The size and maturity of Asia make it very attractive market to investors. But where to begin? Stephen Ryan and Jennifer Kaiser explain
Asia once upon a time dominated trade dating back to the days when Marco Polo travelled the Silk Road and became a friend of Kublai Khan who established himself in Beijing. It is the world's largest continent with 47 countries and approximately four billion people, and has emerged as a major real estate investment destination in recent years. However, only a handful of Asian countries are suitable for private real estate investment.
To be considered investable a country must be politically and socially stable; its economy should be either large enough or wealthy enough; or there should be great growth potential. The countries that meet the criteria are likely to generate relatively stable long-term returns for investors. The ‘Investable Asia' consists of nine countries and territories. With nearly 50% of the world population and slightly over 20% of the world economy, the ‘Investable Asia' merits inclusion in every investor's portfolio.
‘Investable Asia' is not only large in size but also quite complex. Table 1 it is clear that the countries are very different in size, wealth, and growth prospects. The countries' economic structure, demographic structure, political system and legal system are also very different. Nor should we expect to see a uniform real estate market in the region. As The real estate markets in Asia are also quite different in many aspects, such as market practice, convention, investment environment, size etc. The complexity suggests that careful due diligence is paramount before investing in the region.
Asia is such a large real estate market that any passive investors who track market capitalisation should include it in their portfolios. But size is just one side of the Asia story. From a strategic standpoint, Asia provides higher long-term return, diversification and unique opportunities. The higher return is driven by strong long-term demand, which is fuelled by fast-growing economies, rapid urbanisation, and increasing personal income, all of which are positive for real estate demand.
The region's strong population growth and productivity catch-up suggest the higher growth rate is likely to persist for a foreseeable period. According to the Economist Intelligence Unit (EIU), Asia's GDP is expected to account for 45% of the global GDP by 2030, almost doubling its share in 2007. Economic growth and urbanisation naturally lead to a rising middle-income class.
Investors seeking diversification may also find Asia attractive, despite its relatively high supply risk and structural risk. Due to its different demographic structure, political systems, and economic structures, the region's economies are weakly correlated with Western economies, and the same applies to the real estate market. The weak correlations suggest that when US/Europe returns are low, Asia may perform well. As such, a multi-region portfolio is preferable to a US-only, Europe-only or even US-plus-Europe portfolio. (Of course, when a global systemic crisis like the current financial crisis occurs, the correlation is likely to increase.)
Last but not least, Asia provides investors with unique investment opportunities that may not be available in other regions. One good example is residential development opportunities in China and India, driven by the aforementioned rapid urbanisation and economic growth. Another example is the institutionalisation of properties controlled by governments (such as in China, Vietnam) or corporations (such as in Japan, Korea, Greater China). As the economies continue to mature, Asian governments and corporations will continue to unload their real estate holdings. Investors may find good deals, especially value-added deals from these properties.
Caveats on risks
Return comes with risk. A major category of risk is the structural risk, including political risks (government stability, social stability, threat of war/terrorism), regulatory risks (government intervention, legal system strength, prevalence of corruption) and financial risks (banking system stability, inflation risk/interest rate volatility, currency regime and volatility). While political risks and regulatory risks are more prevalent in emerging economies, such as Vietnam, China, India, and Malaysia, financial risks can be observed in every country.
Regulatory risk: Do not expect to encounter the consistency of Western style regulations. Planning, legal and taxation laws are as diverse as the countries under the Asian canopy. Most governments can and have introduced swift legislative changes to the developing real estate markets and taxation. Some governments have been known to challenge legally binding transactions from time to time.
Banking system stability is more of a problem for market-oriented countries - in planned or centralised economies (such as China and Vietnam) the governments stand behind the banks and are ready to inject capital into the banking system using their foreign reserves when necessary.
Expatriation of capital when exiting an investment generally is a slow and arduous task, requiring a number of audits and/or sign-offs.
Transparency: The downside to applying a macro top-down allocation to a real estate strategy is that it can result in an overweight position to countries or regions that may not be very developed in global ‘best practice' principles. Valuations, reporting and the operation of investor advisory boards can be fraught with challenges in an opaque market, and practices have come under the microscope in the past two years. The benefits of independent boards in family-owned mega-businesses steeped in tradition may be dismissed as unnecessary and an impediment.
Manager skill: Globalisation of capital provides a strong headwind for up-skilling in the Asian region but frankly it is an uphill push. Admittedly there are a number of global players who have exported their expertise to Asian shores, but apart from this there is a distinct shortage of skills.
