Investors are moving Asia to their long-term strategic allocations but are they being rewarded adequately for the risk? Richard Lowe reports
Asia Pacific is the region of choice for European institutional investors today, whether they are looking to diversify their real estate investments globally or increase their current exposure. The diverse region, which takes in more mature and transparent markets such as Japan and Australia, as well as the larger, more risky markets such as China and India, has been attracting European institutional capital since the 1990s.
The Dutch industry-wide pension fund PMT, for example, has been investing in Asia real estate since 1998. PMT is one of the first European pension funds to enter into the Asian markets; the majority of capital inflows from European institutions have come in recent years, with many pension funds still yet to make their first commitments.
The first wave of foreign investors came predominantly from the US, including US pension funds, looking to capitalise on opportunities arising out of the Asian financial crisis of the 1990s. But the motivation for these investors - namely capturing exotic, extraordinarily high returns - is not necessarily the same driving Asian real estate investors today, says Claus Thomas, head of client services for German-speaking regions at LaSalle Investment Management.
"Initially investors going to Asia were the ones going for opportunistic returns - 20% returns, something that was considered quite exotic then and also quite risky," he says. "Funds launched in that period have run very well and investors were in fact getting in excess of 20% return.
"That was the first wave - opportunistic investors with more high-risk return budgets and probably not necessarily with long-term strategic property allocations. This isn't the trend that Asia Pacific is currently finding."
In contrast, most of the foreign institutional capital chasing Asian real estate opportunities today is part of a long-term diversified strategy. And investors are no longer just targeting investments at the high-risk end of the spectrum, but are also looking for opportunities further down the scale.
"What we see from our investors is they are finding [Asian real estate's] place in a long-term, strategic international overall property allocation. What was more opportunistic-driven five years ago has turned or is currently turning. There is still a budget for opportunistic investments, but also now, slowly but surely, an increasing ongoing allocation towards core or core-plus lower-risk returns."
This is certainly the case for AP Pension, which has been investing in Asian real estate for less than two years. The Danish occupational pension fund is mostly targeting core and core-plus - and to a lesser extent value-added - as part of its ongoing plan to commit to an increasing number of investments across the Asia Pacific region.
UK pension funds have generally been slower than their continental European counterparts, with many only having made the decision to invest in property outside their domestic market very recently. This is in part due to the past attractiveness of the UK market, not only in terms of performance, but also size and transparency.
"UK pension funds were slower than a lot of the funds in continental Europe to embrace cross-border investment," says Andrew Smith, head of investment strategy and deputy managing director of Goodman Property Investors. "The UK market was one of the best performing, not just in Europe but globally. It is also one of the biggest transparent markets in the world and for a lot of the UK funds there was not a lot of incentive, while the performance was so good, to actually diversify beyond the UK.
"That started to change to a very significant degree about 18-24 months ago when a lot of UK pension funds were becoming aware that the UK market was starting to get rather expensive, certainly compared with some of the continental European markets, and so they started to take a broader view. In the last 18 months in particular, most of the new pension fund money has gone into continental Europe rather than into UK property.
"Since then, the European markets themselves have become progressively more expensive. Yields have been bid down to very low levels as very strong capital growth has come through. That has helped to accelerate the search for other options of which the emerging markets and some of the quite well developed markets in Asia look very much more attractive. For most investors, Asia is top of the list."
Smith describes two means taken by UK pension funds to gain access to Asia. "Some funds are going for a core-satellite approach where you have a core portfolio invested in lower risk markets, which will provide the basis for the return, and then you might have 20-25% of a portfolio targeting more opportunistic markets or funds," he says. "Asia might be included within that."
The second approach is to place the Asia Pacific markets in an overall global real estate portfolio. "Some investors are doing a global asset allocation process for property as you might in any other financial market."
The London Pension Fund Authority, for example, has given ING Real Estate a mandate for a global fund that will include an Asia Pacific exposure. Philip Jones, investment manager at LPFA, says it is too early to know what specific sectors and geographies it will target, because the fund is still "at the creation stages". But he did reveal it will be "a truly diversified global portfolio".
As Nick Duff, head of property at Hewitt Associates, explains, the approach that a UK pension fund takes often depends where it "is in its real estate strategy".
"Some of the larger pension funds have a UK portfolio and European portfolio. The natural progression from that is then to introduce maybe an Asian portfolio or maybe an internationalised European one. Other investors who haven't invested in real estate could go down the global fund of funds route."
As suggested by Thomas, institutional investors are often targeting core or core-plus investments in Asia. However, core investments are limited to certain markets, with the region's two so-called ‘juggernauts', China and India, offering little other than very development-heavy opportunities.
