Improving economic fundamentals and low consumer indebtedness are positives for Asian markets, but the outlook isn't all rosy, says Thomas Au
In 2009, the Asian real estate market benefited enormously from the flood of liquidity provided by central banks and underwent a strong rebound in the second half of the year that few would have anticipated at the start of the year. Yet, we believe that 2010 could be a challenging year for Asian real estate investors.
On one hand, there are clear opportunities as investors capitalise on the gradual recovery of the occupier markets - vacancy rates are peaking and rents are near, if not already at, their cyclical troughs. Renewed optimism and low interest rates also favour real estate investment.
On the other hand, excessive liquidity in certain regions has skewed risk appetite and asset pricing. In particular, there are concerns over a housing bubble emerging in China. Should policy-makers attempt to reverse the capital flow abruptly, it could have an adverse effect on values. As such, a selective and cautious approach is prudent for assessing investment opportunities in Asian real estate.
Without doubt, economic fundamentals have improved. Due to more stable demand and stock replenishment, the purchasing manager's index of major economies in the region has rebounded to above 50, indicating expansion in manufacturing activity. Hence, exports are growing gradually. For example, China's export growth turned positive in December 2009 after declining for 13 months. Besides more stable external demand, domestic demand has also recovered as the employment situation has improved across major economies.
Despite these positive trends and the relatively low indebtedness in Asia, there are concerns. High unemployment rates and high household debt of the western economies are expected to limit growth of consumer spending for an extended period, thus limiting Asian export growth. While stronger intra-regional trade and domestic demand growth could help cushion the impact, growth is not expected to come fast enough or strong enough to completely offset weaker exports. As a result, economies are expected to grow at rates below their potential. In addition, the growth or recovery could be uneven. We may see more promising growth in the first half of the year, followed by a slowdown in the second half as governments reduce lending.
Overall we expect GDP growth rates of key economies to turn positive with growth rates approaching their trend levels. In China, policy-makers are expected to focus on adjusting economic structure. It is likely to continue to support domestic demand while at the same time restrict hot money flows. The government is also curbing bank lending growth and could raise interest rates in order to avoid asset bubbles and control emerging inflation.
Meanwhile, Japan is expected to continue to struggle to drive domestic demand. Although the government proposed another stimulus package towards the end of 2009, the effectiveness of these plans remains in doubt, given the unstable political scene. Interest rates, however, are expected to remain low in the face of deflationary pressure and a weak yen.
With economic conditions stabilising, we expect a gradual return in end-user demand. Our analysis shows that vacancy rates are approaching, if not already at, their cyclical peaks and rents across major markets have also shown signs of stabilising. Low interest rates have also driven demand for real estate. This has been reinforced by investors' strong capacity for investments, which is largely driven by the low indebtedness and strong balance sheets of many regional investors. This demand drove yields down in the second half of 2009.
With government bond yields and saving deposit rates at historic lows, positive spread yield investing could support investment demand in the first six months of 2010. However, if policy changes are enacted, pricing in the second half of the year could be more uncertain. In addition, despite signs of rental recovery, current pricing of some markets may have already accounted for growth. Therefore, we do not expect further yield compression similar to that in the second half of 2009. Investors are likely to remain on the sidelines in order to assess policy changes and to confirm positive rental reversion.
This could be the case in China where massive loan growth has spurred an upswing in the real estate market. Sales transaction volumes increased by 50% year-on-year in 2009 and prices increased by more than 20%, resulting in concerns over a real estate bubble. The government is trying to curb the growth in real estate prices by reducing bank loan growth, raising mortgage lending rates, restricting loan-to-value ratios and removing tax reliefs. These measures could lead to lower transaction activity for luxury residential assets where more speculative activities have taken place. Nonetheless, in Shanghai, a supply shortage in the mid-market combined with rising income continue to drive end-user demand for more attractively priced housing.
The massive distress that was expected in Japan with the coming maturity of large amounts of commercial mortgage-backed securities loans has not materialised, as banks have chosen to renegotiate and/or extend loans where possible rather than pushing for foreclosure. However, there could still be acquisition opportunities arising from J-REIT mergers and from securitised lenders who have closed their business.
Yet, competition for these opportunities, particularly in Tokyo, could be fierce. For example, given current low interest rates, a 6% initial yield for Tokyo offices provides an attractive spread of nearer 300bps. Meanwhile, despite the country-wide depopulation trend, migration into Tokyo has been on the rise and has underpinned residential demand. Higher transaction volumes in the condominium market reflect these trends. Also supply is likely to be limited because projects have been postponed due to the uncertain economic outlook and restricted construction finance.
While the outlook has improved over the last 12 months, we would focus on selective investments, within key markets and with good fundamentals and liquidity. We also regard asset management as crucial as there is limited room for mistakes.
Thomas Au is director of Asia research at Invesco Real Estate.