Interest in the Asia growth story has been further bolstered by malaise in Europe and the US, but those seeking insulation from the west may well be disappointed. Kristen Paech reports
With the US economy seemingly slipping into recession, the importance of international diversification for pension funds could not be clearer.
Contagion from the sub-prime mortgage market has spilled into the wider US economy, where domestic institutions are rapidly abandoning their long-standing home bias and turning their attention to the red hot real estate markets of India, China and Japan.
The US$240bn (€164bn) California Public Employees Retirement System (CalPERS) invests in opportunistic real estate across all three countries, having committed $500m to the ARA Asia Dragon Fund in September last year, and a further $500m for potential co-investment opportunities with the fund.
Earlier in 2007, CalPERS allocated $100m to the IL&FS India Realty Fund, $50m to the Sun Apollo India Real Estate Fund and $100m to Secured Capital Japan Real Estate Partners, Asia.
The investments form part of a wider strategy by CalPERS to shift up to half of its real estate portfolio - which is expected to grow to about $30bn in equity over the next five years - into non-US investments.
The $174bn California State Teachers Retirement System (CalSTRS) is another US fund to have bought into the Asian growth story.
CalSTRS counts two Asian investment funds in its tactical real estate portfolio - CBRE Strategic Partners Asia Fund and MGP Asia Fund III - to which it has committed $125m and $400m respectively.
The MGP fund invests in a range of real estate through tactical and opportunistic investments in Asia, while the CBRE fund targets value-added office, industrial, residential and retail investments across the region.
Anshuman Magazine, chairman and managing director of CBRE South Asia, says in India, most of the money being deployed by foreign institutions is opportunistic in nature.
"So far it's the US pension funds that have showed interest in India but I believe we will see European pension funds, especially German funds, looking at India too," he says.
ABP, the €208.9bn Dutch pension fund, is one such company about to make its first investment in the Indian real estate market as it builds exposure to traditional sectors, hotels and logistics across Asia.
Patrick Kanters, managing director real estate, Europe and Asia Pacific, at ABP, says in most emerging markets ABP prefers to commit capital to opportunistic-style investments in order to capitalise on the shortage of high-quality properties.
"We think we can add more value by repositioning of assets trying to profit from distressed situations," Kanters says.
"In this environment where the capital markets are in difficulties, it's really about the property fundamentals and how you can extract more value by active management since you can no longer rely on yield compression."
ABP's real estate allocation to Asia Pacific stands at 17%. In 2007, the fund committed some €350m to non-listed property funds in Japan, China, Singapore and Australia. It is also actively targeting club investments in Asia following the successful set-up of several joint ventures in the European market.
In China, joint ventures have emerged as a good alternative to individual asset acquisition, which has become more complicated on the back of regulations introduced by the government in mid-2006.
The regulatory measures were an attempt to cool down the overheating property market and dampen inflows from foreign investors, which have contributed to China's rising inflation.
Chris Brooke, president and chief executive officer at CBRE Greater China in Beijing, says: "We are beginning to see more strategic partnerships between foreign investors and local developers and institutions whereby the institutional investor is offering capital markets expertise in structuring the vehicle and the local partner is putting in the assets and they are setting up a joint vehicle."
"Asset acquisition is still possible but you need to take into account the different structuring, legal and tax implications around the new regulations, and have an onshore entity for investing, so it's time consuming because it requires a lot of government approvals," Brooke says.
In January, Denmark's AP Pension made its first direct investment in a property fund in Asia in concert with global property fund Sparinvest. AP Pension invested DKK130m (€17.4m) in the fund, which owns shopping centres in Japan, Malaysia and South Korea. One of the benefits of co-investment is the access the pension fund gains to local expertise. "The co-operation is highly beneficial to us," says Peter Olsson, property investment manager at AP Pension. "It allows us to tailor the distribution of investments between different regions, and we also benefit from the thorough analytical work undertaken by Sparinvest."
Magazine believes local knowledge is essential in an emerging market like India. "It's not like London or other European markets where you can invest on a more remote basis," he says.
This is precisely the reason why CalPERS opted to invest through IL&FS when it made its foray into India. Clark McKinley, information officer at CalPERS, says "We felt it was important to do business with a local firm rather than a US firm that had just recently landed in India and was still in the process of figuring things out."
"Coming in as an outsider to invest in some of these markets is a difficult thing to do. There are so many aspects to be on top of - tax issues, currency risk, political risk, as well as cultural, legal and entitlement issues. There's no question that we need to have partners involved with experience in that part of the world."
Fund managers are bullish about Asia's prospects despite China's economic growth inching down from its record rates of early 2007 and threats of long-term rate rises in Japan. In February the World Bank revised downwards its 2008 projection for China's GDP growth from 10.8% to 9.6%, while the Bank of Japan's stated aim is to raise base rates from the current 0.5% level to around 2%.