"I don't think the markets of China and India provide core strategies at all," says Patrick Kanters, managing director of global real estate at APG Investments, which manages the assets of Dutch pension fund ABP.
"Even though there are a few very high quality locations and properties, I don't think you can call them core investments, given the immaturity of the markets."
There are only a handful of markets that really qualify at the moment for core investments, says Nick Wong, managing director for Asia Pacific at ING Real Estate Select, the multi-manager business of ING Real Estate. These are Australia, New Zealand, Japan and the two city states of Hong Kong and Singapore.
"Because of the size of Hong Kong and Singapore, the opportunities are relatively limited," he says. "So, for core investments the opportunities mainly come from Australia these days. Value-added funds are available throughout Asia."
Other investors prefer to focus on the value-added and opportunistic spectrum for their Asian investments. It is in the more emerging markets such as China and India where the highest returns can be sought. These have have very different characteristics, with the former home to massive economic growth but also the political risks that are associated with an undemocratic regime. India, on the other hand, is seen as better regulated in many respects, but seriously lacks infrastructure to support real estate developments.
Jenny Buck, head of global property multi-manager at Schroder Property, suggests investors generally fall into two camps: "There are those who prefer China and those who prefer India. A lot of people are making the decision to focus in on one market over the other."
The Asian portfolio of PMT is diversified across sectors - namely logistics, office, residential, retail - but has a preference towards value-added and opportunistic investments. MN Services manages the fund's international real estate portfolio.
Carolijn ter Haar, senior fund manager at MN Services, says she continues to find China more appealing than India. "It is 100% development if you want to invest as a foreign investor in India. That is something that is not necessary in China, which is why I have focused more on China before and I still am."
However, she admits that China does not come without its own concerns, not least the way in which regulation can be changed overnight by the Chinese government.
"There have been quite a few changes in the regulations in the last year that make it more difficult for foreign investors to invest in China. But on the other hand, while I do believe the Chinese government will come up with further regulations, they will never go so far as to make it impossible for foreign investors to invest or to make the market unattractive."
Return expectations are moderating in Asia - no longer can investors expect to gain easy access to extraordinarily high returns. But David Edwards, director of Asia Pacific research and strategy at Lasalle Investment Management, believes it is still possible to target returns over 20%."We are still seeing a lot of deal flow that we believe will deliver those sort of returns at the property level," he says. "What it means is taking on higher levels of risk."
However, the era of 2002-04, "when you could buy standing assets, do a little fix-up, use quite a bit of debt and achieve high opportunistic returns" are well and truly over, he says. "I think we look at that period as an anomaly rather than the norm. Opportunistic investing now means you have to have opportunistic levels of risk."
In short, investors have to moderate their return expectations for Asia Pacific, unless they are prepared to take on higher levels of the risk. This, of course, is currently the same for other markets in the world. But still, says Edwards, "on a risk adjusted basis, Asia is the region where we see the best returns in a global context."
Buck agrees: "In general, I would say yes, people's expectations of returns need to come down. You have had that one-off initial yield shift and re-rating of the market. The era when people went out to Asia thinking they were going to get 20-25% returns has passed us by now."
However, the situation might not be so black and white. Buck suggests the picture is being made more complicated by repricing in other markets outside Asia Pacific. "I also think we are in an era that, as the UK and US markets fall back a bit, there is actually quite a bit of interest in those markets again, in terms of people's expectations of being able to invest in opportunity funds or opportunistic possibilities potentially on the horizon," she says. "Some of the money that might otherwise have gone to Asia might be looking back at its own domestic market just on a pricing point of view."
Buck is not implying that the growing attractiveness of markets like the UK, which have up until recently been seen as overpriced, will divert capital flows targeting Asia. She does, however, believe fund managers and product providers may have to readjust the pricing of their funds and "the sort of hurdle rate they should be offering their potential investors to get new equity into their funds."
It is still the case, she adds, that: "investors investing in these markets should ideally be receiving a risk premium. I am not sure, necessarily, that the market has completely worked out whether it is getting that risk premium or not and what the right level of the premium is."
Buck outlines a question that European investors might find themselves asking: "Do I need to go to Asia to take that development and opportunity risk - along with all of the issues associated with tax leakage, currency risk, etc. - when I might be able to get my 15% return more locally in a euro-denominated fund?"
Yet, while Buck believes investors may well be reassessing the risk-return profile of investments in Asia, it is never going to put them off from investing in the region altogether.
"That sort of medium-term horizon has not changed," she says. "People still feel that, in the long run, Asia is the up-and-coming powerhouse of the world. GPD growths and population demographics, etc. are all very compelling cases to go into Asia, so I think you will still see money moving there. But maybe people will be a little more discerning."