Local operating partner risk: Many Asian real estate investment funds use local joint venture operating partners to source investments. Due to concerns about transparency and foreign culture, due diligence on joint venture operating partners must be at the highest level.
Currency risk: It is worth highlighting currency risk because of the high volatility of Asian currencies. Most Asian real estate investment funds are denominated in the US dollar. However, cash flows from Asian real estate investments are generated in local currencies. Even though managers may be able to hedge the equity and rental income, there is a risk that the exit value cannot be hedged.
Liquidity: Liquidity is another concern, particularly for the secondary and tertiary cities where the transaction volumes are traditionally low. Additionally, Asian real estate markets were historically more volatile than the Western markets, partly due to a less robust financial system and partly due to supply being less constrained.
Where to invest?
One cannot apply general risk and return assumptions to all Asian countries. Each one has its unique cultural diversity, dating back even beyond the middle kingdoms and the silk trade routes. Real estate markets in Japan, Singapore, and Hong Kong are much more developed and transparent than those in Greater China and India, while Indonesia and Malaysia have Shariah compliant requirements enshrined in legislation.
Like a passive stock investor who allocates capital among different sectors based on their respective market weightings, a passive real estate investor could allocate capital among different countries in the same way. Using a formula adapted from the model originally developed by Prudential Real Estate Investors, we estimate the real estate market shares of the Asian countries. Clearly, Northeast Asia has the largest market share, followed by Greater China. Given the rapid growth in Greater China and South Asia, we expect the two sub-regions to account for much larger market shares in the future, while Northeast Asia is likely to experience dwindling market share.
A ranking of return and risk factors and country profiling.can help differentiate and select target markets for investors with different risk appetite. For instance, a low risk-tolerance investor should be overweight on the countries in the first row (i.e. Japan, Hong Kong, and Singapore), underweight on markets in the last row, and neutral to markets in the middle.
Real estate investing and ownership in Asia has historically been dominated by wealthy individuals or corporations. Institutional investors are able to access Asian real estate through both public and private markets. Many institutional, global investors are invested in REITs and listed property companies in addition to commingled funds.
In general, mature Asia provides opportunities for lower risk and lower return investment strategies, while emerging Asia offers higher risk but higher return investment opportunities. The majority of Asian real estate investment strategies are either opportunistic or value-added. Typically, over 75% of funds in Asia follow an opportunistic strategy; about 20% of them are value-added strategies; leaving core strategies to account for less than 5%.
Over 90% of Asian strategies are in closed-end commingled vehicles. These funds can be organised by different geographic focus - country specific funds; Pan-Asian funds or fund of funds; global funds with certain allocations to Asia. Global and Pan-Asian strategies are suitable for smaller investors who do not know the market well or whose Asian allocations are not sizeable enough to get meaningful diversification through direct investment. Larger investors with high conviction could consider country specific strategies.
Investors should focus on strategies sponsored by firms who have successful track records of investing in Asia and/or who have unique competitive advantages. Managers who achieve our highest ratings are those that have strong, replicable strategies underpinned by sound investment philosophies and processes. We look for cohesive teams with local skillsets within well managed companies, whether global investment houses or boutiques. The best guarantee of alignment is a house that co-invests with staff who are also incentivised to achieve outperformance commensurate with the fund's risk profile.
Real estate firms investing in Asia and tracked by Mercer include a number of institutional quality firms, most of which are global investment houses. Many of these offer Pan-Asian strategies focusing on diversified property types, as well as country specific strategies targeting the main markets.
In addition, Mercer covers a wide array of strategies across the risk/return spectrum with a number of clients invested in core, core-plus, value-add and opportunistic funds, either at a regional or global level.
The sheer size of the Asian real estate market suggests that Asian real estate will become a large and indispensable component of an investor's global real estate portfolio in time. As the market continues to mature, we expect more institutional investors will invest in real estate in the region. Due to Asia's higher growth and low correlation with other regions, investors who seek higher long-term returns and lower portfolio risks should seriously consider Asia.
A useful starting point is to adopt a top down macro-driven investment approach. Given the relatively high risk profile of the region, investors should select markets before they start considering selection of investment managers and strategies. As there are many Asian real estate investment vehicles for investors to choose from, it is crucial for investors to invest only with experienced and capable real estate managers, whether via commingled funds or segregated accounts. A thorough and extensive manager due diligence process is a must in this region. It is all about great managers who will survive market cycles and consistently outperform their peers.
Stephen Ryan is a principal with Mercer
Jennifer Kaiser is head of Mercer's Real Estate Boutique in Asia-Pacific