The challenge today for fund managers is to create strategies for operating in Asia real estate markets without relying on excessively high leverage. Kristen Paech reports

In Asia, where opportunistic funds are the dominant route for institutional investors looking to access the region, excessively high leverage has been the key driver behind returns in both the listed and unlisted real estate markets.

In markets such as Japan, where debt was cheap, interest rates low and real estate transactions highly leveraged, it had been common for companies to take out 80-90% loan to value (LTV) ratios to take advantage of the positive yield spread.

Those days are now over. With the exception of China, where the government has moved to stimulate lending by local banks, the availability of debt in Asia has almost completely dried up.

Scared of breaching capital adequacy requirements, local banks are bumping up their tier-one capital to ensure they remain compliant with Basel capital adequacy ratios, which require them to have capital equal to 8% of their assets.

Their reluctance to lend to institutional investors is pushing up the cost of debt and having a detrimental impact on investment in the Asia region.

With many loans due to mature this year, refinancing is proving a significant challenge for investors.

"The syndicated loans will be more difficult to refinance, particularly those which are syndicated with foreign banks," says James Buckley, head of Asia property multi-manager at Schroder Property Investment Management in Hong Kong.

"We've seen a lot of that in Australia. Syndicated debt constitutes A$23bn (€12.5bn) of Australian real estate investment trust (A-REIT) debt, of which 71% is provided by foreign lenders with a weighted average maturity of only 2.4 years. With refinancing expected to be difficult in the short term, there could be opportunities to take A-REITs, with substantially undervalued management platforms, private and access high quality real estate at attractive pricing."

Investors that have strong relationships with local banks and stable assets on their balance sheets will be better positioned when it is time to renegotiate. However, even if they do manage to refinance, Buckley says it is unlikely to be at the levels seen in the past. "In Japan we've seen an increasing amount of distress and we see that getting worse during 2009," he says.

"There will be, on a deal-by-deal basis, some very attractive opportunities emerging; it's a question of making the right selection and being able to get in at the right price, given the uncertain outlook. We think it's probably a bit early to go into that market indirectly, but assuming we start to see an improvement in the macro picture, we could be more active investors by the second half of 2010."

In continental Asia, sentiment varies from country to country. Standard Chartered Bank, which derives most of its profits from Asia, Africa and the Middle East, recently reported a 13% rise in operating profit before tax, to $4.57bn (€3.48bn), for 2008.

But despite the strong results, the group said it had been taking "proactive risk management initiatives", including tightening underwriting criteria, seeking more collateral on loans and improving collections activity.

The deflationary environment presents opportunities for fund managers looking to buy assets in the region, but as Peter Wittendorp, managing director of AEW Asia, says, "how do you bridge the [funding] gap?"

He says: "If debt is not available, we have to reprice assets [downwards]. That's where forms of structured equity or mezzanine debt come into play - you put quasi-equity into a deal with a lot of protection, so you structure it like a loan but you call it equity, which hopefully reflects the current market conditions."

Structured mezzanine deals can be used where banks are repossessing assets or putting them up for auction, Wittendorp explains.

"If you're able to lower the LTV to, say, 50% from 80% by putting a quasi piece of debt in place, the bank doesn't have to foreclose and the loan can be paid down," he says.
"Still, the equity is more or less gone, but you give the current equity holder an option to recoup some of the losses."

Japan is widely regarded as the Asian country likely to be hit hardest by the credit crunch.

Kang Puay-Ju, head of property, Asia Pacific, at Aberdeen Asset Management, says the Singapore and Hong Kong property markets have likewise relied on gearing to bolster returns, but not to the same extent as Japan. "The impact [in Hong Kong and Singapore] will certainly be bad, but not to the same degree as in Japan," she says.

"People who have been over-reliant on debt will find it hard to roll over the loans that are becoming due this year and next year, and if they can't there'll be a lot more distressed sales, which would destabilise markets further."

In Hong Kong, transactions have ground to a halt, which suggests that further re-rating of asset prices is likely.

The recent rights offering from HSBC to raise £12.85bn (€14.26bn) also bruised investor confidence. The bank claimed the move would enhance its ability to deal with the impact of an uncertain economic environment, and to respond to unforeseen events.

"In the commercial market people are talking about a possible deflationary scenario, but in Hong Kong the sentiment until now was very positive in the sense that people look at the core central business district [CBD]… and there is no supply coming up in the foreseeable future; it's all in the secondary market," says Wittendorp.

"So people think there's no supply, like in 2003 when SARS hit Hong Kong badly, so we're going to be in good shape. But the availability of credit is drying up. We recently saw HSBC do a rights offering, so now sentiment is slowly changing, and I expect prices to come more our way over the next couple of quarters."

