The global Real Estate correction that is currently underway may go down in history as one of the greatest asset bubbles the world has ever seen. The global markets have experienced numerous asset bubbles in the past dating back to the Dutch tulip crash of 1637 through the Dotcom bubble of 2001. However it could be argued that no single speculative asset bubble of the past was as far reaching and as the financially traumatic as the current housing crisis!

At the epicenter of this maelstrom was the US housing market which saw housing prices explode increasing in some cases by 50% or more with a two year period. The US consumer and US financial system became addicted to leverage with home owners taking home equity loans on non-realized housing appreciation to finance new cars and vacations while financial institutions jumped in head first with leverage ratios of 40 to 1 or greater. Often described as the world’s greatest Ponzi scheme the carnage was not limited to the United States spreading quickly to various parts of Europe as well. Financial regulations had been gutted in 1999 at the behest of the US Republican dominated congress and new regulations that should have regulated exotic derivatives simply did not exist. The initial response to the crisis by the Bush administration was schizophrenic with the administration first claiming that the US economy was fundamentally sound and then days later rushing to congress to ask for $700 Billion in funds to stave off a financial Armageddon. In many cases that capital was pumped into financial institutions that had made bad management decisions and had engaged in risky financial practices ultimately rewarding bad behavior with US tax payer capital.

There has now been a concerted attempt on behalf of the G20 to stabilize the global financial system and in the case of the US to stabilize the housing market. While I believe that to a large degree the efforts to stabilize the global financial system will be successful which have included fiscal stimulus measures, capital infusions and mark to market accounting rules I am less certain as to the prospects for the US housing market. There are a number of reasons for this pessimism; first, there are more than 20 million empty homes in the United States with relatively low demand. Second, easy credit with low or in some cases no equity no longer exists making it much more difficult albeit more rational for the financing of new homes. Third, more than tweleve trillion dollars of equity and capital have been wiped out in the United States making speculative buying a distant memory for most. Fourth US financial institutions are still adding to their loan loss reserves and until the bleeding stops credit will continue to be tight. So while the US housing market maybe approaching a bottom of sorts it is difficult to envision any significant rebound and concurrent appreciation of these assets in the near future.

This brings us to the proverbial light at the end of the tunnel. There are currently three real estate markets in the world that will offer investors the opportunity for significant returns going forward; China, India and Brazil. There are a number of commonalities that these three countries share; a growing middle class, a shortage of affordable/quality housing, increasing availability of financing, financial institutions that have no or limited exposure to subprime debt and growing rates of domestic consumption. China and India also have some of the highest domestic savings rates in the world adding to their value proposition. In the case of China the shortfall in housing versus demand exceeds seven million units by official estimates. But this may mask the true demand as demographic shifts to the coastal areas drive up demand for mid tier multifamily housing in the coastal regions.

The opportunity for real estate investors in these three countries may be greater today than at any other point in recent memory. All three markets have felt the impact of the global recession with reduced exports, falling commodity prices and shrinking liquidity. This has created a concurrent correction in the real estate markets of these markets. For the Chinese market real estate prices have fallen 30% to 50% in some areas with numerous small developers unable to complete a myriad of developments. While the Chinese economy was clearly over weighted to exports the collapse in the demand for those exports has forced the Chinese government to reorient the economy to a much more balanced domestic consumption model. At the core of this reorientation is a $580 Billion stimulus package which equals 20% of China’s GDP. This capital is being invested in infrastructure, education and healthcare all of which will foster domestic consumption.

Russia is a somewhat different story in my opinion. The Russian economy continues to be overly dependent on commodities for growth and when commodity prices decline so does the Russian economy. The current Russian recession is deep with double digit unemployment and high rates of inflation. Any potential rebound in the Russian economy is not likely until 2010 at the earliest and with high rates of inflation even an economic rebound would be tempered. This makes Russian real estate a less attractive value proposition when compared to China, India and Brazil and as such I would recommend focusing on the markets that have the potential for the greatest returns.

The key challenge for potential investors in any of these markets is executing a successful entry strategy. In most cases these market are opaque with byzantine legal systems that can make legal recourse difficult or take years to resolve. Many global funds have created country specific or regionally specific funds for these markets. But they are ultimately dependent on partnering with local real estate developers to deploy capital and to realize returns on successful projects. The challenge to this approach is that while the fund manager will claim to be an active partner and that they carefully screen local developers they are ultimately third party observers subject to the whims of the developer in question. Additionally this model erodes the ultimate returns of the fund and concurrent profit of the Limited Partners as the developer will demand a portion of the profits from the development in question. The developer may also use many other methods to insure that they are making a hefty profit!

A Possible War of Currencies?, April 9, 2009