As Asia's markets develop, well-timed value-added opportunities will enable investors to harness the continent's vast potential when the markets begin to stabilise, says Charlie Duke

The real estate investment industry in Asia is faced with dual and somewhat opposing challenges in today's market environment. While inevitably it needs to refocus from active investment to active asset management, at the same time it has to keep an eye on the future and an almost certain wave of opportunities and business growth that will come quickly and in considerable volume. The markets will inevitably stabilise around the world and when that happens, Asia will once again be a prime destination for global investment capital.

As Asia is poised to outperform other regions of the world with better capital growth prospects driven by pent-up domestic consumption and a burgeoning middle class, there will be investment opportunities across the full spectrum of asset classes and investment strategies. The challenge for investors will be in developing a strategy that allows flexibility in a risk-averse environment requiring increased levels of due diligence and governance that will likely linger for some time.

Although value-added investment strategies are not new to Asia, they are not widely employed. Investment strategies in Asia have so far tended towards the opportunistic end of the spectrum. However, as the Asian markets continue to mature, core and value-added strategies will become more prominent in diversified, risk-adjusted portfolios.

Value-added strategies generally consist of two broad classes of investment opportunity. The primary class is asset enhancement in which problematic properties are acquired where the investor believes they are able to achieve enhanced returns through intensive asset management. The second is market timing, where properties are acquired in a market with strong cyclical growth prospects and the investor sees an opportunity to invest ahead of a period with strong rental growth potential.

Considering the current and expected market environment, market timing will feature prominently in nearly all investment strategies which, when combined with a well-conceived value-added execution plan, will enable the investor to outperform traditional return benchmarks. Additionally, and since the base strategy is value added, investments are less time sensitive and therefore have more flexibility in the execution plan, allowing the investor to adjust the strategy as market conditions develop.

The main focus of value-added investment strategies is to find underperforming properties that have fundamental flaws in their operations, positioning or physical configuration. The investor puts together a plan to achieve a targeted level of performance relative to the market.

Depending on the asset's performance and assuming the acquisition price was appropriate for that performance, it is not always necessary that the property outperforms the market in order to achieve the targeted returns. Value-added investment strategies rely less on leverage and more on the underlying fundamentals of the asset combined with proactive asset management and an element of market timing to achieve their returns.

Value-added investing requires a significant amount of hands-on management and specialised expertise. Many of the investments will require some form of capital expenditure in order to transform the asset, therefore the investor needs to have management staff experienced not only with putting together comprehensive positioning, marketing and leasing plans, but also with planning and managing complex renovation projects.

This specialised expertise should enable the investor to identify investment opportunities that many, without such in-house expertise, would normally pass over. The hands-on nature of the strategy means you need to be closer to the ground and able to make informed decisions when circumstances arise and a change of strategy is required.

Over the course of 2009, and as the markets and valuations settle, investors should not be too focused on timing the bottom of the market, but more on identifying the markets and investment opportunities that are most likely to outperform in a risk-adjusted, lower-leverage environment. Looking ahead, we believe that opportunities will arise that are similar to those that followed the Asian financial crises of the late 1990s. For example:

Corporate restructuring of assets: As the credit crunch continues, corporations will feel greater pressure to dispose of assets through discounted sales by means of a sale and leaseback structure;  Increasing vacancy rates in retail and office sectors: In most Asian markets, rental contracts are short-term, providing tenants with the flexibility to reduce their leased space quickly. Increasing vacancy and reduced valuations can trigger default of lending covenants, forcing distressed sales or lender foreclosures. We believe that throughout Asia there will be opportunities to acquire well-located but poorly designed and underutilised existing shopping centres and reposition them with an intensive asset management programme with a moderate-to-extensive refurbishment; Grade B offices in CBD areas: Increasing vacancy and pricing pressure will create opportunities to acquire grade B office buildings in prime locations that will benefit from refurbishment and repositioning in advance of an improving market; Pre-purchasing development projects: Lock in lower cost developments in the short term with underwriting that has more moderate leasing assumptions that are likely to improve over the development period. Development costs are falling across the board. Labour and commodity prices have already come down and land prices are beginning to come under pressure. Few deals are being done and investors remain on the sidelines, driving down profit margins. Developers will be more aggressive in pricing in order to maintain cash flow and market position; Suspended development projects and non-performing loans: Many markets across Asia are already starting to see a number of office/retail development projects fail due to the inability to secure or renew bank financing.

Over the coming 12 months the markets are likely to remain unsteady. Investors will need to be more proactive in the management of their investments through application of a higher standard of due diligence not only in the review of the transactions but also in the selection of their managers.

Although the effects of the global credit crunch have not, as yet, affected Asia to the same extent as the US and Europe, it has had an impact on the upper limits of leverage as well as causing lenders to take a closer look at the assets and the overall operating and financial plan for both the investment as well as the sponsor.

To achieve higher returns, investors can no longer rely on leverage but will need to go back to the fundamentals and focus on discovering how the operating performance of the underlying asset can be improved.

Charlie Duke is managing director at ING Real Estate Investment Management Asia