Buckley expects the Hong Kong office market to be one of the fastest markets to correct, particularly because of the large contraction in the finance sector and low supply in central Hong Kong.

"The problem with Hong Kong from an institutional perspective is that it's difficult to access through the unlisted route," he says.

"It's so tightly held by local developers that it might be a market where we look to get exposure through the listed sector."

In Singapore's residential and commercial property markets, prices have fallen and stress is emerging in the latter. "On a wholesale basis, the [residential] market has come off by 30-50% from its peak and that means a lot of developers are stuck with units they can't sell," Wittendorp says.

"However, the encouraging thing about Singapore is that at the lower end of the residential market transactions are still happening and [there seems to be] a little bit of equilibrium."

The shrinking credit market is also causing problems for Asian real estate investment trusts (REITs) looking to refinance, with many trading below their net asset value (NAV).

In early February, the Asian Public Real Estate Association (APREA) asked the Singapore government to help REITs refinance S$4bn (€2.03bn) of debt, stressing that these vehicles are what will attract investors to the market as the country moves out of recession.

But it is the Australian REIT market that appears to have suffered the worst fallout from the global financial crisis, with the sector falling 55.3% in the last calendar year - underperforming both the local share market and the major international REIT markets.

A recent market update from Vanguard Investments suggests that the increased correlation between REITs and shares over the two years to the end of June 2008 flies in the face of the defensive nature of the sector.

"It is the steady income and lower volatility of REITs when compared with shares that have seen investors flood into the asset class," the update notes.

But while REITs have traditionally relied on long-term leases for steady income, and maintained conservative debt levels, Vanguard says the allure of higher returns for shareholders has more recently led them down the path of development profits, funds management and leveraged capital gains.

"The availability of easy and cheap credit, coupled with rising property values, saw many trusts embark on ambitious growth and diversification projects, both locally and internationally, and increase their exposure to more complex, riskier investments," the manager writes.

"The global economic slowdown has forced some REITs to put development projects on hold, while the lower Australian dollar has negatively impacted trusts with international exposure."

Given the issues both sectors are facing, and the continuing risks to the downside, many pension funds are adopting a ‘do-nothing' approach to new investment in Asian real estate.

Furthermore, some pension funds have a ‘denominator effect' on their books, meaning that the re-rating in stock markets globally has pushed the real estate allocation above its strategic target, causing them to breach their long-term asset mix and hence rebalance by retracting from the property market.

"Investors are holding off on buying unless assets are realistically priced, and there typically is a six to 12-month pricing gap in market conditions like these. Buyers are looking ahead in terms of where prices are going to land, whereas sellers are still looking back in time on what they can achieve," says Puay Ju. "People are looking a lot more closely at the risks in the existing portfolio - I don't think institutions are looking to rush into making new investments."

Those that are brave enough to invest are targeting funds that have a more prudent approach to leverage and that have a clearly defined gearing strategy that will allow sufficient headroom to avoid loan covenants from being breached so quickly.

Schroders is preparing to launch a multi-manager platform in Asia, and Franklin Templeton Real Estate Advisors announced in mid-March the final close of the Franklin Templeton Asian Real Estate Fund, with total commitments of $383m.

The fund is a private closed-end fund that invests with selected private real estate funds across Asia, but does not invest in listed property securities or direct property.

"Recent turmoil in the global markets and reduced access to financing have been creating unique investment opportunities in both the developed and emerging Asian property markets," says Glenn Uren, managing director of Franklin Templeton Real Estate Advisors.

"Savvy investors are cautiously exploring the region, looking for undervalued and distressed assets. It's a unique investment climate in which to deploy capital. We believe that 2009 and 2010 should provide excellent opportunities for real estate investing in Asia."

Buckley says that in this tight credit environment a much more conservative strategy needs to be adopted by opportunistic funds. "I don't think leverage has been used particularly wisely in the past by some fund managers," he says.

"Investments leveraged to 80-90% LTVs, which were quite common in Japan, will help enhance returns in a rising market, but real estate values fluctuate in cycles and excessive use of leverage just increases the risk of loss when markets change.

"[Today] we're seeing more reliance on real estate fundamentals, so returns are coming from the underlying assets, with less emphasis on leverage. Opportunistic funds will always have some leverage, but it won't be the same amount that it was previously."

Puay-Ju says opportunistic funds will be forced to bring more asset management skills to the table. "The days of relying on gearing are more or less over, so those people who are able to do development management and value-add well could still be in a good position to get relatively good returns," she says.

"It comes down to the bricks and mortar skills that the managers can bring."

Wittendorp agrees: "If you don't combine the real estate skills with a relatively conservative financing strategy, people don't want to allocate capital at this moment in time."