"We believe that the fundamentals for Asian property equities remain strong, and occupancy around the region has been holding up well, despite market weakness," says Chris Reilly, director of property, Asia, at Henderson Global Investors.
"We have reasons to believe that Asian economies and property markets will fare not only better [in 2008] than during the US-led slowdown in the last cycle, but also better relative to both the US and European counterparts."
These reasons include low corporate and household borrowing in the region, and the continuing rise of precautionary cash reserves.
Furthermore, intra-regional trades have increased, with China now Japan's largest export destination and Europe now China's, rather than the US.
But with the US economic maelstrom threatening to topple the global economy, the question is whether Asia has emerged far enough from US's shadow to avoid getting caught in the eye of the storm.
A common view globally is that when the US sneezes, the rest of the world catches a cold. While that might have been the case 10 years ago, some commentators now believe that the emerging markets have ‘decoupled' from the US economy.
In China, domestic factors such as rising consumption and urbanisation are expected to continue driving demand for residential apartments, shopping malls and office space. Kang Puay-Ju, deputy fund manager for AIPP Asia and AIPP Asia Select at Aberdeen, does not believe in the decoupling story and says there may be deeper implications on the economic front if the US spikes into recession.
"Obviously the Indian and Chinese economies are exposed to the US so there could be a slowdown but we see the issue with China more in the regulatory framework," Puay-Ju says. "Beijing seems very concerned about the rising inflation and we expect they will continue to tighten policies regardless of how the external environment in the credit crunch framework plays out. That will have an impact on the property markets, especially when it comes to developments."
The consensus is that the Asian economies would see slower growth which would feed through to demand for real estate, potentially prompting a period of softer total returns.
However, Puay-Ju does not see this as a major problem. "The fundamentals of the Asian economies and real estate markets remain healthy so there is no reason to think that we're going to enter into negative return territory. There is upside, it's just going to be more subdued than we've seen over the last few years and that's not necessarily a bad thing, it could just calm the markets down a bit."
Nick Wong, head of indirect/multi-manager business at ING Real Estate Select in Asia, says economic growth will come down but China, India and Japan should still perform well. "Investors need to be more selective in the current environment because the era of easy debt and automatic appreciation is over, so they depend on the managers that can add value to the properties to deliver the returns," he says.
Japan is still in recovery mode after suffering a long period of economic malaise. The country is expected to suffer more from an earnings perspective than its neighbours if a US recession does take hold, given its trading relations with the US.
As in other real estate markets, the recent market turmoil has seen lenders in Japan become substantially more cautious compared with 12 months ago, when both domestic and foreign institutions were lending freely and giving high loan-to-values.
Andy Hurfurt, director of CBRE Japan, says that in the last three months the number of lenders in the marketplace has shrunk substantially. Those that are lending are charging high spreads on the debt costs and capping loan-to-value at 70%.
"The impact of that has been that these opportunistic players that need 80% or 85% loan-to-values to generate the information ratios they are targeting are no longer competitive, because they can't raise the debt to buy the assets," he explains.
However, while he concedes a major slowdown would have an impact on Japan, he believes it will be less pronounced than would have been the case a decade ago when the country relied more heavily on the US.
Puay-Ju agrees: "If the credit crunch is such that it increases the cost of borrowing too much, that will erode much of the value proposition in Japan, and if the economy slides into recession again that will hurt Japan. But we don't think it will cause a crash because the real estate fundamentals are still looking good; supply is muted, so it's a different scenario to 10 or 15 years ago."
What is more, Japan is the only major economy in the world that still offers positive carry, meaning borrowing costs are lower than yields.
This is where a lot of value creation can be found, especially in the value add and opportunistic space.The sub-prime crisis has also reduced the chance of interest rate rises this year, with a minority speculating that the Bank of Japan could even cut rates in a bid to protect the economy.
"If [Japan] starts to see wages growth and asset prices increase, and we've certainly seen asset prices increasing in both residential and office markets, you would expect the wealth effect to multiply over the coming years and that the Bank of Japan would need to raise rates," says Chris Lepherd, co-portfolio manager, Global Property Securities Fund at Principal Global Investors.
"Having said that, with the US effectively moving into recession and the effect this is likely to have on its major trading partners, we don't expect inflationary pressures to come through in the short term."
Rather than scare off pension funds, Wong believes the shaky global environment could cause funds to up their allocation to Asia-Pacific.
"Most institutional investors in Europe are underweight real estate Asia-Pacific, so given the current physical markets in the US, UK and Europe, the intention is to reduce weightings in the US and Europe and put more money into Asia-Pacific," Wong says. "Given the situation with equities and bonds, many are leaning towards putting more money into alternatives, which means private equity and private equity real estate and hedge funds."
