With only 4-5% of Asia's investment grade stock held in REITs, the growth potential is enormous, not least due to a new alignment between the interests of foreign capital and regional developers. Michael Grimes reports
The stock market volatility seen in the last quarter of 2007 and the first few months of 2008 may slow the Asian real estate investment trust (REIT) sector but seems unlikely to stop it completely, says the Asian Public Real Estate Association (APREA).
This is probably because Asian REITs came into being for textbook reasons of global capital allocation when other real estate markets matured and growth in them slowed. Those fundamentals should remain in place despite the fact that the cost of equity for REITs in Singapore, one of the key listing jurisdictions for Asian trusts, has reportedly risen by 30% since the summer.
Singapore, along with Japan and to a lesser extent Hong Kong, was a pioneer in domestic REITs for the same reasons it tends to be a pioneer in most financial service innovations in Asia. They have the greatest depth and structure to their markets, particularly in the fields of equity and property, they have good quality regulation and they have laws that more or less protect investor interests.
Peter Mitchell, chief executive of APREA, says Singapore currently accounts for about 65% of Asian REIT capitalisation and Japan roughly 20%, though he expects to see Singapore growing and Japan diminishing as Singapore ramps up its role as a regional hub for offshore Asian REITs.
Before the recent stock market corrections, the market had expected a raft of REIT IPOs in Singapore during the year, including a US$1.5bn (€1bn) flotation by DLF group, one of India's biggest developers, which specialises in commercial property.
The existing domestic Asian REIT markets are not yet mature, but they are showing signs of age. The Global REIT Report compiled by the financial services company Ernst & Young, notes that the price to earnings ratio for Singapore REITs crept up last year driven by generally strong stock market performance that saw capitalisation rise 57.1% year on year from US$8bn at the end of Q2 2006 to US$22bn at the end of Q2 2007.
"PE ratios are arguably unsustainable in the future," argues Ernst & Young, though this statement was made before the valuation opportunities created by the general market corrections in late 2007 and early 2008.
In Japan, price growth for J-REITs was also very strong in the first half of 2007 with cap rates up 58% from US$31bn to US$49bn.
Asia now seems likely to have a secondary wave of REIT launches in 2008 if market conditions settle down sufficiently. Some of them will be as a result of consolidation among existing players through mergers and acquisitions.
In mid-February, the Japanese property conglomerate Mitsui Fudosan agreed to buy the asset manager of Frontier Real Estate Investment Corporation J-REIT, leading to speculation of more takeovers and consolidation in the market.
"Some REITs are unable to raise money and boost their capital because of the ongoing sub-prime problem," says Naoki Fujiwara, chief fund manager of Shinkin Asset Management in Tokyo, which controls inventory with a current market value of US$5.2bn.
"I think we will see some Asian REITs prove to be more solid and attractive to investors than others," says Mitchell. "It's a healthy stage to reach because until now conditions have been really good and all Asian REITs - with one or two exceptions - have performed well. But those that either over geared or are small and don't have the relative capital advantage, will find it hard - or at least tougher - than the bigger ones. I think one of the lessons to come out of current market conditions is that those REITs that are well capitalised will do well and those that are under-capitalised will find it tougher."
Asian REITs have been popular with foreign institutional investors because they are seen as essentially a defensive holding but with a yield profile superior to other defensive investments such as government bonds, thanks to the support of strong rental growth and high occupancy levels in Asian real estate markets. In January the gap between the average dividend yield of the Tokyo Stock Exchange REIT index and 10-year Japanese government bonds widened to 3.1 percentage points in favour of J-REITs - the largest differential for five years. It coincides with what David Edwards, regional director, LaSalle Investment Management, Japan, describes as historically high occupation levels in the Tokyo office sector.
This underlying faith in Japan's real estate story meant that when J-REIT shares tumbled in line with general equity market corrections at the beginning of January, investors saw it precisely as a valuation opportunity rather than a reason to dump stock. At that time 34 out of 41 J-REITs listed on the Tokyo Stock Exchange were trading below their net fixed asset value, according to data from Bloomberg. Research from UBS Securities Japan covering the same period estimated J-REITs were trading on average at 1.2% below net asset value - almost the lowest level since the Japanese REIT market launched in 2000.
When the SREIT index fell by 20% in the first few weeks of 2008 in line with general falls across the SGX, investors also saw buying opportunities.
New offshore trusts with assets in emerging markets such as India and China may be seen in 2008, according to Mitchell. There may also be new onshore trusts in secondary emerging markets such as The Philippines, Indonesia and Pakistan if those countries can frame workable regulations.
Mitchell adds that from conversations with banks his organisation estimates only 4-5% of Asia's investment grade real estate is currently held in REITs. The potential for capital growth through this type of real estate securitisation is enormous.
"The banks are saying there is a huge amount of investment grade real estate in private hands or in non-REIT public hands that will find its way into REITs. The mere fact these assets are investment grade probably offers some protection from diminishing asset return," he explains.
The recent success of Asian REITs is due not simply to general growth in what has been an extended bull market but because of a new alignment between the interests of foreign capital and regional developers, says Ng Nam Sin, executive director of the Monetary Authority of Singapore (MAS).
"Investor interest and infrastructure investment demand in Asia have often been mismatched in the past," says Ng. "The REIT market has developed because those interests are now aligned."
