Real Estate Boom
The Central American economy grew last year at an average rate of 4.1%, and its capital markets advanced toward greater integration with the rest of the world. As a result, Central American real estate is experiencing a boom. Prior to this dramatic growth, many years had passed without the region witnessing a major expansion in residential and commercial projects, but now, one can simply watch the increasing number of apartment towers overlooking San Salvador and beachfront condos rising high over the Pacific shoreline of Costa Rica and Panama to see this change.
Several factors can explain this real estate boom. Macroeconomic stability has enabled productive sectors to flourish, especially in Costa Rica, El Salvador, and Panama, with the latter two countries having U.S.-dollarized economies. These three nations continue to appeal to high-net-worth retirees from North America and Europe seeking a second or third vacation residence with access to top-quality, low-cost medical services.
In the case of Costa Rica, the long tradition of political democracy and a high literacy rate have made it a preferred destination for foreign companies, such as Intel, to establish part of their operations. In addition, its country-wide tourism strategy has spurred the development of hotels and infrastructure to meet external demand from young travelers. International banks with a regional presence have followed suit, funding the construction of resorts, corporate offices, and private hospitals at competitive interest rates and with viable credit financing structures.
Not surprisingly, the future for Costa Rican real estate is promising. The country is an attractive place with favorable political, economic, social, and weather conditions. But can foreign investors benefit from investing in it?
Investing in Real Estate
As an alternative asset class, real estate provides good diversification because of its low (or even negative) correlations with stocks and bonds. It further enhances portfolio returns and protects from inflation risk because of the potential for capital appreciation. Investments in real estate may be direct or indirect, with direct investments being the traditional form. For example, in a direct investment, a large investor, knowledgeable about the local real estate market, leverages his own financial resources to buy property and develop it for sale or lease to potential buyers or tenants. This may require a relatively large investment, something not always possible for everyone, with the investor’s funds committed for a long period of time, during which he will have to cope with the property’s low liquidity. The investor will have to take a dedicated, active role in the management of the investment.
Indirect real estate investments, in contrast, can offer the best of both worlds for investors seeking more accessible opportunities in terms of initial investment, at their preferred risk-adjusted returns, without sacrificing liquidity. They are commonly known as real estate investment trusts, or REITs. Similar vehicles, called fondos inmobiliarios cerrados, or closed-end real estate funds, have emerged in Costa Rica as a result of the expansion in real estate projects. These are collective funds with fixed equity capital and are the only such funds available in Central America. They are constituted as special purpose vehicles that issue shares or participation rights to investors, large and small, wishing to gain exposure to the real estate sector. The closed-end real estate funds are managed by sociedades administradoras de fondos de inversión, or SAFIs, which are real estate asset management companies registered with, and authorized by, the Superintendence of Securities in Costa Rica.
Closed-End Real Estate Funds
A closed-end real estate fund and a SAFI are separate legal entities. A SAFI possesses knowledge and expertise in the real estate market. It invests according to an investment mandate governing a diversified portfolio of completed real estate projects already running in Costa Rica (or another country). The properties are owned by a closed-end real estate fund and administered by a SAFI. The investment risk is borne by the investors holding the shares or participation rights of the fund. Because the funds are closed-end, investors wishing to exit must redeem their shares or participation rights in the local securities exchange at the prevailing secondary market prices.
Closed-end real estate funds have existed in Costa Rica for roughly five years. Their assets are mostly invested in commercial property for lease, and their capital structure is largely constituted by the equity representing the investors’ shares or participation rights. The fund can also use leverage to grow its capital structure through bank loans or bond issuances. Income is generated by the rental payments from commercial tenants, typically shopping malls, multinational companies, foreign embassies, and government institutions. Appreciation of property value provides the potential for capital gains. Lease contracts are inflation-indexed and are established for periods beyond one year. Costa Rica’s inflation rate has been in the range of 4%–6% in recent years. Fund expenses consist mostly of fees charged by a SAFI to administer the portfolio of real estate properties. Closed-end real estate funds diversify their investments by property assets, geographical location, and economic sector of the tenants.
Investment, Returns, and Liquidity
The required initial investment to buy a share or participation right of a closed-end real estate fund is a minimum of US$1,000 or US$5,000, depending on whether the fund’s property assets are located in Costa Rica or abroad, respectively. Therefore, retail investors, whether local or foreign, can easily access these funds because the initial investment is very low compared with a direct real estate investment. Closed-end real estate funds have reported average annual returns between 7% and 8% during the past five years, composed of dividend yields from rental payments and capital gains from property appreciation in value. Key drivers of investment returns are occupancy rates, price indexation clauses, and strategic value of the property.
In terms of liquidity, closed-end real estate funds have an active secondary market, with daily pricing in the Costa Rican securities exchange. This is a large advantage compared with direct investing. Investors can exit their investments with relative ease without having to pay a liquidity premium. Moreover, SAFIs have started to promote and list closed-end real estate funds in the securities exchanges of other Central American countries in order to provide them with deeper liquidity.
Retail investors wishing to invest in Costa Rican closed-end real estate funds should consider the risks inherent in the investment. Following are the most relevant risks:
•Financial risk affects the fund when there are changes in the country’s macroeconomic policies that impact the general level of asset prices, interest rates, and the exchange rate. A rise in interest rates depresses the asset property values and increases the financial cost of a loan taken by the fund.
•Liquidity risk arises when the investor cannot redeem the investment in the secondary market within an expected time frame to meet a requirement
(funding liquidity risk). It can also result if the investor is not able to sell at a fair price because of the difficulty of finding an interested buyer (asset liquidity risk).
•Operational risk is higher when a SAFI is unable to fulfill its responsibilities as administrator of the properties, therefore placing at risk the economic value and income generation of the investments. Not providing good maintenance to the property will contribute to its rapid deterioration and losing tenants.
•Concentration risk occurs if the fund’s income depends on a few properties, a few tenants, tenants from the same industry, and/or properties from the same location. A well-diversified fund has investments in several properties located in different areas and leased to many tenants from various economic sectors.
•Occupancy risk impacts the fund’s value when a real estate property for lease remains vacant, or has a very low occupancy rate, for a long period of time. The level of revenue coming into the fund drops substantially, with the resulting unfavorable effect on dividend payments from the fund.
•Price risk can materialize when the fund buys properties at very high prices or sells them at very low prices. Therefore, the potential for capital loss being absorbed by the fund’s equity is large, with the subsequent impact in the value of the investor’s share or participation right.
The political and economic stability of Costa Rica, coupled with its high standard of education and top positioning in tourism, are fundamentals sustaining its real estate boom. Investing in the country’s closed-end real estate funds would provide foreign investors an adequate exposure to an expanding sector of an emerging market country that enjoys investment-grade status. As previously explained, these are suitable and accessible investments for the retail investor, providing liquidity, diversification, inflation protection, and return enhancement benefits.
It is probably a good time for foreign investors to take an objective look at these funds and evaluate their advantages and risks. Just as retirees and ecotourists are benefiting from the real estate boom, foreign investors can, too.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: MHJ