small, you may wish to increase your real estate holdings if you are very optimistic about the long-term effects of economic and population growth. Moreover, real estate in such countries as Argentina, Brazil, India, Indonesia, Malaysia, and Thailand is under-represented in many funds.

We also believe that large institutional investors will be well served by adding some emerging market properties to their real estate portfolios. If these admittedly risky properties are combined with real estate in developed countries, the low correlation of their returns can actually reduce the overall risk of the portfolio. Institutions should not only diversify across different countries, but also across different property types. Portfolio managers may do so by investing in shares of local companies or by taking an equity position in some development projects. Our study also suggests that institutional investors with moderate holdings in emerging market real estate are probably better off sitting through the current market storm in Asia rather than offering these assets at fire-sale prices.

In conclusion, our analysis suggests the foundation of emerging market real estate is still quite solid, despite some structural problems, such as excessive market speculation and political risks. Therefore, they should be included in the construction of any well-diversified portfolio.



Crocker Liu and J.P. Mei, Evidence On the Integration of International Markets and Benefits of Diversification, Real Estate Economics, forthcoming, 1998.

Burton Malkiel and J.P. Mei, Global Bargain Hunting: An Investorís Guide to Emerging Markets, Simon & Schuster, New York, 1998.

Mike Miles and J.P. Mei, China Real Estate Investment: How Risky? Real Estate Finance, 1995.

Danial Quan and Sheridan Titman, Commercial Real Estate Prices and Stock Market Returns: An International Analysis, working paper, University of Texas, 1996.