by Privcap
June 15, 2015

Development Strategies and Mexico’s Growth Potential

How development in Mexico real estate can offer investors a 500bp premium over comparable new build projects in the U.S., and how Mexico could be a 20-year growth phenomenon.

In a Mexican marketplace buoyed by strong fundamentals and an impressive long-term growth story, developing real estate assets might be the best bet for investors who have already missed the run-up in asset prices over the past three years.

“At 100M people, Mexico is the second biggest out of the five main investable Latin American markets—Brazil, Mexico, Colombia, Peru, and Chile—where you have an attractive combination of scale, relative safety of capital, foreign investors, and a growth opportunity that is likely a 10-to-20-year phenomenon,” says Fred Gortner, managing director and chief operating officer at Paladin Realty Partners. It’s a mix of factors that could bode particularly well for industrial, mixed-use retail, and residential development strategies in the foreseeable future, he says.

Alfonso Munk, Prudential Real Estate Investors

“In emerging markets, with limited existing stock to buy, most of the best plays are to develop institutional-quality, attractive assets where you can develop, stabilize, and sell,” adds Alfonso Munk, Americas chief investment officer for Prudential Real Estate Investors (PREI)—a firm that manages approximately $4B in Latin American investments.

For Munk, changes in the country’s capital markets—not least the introduction of the Mexican REIT-like listed structures, or FIBRAs—have also set the stage for developers and investors alike.

“Before 2010, investors understood the play in emerging markets, but the question was: How do you sell or exit?” says Munk, who oversaw the launch of PREI’s Terrafina FIBRA. “Capital markets and FIBRAs have opened up the ability to understand and plan. These structures alleviated big risks for international investors.”

With the landscape set, both Prudential and Paladin—which have been investing in Mexico continuously for the past two decades—see exceptional potential in development platforms that benefit from Mexico’s flourishing demographics, with strategies that build new assets to a potential 500 basis point premium over comparable projects in the U.S.

“There are at least four macro themes that are reasons to be bullish about Mexico going forward: proximity to a growing U.S. economy, stimulus from the wide-ranging government reform package implemented two years ago, a globally competitive manufacturing sector due to currency levels and relative labor costs, and gradual progress in reining in drug violence,” says Gortner.

Fred Gortner, Paladin Realty Partners

Initially stoked by comprehensive policy reform that attracted significant foreign direct and local pension investments, a “virtuous cycle” has formed, fueling economic growth that has fed new industries that have in turn helped expand the skilled labor force, spurring demand that has propelled real estate asset prices to new highs.

“Manufacturing is the engine of the country,” adds Munk. “Reforms increased highly qualified labor in the country. The country was focused on education, and now they have a large pool of engineers. A lot of people are getting employed. They are earning a paycheck and paying social security and taxes, and they have access to things like social services, housing, and financing. So people do two things: buy homes and consume at shopping centers.”

Manufacturing, employment, and consumption drive demand, so industrial and residential properties and shopping centers were built, Munk continues. There are very good yields on developing industrial assets, and warehouses are leased by multinational tenants with good credit, with leases in dollars, not pesos. “You are developing in an emerging market, but it’s safer because your fundamentals are closer to the U.S., without depending on commodities or the growth of the middle market,” Munk says.

This cycle has also stimulated household formation. Paladin has produced compelling development premiums, focusing their efforts on for-sale residential housing projects.

Santiago Gil, Paladin Realty Partners

“Nearly half of Mexico’s population is under the age of 25,“ says Santiago Gil, Mexico country head at Paladin. “At current growth rates, there are 600,000 new households being formed every year, and that number could go to 1 million annually if the country grows at 3 percent to 4 percent. There’s not enough new housing being built to meet this potential demand.”

Gil says that in Paladin’s for-sale residential platforms, they target higher profit margins than comparable investments in the U.S. or developed markets. Housing developments in Mexico and throughout Latin America are high-margin, low-leverage businesses where there are profit margins of more than 20 percent in most markets, while leverage is typically in the 30 to 40 percent range. “So there’s a much greater margin for error if something goes wrong at the macro level,” he says.

While development opportunities certainly hold promise, market risks are still a concern for many investors. From Munk’s perspective, continued policy strength will be key in Mexico’s ongoing growth. In addition, continued strength in the U.S. economy will play a role, given the two countries are highly intertwined as trade partners. “If the U.S. economy is healthy, then Mexico should grow exponentially,” Munk says. “On the other hand, if the U.S. catches a cold and goes into a soft patch, Mexico is likely to suffer.”

Drug violence, long the subject of headlines, has largely abated in recent years and is now concentrated mostly in specific regions and comprised mostly of infighting among rivals.

For Gortner, though, Mexico should also be viewed through a pan-regional investment lens. “There’s been a somewhat spotty investment history among institutional investors in Mexico over the past two decades,” he says. “We are finding greater interest in a pan-regional investment approach to the growth story in Latin America. Rather than focus solely on Mexico, investors can get the same growth dynamics and better macro diversification by including Brazil and the Andean region among their target markets.”

Investors who have missed the recent momentum in the Mexican market may find industrial, retail, and residential development a lucrative long-term solution.

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