Overpriced Chinese residential is pushing investors towards greater Asia - but pan-Asian funds are out, reports Shayla Walmsley

Overheated, overpriced and, oh, so over? It's still an unlikely verdict on China but there are signs that European institutional investors, including pension funds, are looking at a cooling-off period.

Tightening will continue for the rest of the year, predicts Stuart Crow, head of the Asia Capital Markets Group at Jones Lang LaSalle, and it will result in relatively low transaction volumes until demand catches up with supply.

Until then, investors are looking not necessarily outside Asia but elsewhere within the region. According to Soo Hai Lim, manager of Baring ASEAN Frontier fund, the binary focus on China and India emerged in the wake of the Asian financial crisis.

"ASEAN economies used to be known as Asian tigers. Now's the time to look at them again," he said recently, pointing to successful IMF-required restructuring after the Asian financial crisis - a crisis that ironically prepared them to withstand the more recent one.
Almost every country across the region either didn't go into recession or recovered quickly. "The Asian prognosis is remarkably strong, considering what the global economy has been through," says David Green-Morgan, head of research at DTZ.

For most investors, Asia means emerging - and growth - Asia. But Australia - which dipped into recession but only briefly - still has its backers. AFIAA, the investment manager owned by 18 Swiss pension funds, is building up a €280m exposure to Australian commercial. The move is the beachhead to eventual investments in other Asian markets before the end of 2010. AFIAA's owners include BVK, the €2.6trn Zürich civil service scheme.

Yet Australian value is starting to disappear, according to Adrian Baker, head of Asia-Pacific at CBRE Investors. High interest rates mean investors have to hedge currency risk. "But large pension funds like it because it's transparent and linked to the Chinese growth story and, long term, it's a very good core real estate market, with good-quality, income-producing, well-managed assets."

Even Japan, despite being a European-type economy with high government debt and a high savings ratio, at least offers distressed debt as an asset class. ING REIM Asia CEO Richard Price sees investment opportunities already in non-performing or underperforming assets - "not a flood, but a decent trickle, especially if you're working with banks", he says. "Providing equity puts you in a good position."

Despite some residual investor interest in mature markets, the regional hype is around former frontier economies such as Vietnam, which is at the start of the cycle, and which still offers cheap manufacturing. Baker points out that these are taking advantage of proximity to China. "You see higher wages, then the domestic population will have money to spend on consumer durables. But Vietnam doesn't have a billion people like China."

So the regional story is good. The problem is, investors don't want a regional story. If there's one thing investing in failed funds has taught them, it is to be market-specific.
"It's tough to cover the region intelligently from Europe. It's big, it's complex, and it's difficult to do," says Plummer. "Investors are seeking out specific strategies at the granular level."

There's money for Asian markets - although it doesn't necessarily have to come from Europe or the US. The recent refinancing of Treasury China Trust's Shanghai office and retail City Center refurbishment shows one of the trends in the region - that capital is as likely to come from within the region as from outside it. The AUM S$1.94bn (€1.09bn) Singapore-listed developer in July secured a five-year US$480m (€367m) multi-currency loan facility from the Industrial and Commercial Bank of China on "considerably more favourable" terms than a soon-to-expire loan from Credit Suisse. "It was the strongest possible vote of confidence," says CEO Richard David.

The emphasis on local sourcing will be familiar to European pension funds, too - especially those which Baker says "thought they could manage 30-40 funds with three people in Europe". The shift towards funds of funds is a consequence of it, he says. "Now they understand the need for people on the ground. That's been a significant shift. They thought they could do it themselves and they couldn't."

Instead, they're looking to fund of funds with a bias towards smaller, specific funds run by local managers who used to partner global funds. "Pan-Asian funds have been doing very badly and even blowing up," says Baker. "The problem with pan-regional funds is that they don't know where the region is going."

ING REIM in April took over the €824m Creed Real Estate Partners Japan fund, now renamed Nozumi, a year after taking over the New City Asia Opportunity fund. The fund, which delivered a negative return of -19.2% in 2008, has the €10.3bn investment arm of Dutch pension fund TKP as one of its investors. "A couple of investors from the New City fund, pleased with the work ING REIM had done on that fund, asked it to take it over," says Price.

The club-deal fetish has found its way to Asia, too. CBRE Investors raised €218m from 10 European pension funds for an Asian fund of funds but it sees four- or five-way club deals with large pension funds as the way forward - a common enough belief among fund managers but an unusual one for a fund of funds manager. In this case, he's looking towards small funds with three or four ‘like-minded' investors, focused strategies, and manager discretion within tight ranges.

All roads lead to Beijing

For all the local focus, all Asian roads lead to Beijing. Korea has switched its economy to satisfy Chinese appetite. Vietnam produces for relatively well-off Chinese consumers. Even investing in Australia is an indirect play on China's strength - but in a developed market.

In other words, both regional economic performance and the specific economic performances of the region's various markets are in one way or another all predicated on continuing Chinese growth or proxies for it.

Diana Choyleva, an economist at Lombard Street Research, in a research note earlier this month forecast that there would be instability as a result of sustained overheating in the Chinese economy. According to Choyleva, the good news is also the bad news. The economy's response to policy stimulus has been "impressive". But the strong rebound is itself "inherently unstable". "The longer it continues the worse the growth correction is set to be," she said in the note.

Not so, according to Henderson Global Investors' Stanley Chin, director of portfolio management for Asia. He argues that there is no chance of a major market crash in China, despite pockets of overheating. Recent government measures aimed at cooling the property market would likely dampen speculative investment in first and second-tier cities.

Perhaps the mooted uncertainty would be graver were it not for what amounts to a near-consensus on China's long-term economic prospects. "In mature western markets you find you're fighting the fundamentals of the market," says Price. "That's not the case in China. The fundamentals of demand, demographic and economic growth, are all in your favour."

According to Matthew Richardson, head of research at Fidelity, the problem is that investors were so taken with growth they failed to properly evaluate the risk of investing in Asian real estate in the first place. "What interests me about this cycle is that not enough attention was paid to risk," he says. "For some pension funds, reducing risk meant taking money out of the UK and putting it in China. The correction has been priced in but you'd expect to see a risk premium for investment there."

With an eye to risk as well as return, Richardson points out that investors must distinguish between long-term as distinct from income returns. "The entry yield is key to performance," he says. "In the UK and Europe, the typical long-term return you'd expect is 7.5-8%. In emerging markets you would want 10-12% return. In current pricing, if you look at the return of 7%, the risk to return ratio is low in the UK and France. In Shanghai, the yield is 6% but you would want 14%."

Even now, says Plummer, many European pension funds want "to have some property allocations to a region with higher economic growth than fiscally squeezed Europe".

For the time being it might be in abeyance - not necessarily because of emerging market risk but because they can pick up a better bargain within Europe. "On Asia, in general, our clients are relatively optimistic and bullish," says Price. "But the non-Asian ones recognise that at least in the short term there are better cyclical opportunities at home."