He suggests the REIT principle could be applied to high-quality strategic infrastructure in Asia such as airports, as well as to obvious commercial assets such as offices and shopping centres. The Asian Development Bank (ADB) estimates that Asia requires US$300bn worth of investments a year.
In Ng's scenario, the Asian green field developer takes the financial, regulatory and political risk, and the REIT owner holds what in effect is a real estate beauty contest to package up the best assets so that institutional investors can harvest reliable rental income. In return the developer gets much needed liquidity for other projects. When Link REIT launched in Hong Kong 2005, it packaged 180 shopping centre and car park assets previously owned by the government, producing a HK$30bn (€2.6bn) windfall for the public purse.
Potential conflicts of interest can occur though when developer-managers set up REITs to monetise their own projects. In May 2006, Great Eagle Holdings, the Hong Kong developer in the 1990s of a 50-storey site in Central district now known as Citibank Plaza, injected its holding in the building into Champion REIT. The trust in turn owns 91.5% of the gross rentable area.
Champion REIT, listed that year with just that one asset, and used interest rate swaps and a dividend waiver by Great Eagle to incorporate the income of future rent rises in its IPO valuation. There was nothing illegal or unethical in this within the generally permissive framework of Hong Kong investment regulations and in the context of the city's tradition for innovative financing. It led though to the perception among some commentators that Hong Kong REITs were lacking sufficient investor focus, and were possibly using the format as a way of dumping assets at inflated prices.
Regardless of whether it was a fair observation, such perceptions, once established, can be deadly for real estate investment prospects.
Mitchell of APREA says because Asian jurisdictions have varying approaches to best practice and due diligence it is not practical or particularly helpful to generalise about investor value across markets.
What can be said is that Asian REITs - as with real estate trusts in North America and Europe - tend to have all the virtues and possibly some of the shortcomings associated with their host economies.
SREITs - like most things in Singapore - tend to be robustly engineered and are served by a stress-tested regulatory framework. In Japan, conservative investment practices mean real estate is barely even considered an asset class in its own right, which means J-REIT managers tend to be less inclined to innovate than SREIT managers.
The MAS says what it describes as its "robust yet pro-business" regulatory framework combined with a competitive environment on taxation - such as a five-year exemption from stamp duty when buying Singapore properties and a 10% reduction on withholding tax on payments to overseas corporate and institutional investors - has helped the city to become the established centre for securitisation of offshore as well as domestic real estate assets.
In Singapore are listed cross-border REITs giving investors exposure to assets in China, Indonesia, Vietnam, The Philippines and Australia. One could argue Singapore is becoming a hub for cross-border REITs in the way Hong Kong became a hub for the initial capitalisation of mainland China's industrial and banking companies from the mid-1990s onward.
There are though potential limitations with cross-border REITs. The first is that because the assets in which they invest are fixed and tangible, such trusts are vulnerable to political risk. If a national regulator or the taxman decides to change the investment rules, the offshore trust has to play along or risk loss or diminution of asset values. The second is that cross-border REITs still need onshore management in order to maintain shareholder value.
Ascendas India, a developer of commercial property including technology parks, launched India's first listed REIT on the Singapore Exchange Ltd (SGX) in August 2007 under the name a-i Trust (Ascendas India Trust). It raised US$500m for the venture from an IPO. Under the Indian government's current investment rules though some of Ascendas' most valuable assets - international quality business parks - cannot yet be injected into foreign vehicles, says Rob Blain, chairman and CEO Asia Pacific of CB Richard Ellis.
"India certainly has some investment grade technology parks and developers there are looking for an exit strategy. When the Indian government eventually allows them to inject these assets into vehicles listed abroad, I think these investments will go well," he says.
DLF group was originally scheduled to list on SGX in the first half of this year but that may be delayed because of market conditions. DLF has more than 224m ft2 of completed development in the housing, office and shopping mall sectors and 748m ft2 of planned projects.
It has been rumoured in the Indian media that in future the national authorities may try to bar Indian assets from being listed in offshore real estate investment trusts.
Mitchell declines to comment on such speculation, but says the country's draft REIT law has raised concerns within the industry.
"The issues that have come up regarding the draft REIT law for India are perceptions of low tax transparency, concerns about low levels of committed gearing - much lower than elsewhere - and the suggestion trusts should be limited to closed-end funds," he says.
Ramesh Sanka, DLF's chief financial officer, wants the Indian government to introduce a competitive tax regime for REITs invested in Indian assets along the lines of Singapore's system. This would include a waiver on real estate stamp duty. Sanka would also like to see tax ‘pass through' regulations allowing income or loss generated by an investment to be consolidated into the income tax return of the owner, thus avoiding the risk of double taxation if the investor or the asset vehicle is based abroad.
So far the Securities and Exchange Board of India (SEBI) has said any planned onshore Indian REITs should pay at least 90% of annual income as dividends and borrow no more than 20% of gross assets but has been short on specifics about REIT taxation, Sanka notes. "The taxation part needs to be made clear," Sanka says.
Mitchell says the second major regulatory development is likely to be a REIT law in China.
"Whether it's a national law or whether it's localised - perhaps just for Shanghai - isn't yet clear. There's concern at government level in China that introducing a REIT law would be contrary to their efforts to hose down the real estate markets by making things harder for foreign investors. I'm not sure I agree with the Chinese government's analysis of the issues, but nevertheless that seems to be its current concern."