Following the withdrawal of Western capital from the region, the diverse markets of Asia have been buoyed by growing investment appetite from local institutional investors. But, as Gail Moss finds, opportunities and challenges remain in equal number

As world stock markets continue to suffer the jitters, Asian institutional investors are adding real estate to the armoury of weapons intended to win them consistent real returns.

"With bond yields extremely low and a very volatile equity market, chief executives are increasingly worried that returns cannot cover their liabilities," says Frank Khoo, global head of Asia at AXA Real Estate Investment Managers. "They are looking at upping their real estate allocation to give them an income stream. And those who don't already have any real estate are looking at it seriously."

This renewed interest, plus a degree of cold feet on the part of European investors, means that Asian investors - particularly Koreans such as the National Pension Service (NPS) - are now the most significant in the region, he says.

"The current preference is to buy an asset which they have already physically seen," says Khoo. "The look and feel of what they're buying is important. So many of them have direct holdings, either wholly-owned or through joint venture structure. They are reluctant to go into funds, especially blind funds."

"A number of European and North American capital sources divested from the region's real estate markets during, and shortly after, the global financial crisis," says Shane Taylor, head of research and strategy at ING Real Estate Investment Management Asia. "In some cases they were highly leveraged or had other unsustainable strategies that were unsuccessful during the downturn - such strategies proved insufficiently defensive."

However, other Western investors sold their Asian assets, since these assets were the most profitable part of their portfolios, using the proceeds to bolster their harder-hit domestic holdings. "Since then, comparatively few of those non-Asian sources have returned, although we know that interest is strong," Taylor says. "The most significant amounts of investment capital in Asia have come from domestic investors."

Another driver to local enthusiasm has been that some sizeable Asian institutions - from pension plans to insurance companies - have recently decided, or been permitted, to increase their investment allocations to real estate for the first time. "As these sources of capital expand their real estate portfolios in the coming decade, they will likely play an increasingly important role in driving the regional real estate markets," says Taylor.

Warning signs in China
One booming market - the residential sector in China - is in the process of cooling down. Property prices have soared over the past few years, fuelled by the growth in middle incomes. The Chinese are also starting to release personal savings. China has a high (45%) savings rate and, with a still-underdeveloped equity market and controls on sending capital abroad, this excess liquidity is set to be invested over the years into residential property, a traditional safe haven for Asians.

To head off a potential price bubble, the Chinese government has introduced policies designed to squeeze the availability of credit, including raising the reserve ratio for banks, making it harder for them to lend. The government is also making it harder to buy, by requiring bigger down payments from purchasers.

Furthermore, at the start of 2011 the government introduced regulations banning individuals from buying more than one additional property to their current holdings.
There are also a number of restrictions on people who have been buying in other cities; a typical requirement is that the purchaser has to have paid taxes in the city for more than one year, but in some cities such as Beijing, this can be as much as five years.

Commentators, however, are not necessarily expecting a market crash, but rather a slowdown. "In some segments, notably the luxury end, and in some locations, mainly first-tier cities and selected resort areas, an oversupply of over-priced residential units has been built," says Taylor. "The market for these has greatly diminished due to a number of restrictions, including those on residency, the permissible number of homes per person and new taxes and LTV [loan-to-value] ratios."

Taylor says there may be some falling prices and volumes of sales in selected markets for the rest of 2011, as developers need to clear inventory. Other markets, such as those with higher owner-occupation rates, and where smaller unit sizes target the middle classes rather than the luxury end, should prove to be more resilient.

"We also believe that a good entry point is currently being presented in China for private equity, as many developers are faced with dwindling sources of capital," he adds. "However, the down cycles in China's residential markets tend to be quite short, as pent-up demand tends to rush back into the market at certain times of the year, or when good value is perceived by end-users. We certainly expect nothing like the four-year down cycle which continues in the US residential markets."

Khoo agrees. "The market will correct, because the government is hell-bent on making that happen," he says. "But I don't think the market will crash, as it will be a policy-driven correction rather than a demand-driven correction. And we still see demand there."

Khoo expects the market will correct to a level where the government is comfortable with the consolidation. "If it cools too much, the government will lift the measures," he says. "Too little, and the measures will be tightened."

Simon Smith, head of research for Asia-Pacific at Savills, emphasises the point that China is becoming a large and complex market, with several tiers of cities, each with its own characteristics.

"Data from first-tier cities, such as Beijing and Shanghai, is mixed, but prices there appear to be rising more slowly than before," he says. With the Chinese government anxious - and seemingly able - to maintain the ‘Goldilocks' 8% rate of GDP growth, the continuing expansion of the labour force and rising wages should help to underpin residential asset values, Smith argues.

Furthermore, the recent rule change allowing insurers to buy commercial property is making the Chinese housing market more competitive. However, barriers to entry, such as the importance of local knowledge and the superior speed of local investors, mean foreign investors remain at a disadvantage.

Hong Kong & Singapore
But the big question, as ever, pertains to the wider business outlook. "China is forging more and more economic links with the rest of Asia," says Smith. "So a slowdown in China would have a drastic effect on the rest of the region. And in the opposite direction, the concern is: how much can Asia decouple from the rest of the world?"

Hong Kong meanwhile continues to plough ahead at full speed. "Until recently, the Hang Seng was doing very well, and we are also seeing a very big IPO pipeline, which has prompted a number of investment banks to expand their presence here quite substantially," says Smith.

"Companies from mainland China are also coming in to set up operations. This all means there is a shortage of grade-A space in core locations, so the focus is still on rents, which have risen dramatically."

And money is flooding into the commercial sector as the Hong Kong government pursues policies to cool the residential markets - notably the recent introduction of higher stamp duties for properties bought and sold within two years.

"It's difficult to find en bloc space as local landlords tend to hold this as a long-term asset," says Smith. "Furthermore, development has been held back because the government has failed to deliver more land into the market. So values are pushing northwards, capital rates have fallen to 2.5%, and it is becoming difficult to invest."

On the sales side however, Smith says investors are more likely to be speculating on capital growth than fall back on yield. Typical of the continued interest from foreign investors has been the recent sale of the gigantic Festival Walk shopping mall in Kowloon Tong (pictured) by Swire Properties to Mapletree Investments, in a joint venture with other institutional investors, for HK$18.8bn (€1.67bn). This made it the biggest deal of the year so far.

Singapore is another jurisdiction with a government initiative under way to cool the market, including stamp duty for short-term transactions; there is a 16% tax on properties sold within a year, reducing to zero after four years.

Generally, however, and in contrast with this specific rule, Singapore enjoys a low-tax environment. Furthermore, the two new casino resorts now in business are projected to pull in more revenue than Las Vegas for the current year. These two drivers are proving attractive for expatriates.

"Private individuals and companies are moving to Singapore from higher-tax countries, and are also attracted by the stable government," says Khoo. "So property there has become much more of a global market, with Europeans now buying alongside more long-established investors from China and India."

Glyn Nelson, head of property research for Asia-Pacific at Aberdeen Asset Management, says there has been a surprise recovery in the Singapore office sector. "People were expecting a rebound, but not so early, and not so strong," he says.

Figures from Savills attest to this: the cap rate for offices in Singapore's central business district (CBD) plummeted from 5.2% for the second quarter of 2010 to 3.8% for the same period in 2011.

"A large wave of new completions is coming onstream and, in spite of some concern that demand would not be enough, it has surprised on the upside because of the positive projections for the economy," says Nelson.

Though unlikely to achieve anywhere near the heady 14.5% GDP growth seen in 2010, Singapore is still expected to achieve GDP growth of 5-6% for 2011, according to the Singapore Department of Statistics.

And the good news extends to other sectors. "Singapore retail has enjoyed a strong V-shaped recovery, driven by developments in infrastructure, including its public transport system," says Nelson.

India back on the map
India has not been in the spotlight so much as some other countries but demographic changes similar to those in China make it a future prospect, according to Nelson. "We do see opportunities in both these markets," he says. "Whereas China has just had its recovery, India has had a much longer economic cycle and is just starting to come back."
Nelson is a fan of Indian residential as a long-term play. "The country is experiencing rapid population growth, it has a young workforce and is a leading exporter of information technology services and business process outsourcing," he says. "This is leading to a degree of urbanisation and a demand for good quality, appropriately-priced residential units."

Nelson also prefers retail - which he says has become much more of a stable sector - over offices. "However, we do have exposure to offices over the region, and have achieved high risk-adjusted returns from this sector," he says. And over the next 12 months, Nelson expects both offices and retail to consolidate the slow recovery seen throughout 2011.

However, Rami Kaushal, head of the consulting and valuation team at CB Richard Ellis South Asia, warns of a potential future shortage of stock. "Conditions for developers remain tough, with banks reluctant to lend to the property sector," he says.

"Some developers facing shortages of funds have been approaching private lenders and high-net-worth individuals to borrow money at interest rates as high as 40% to fund ongoing projects or repay bank loans. Others, including real estate giants DLF, are opting to sell off plots in their land bank to raise cash."

Meanwhile, Japan had started on the road back from its long-term economic slump, only to be hit by the catastrophic events of last March. "The triple disaster of earthquake, tsunami and nuclear meltdown has delayed, but is unlikely to have derailed, an economic recovery in Japan," says Taylor.

"The areas most directly affected by the tragedies contained comparatively little institutionally-held, investment-grade real estate, but the events did represent a major supply-side shock to production, and the ongoing power shortages have also affected economic activity."

But although Japan is now back into a technical recession, Taylor says many commentators believe that the recovery has been quicker than they initially assumed.
"The J-REITs [Japanese real estate investment trusts] have been fairly active and some prices in recent property transactions have surprised on the upside," Taylor says. "A key impact has been that occupiers and investors are placing a higher premium on the newer stock of more earthquake-resistant structures."

"There has been a flight to safety within Japan," agrees Khoo. "The spread between prime and lower-quality assets was not that big before, but people are taking the opportunity to move from inferior to better-quality assets, so yields are widening. However, some buyers are buying inferior assets to convert them into better quality properties." Khoo adds that - surprisingly - spreads for loans have compressed, so it is now much cheaper to borrow than before.

Tom Moffat, associate director, investment properties, Tokyo at CBRE says that sentiment for investing in Japan has improved. "The summer has seen continued interest from opportunistic funds, with buyers aggressively looking for deals," he says. "Perhaps more significant was that July saw the return of foreign core funds to the Japan market. There has also been an increase in appetite for retail assets, with investors attracted to the longer lease terms available in this sector."

Interest in logistics continues to grow, with investors anticipating strong demand as reconstruction and rebuilding work starts. And Moffat says the residential sector remains a preferred asset class for investors, as the number of people living in Tokyo continues to rise despite the decline in the country's overall population.