Sentimental education

In a detailed analysis of the recent ULI/PwC survey of investor sentiment towards Asian real estate, Chuck Di Rocco and John Forbes identify a few concerns clouding an otherwise bright horizon

Recent articles in IPE Real Estate have identified a trend for European institutional investors to become increasingly global in their outlook, with much of the attention focusing on Asia. This looks set to continue. The growing Asia Pacific real estate market still offers opportunities for investors and developers in 2008, according to ‘Emerging Trends in Real Estate Asia Pacific 2008', recently published by the Urban Land Institute (ULI) and PricewaterhouseCoopers (PwC).

The report provides an outlook on Asia Pacific real estate investment and development trends, real estate finance and capital markets, trends by property sector and metropolitan area, and other real estate issues pertinent to the countries in Asia. Twenty markets are included in the report.

According to the report, capital continues to pour into the region and, according to many Asia Pacific executives, the outlook remains strong on overall economic and market fundamentals, despite interest rate increases. In addition, survey participants project their firms to have good real estate profitability in 2008, albeit slightly lower than for 2007. As a result of projected growth in profits, survey respondents believe money will continue to flow into the region for the coming year. However, increasing competition continues to compress yields to their lowest points. "Yields are as low as they're going to get - they've been lower than they should be anyway," one interviewee from China declared. In Japan, an executive stated: "I can't see much more yield compression in Tokyo Grade A offices." From Singapore, another noted: "The market just won't take it anymore." Even in China, an interviewee added: "Those who have promised investors high returns are simply not buying."

Private equity, opportunity, and hedge funds lead all others as the primary source for equity capital, followed by institutional investors and pension funds (see figure 1). On the debt side, non-bank financial institutions will be the primary source of funds, according to survey participants; however, mezzanine lenders should be close behind in offering capital in 2008 (see figure 2). Survey results show that the rate of increase in availability of equity and   debt from all sources is slowing slightly compared with 2007, but both are projected to continue to have positive capital flows in 2008, leading to an oversupply in both arenas.

So where will the capital come from? Although European investors are expected to
increase their investments in the region, the rate of increase is expected to slow slightly. Europe is well down the league table for change in availability of equity capital. According to the 2008 survey, the Middle East will continue to be the top supplier of new capital, as it was in 2007. Many people interviewed noted a trend in which Arab investment houses set up regional teams rather than operate though proxies such as global funds.

Direct or indirect, the increase in profits from oil sales has left Middle East wallets bulging and their owners looking for opportunities in real estate. However, there is a problem: as one interviewee said: "The reality, of course, is that much of it [capital] isn't finding a home. It's sloshing around the region forcing up prices and compressing yields." Regional investment from other Asian countries is also a major feature of the market.

Yield compression generated by this continuous flow of capital has greatly reduced opportunities and returns in many of the top real estate markets, although certain tier 1 markets, such as Shanghai and Beijing, should still be able to benefit with rent increases to satisfy bottom-line requirements. Survey participants still rank investment prospects in the major markets of Shanghai, Singapore, Tokyo, and Beijing first, second, third, and sixth, respectively (see figure 3). However, the sheer volume of money in these markets makes it more difficult by the day to find property.

Japan continues to attract the largest share of inbound real estate investment into the region. There are a number of reasons for this. For one, Japan's economy is emerging from a multi-year period of stagnation and is seen by investors as a good bet for a cyclical recovery. Tokyo has seen very strong rental growth for prime property since 2006. Second, while deals there are hard to execute technically, nowhere else in Asia has a market with the same depth. As one investor says: "It has the stock and there is an active market that is not reliant on foreign investors for transfer of completed buildings." Third, it offers a level of maturity that can only be rivalled elsewhere in the region by markets in Australia, Hong Kong, and Singapore, which makes it attractive to much of the new money arriving in Asia.

According to one consultant: "There's generally an increased allocation to Asia Pacific property and a lot of it is coming for the more institutional rather than opportunistic funds. When they've done their homework, they do like Japan - the more risk averse they are, the more attractive it is." Another executive stated: "China has growth that Japan doesn't have, but China has risk attached to it and the price is very competitive now. So, if you do a risk-adjusted return calculation, Japan is a better market."

The competition in the more obvious markets is also resulting in a new flow of investments as the more opportunistic investors head into less mainstream markets for the possibility of producing higher returns. Investors are looking at secondary markets, creating development opportunities, investing in niche markets, and risking capital in emerging real estate markets.

According to the survey, secondary markets offer opportunities, and many real estate investors are placing money in markets they have never heard of - cities such as Changsha, Hangzhou, and other provincial locations in China. In order to get assistance and to reduce risk, they often find themselves doing joint deals with other Asia Pacific investors, in particular those from Hong Kong and Singapore who have much more experience in these lesser-known markets.

In addition to secondary markets, real estate investment continues to grow in emerging Asian economies, the standouts being Vietnam and India. People interviewed said they believe Vietnam is "like China 10 years ago", "hugely ambitious", and "well on its way to being a major force in the region". The attractiveness of the Vietnamese economy is supported by other research by PwC.

The PwC EM20 index of emerging markets rated Vietnam as the most promising emerging market for manufacturing, followed by China. The EM20 provides a risk adjusted measure. Vietnam's success in the index illustrates the interplay between risk and reward. Vietnam is highly cost competitive and offers investors the highest potential returns. On the other hand, it is also the fourth riskiest investment location within the EM20 based on bond market data. Nevertheless, so great are the potential returns that they offset Vietnam's relatively high risk premium. As with Vietnam, low costs lie behind China's second placed ranking for manufacturing. Offering relatively high rewards and benefiting from a lower risk rating, China is a highly attractive manufacturing location - as indicated by the great interest in the country already shown by many international businesses.

India is also increasingly attractive as the country finally started to open its doors to foreign investors by easing several restraints in 2005. The Associated Chambers of Commerce and Industry of India projects that the total size of the domestic real estate market will rise from $16bn (€11bn) in 2007 to $60bn by 2010.

Survey results support this interest in secondary and emerging markets, with Ho Chi Minh City, Guangzhou, and Mumbai rising to eighth, ninth, and tenth, respectively, among investment prospects.

As economies and markets continue to grow in many areas, the focus on development grows as well. Survey responses show that investors have allocated the largest portion of their portfolios to development at 28.6%, followed by core investments at 23% (see figure 4). According to one interviewee: "Many of the traditional pension funds and insurance companies that had hoped to buy a standard investment and hold it for a combination of income plus capital growth now have to take development risk."

An example of a place where development risk is not frightening away investors is Ho Chi Minh City, ranked the top development prospect in Emerging Trends, but also the third-riskiest city. But development capital also likes to play it safe, as shown by Singapore ranking third among development prospects as well as the overall least risky city in the survey.

"The funds that are investing in development are being very complacent," one analyst said. "They've stress tested their internal rates of return and are feeling comfortable, but most of these guys don't have enough people to even check up on the checkers. And I don't think because you have a good development partner you're going to insulate yourself from a downturn."

Niche markets in the Asia Pacific region are starting to come into view for the large
supply of capital. These newly found sectors include hotels, casinos, logistics facilities, retirement homes, and other speciality sectors. Survey participants rank the hotel sector as the top real estate investment prospect and say it has the largest projected yield for 2008. However, many question whether there is enough demand to take up the increased hotel supply. One person interviewed expressed confidence in the sector, stating: "I was probably cynical about this several years ago, but I'm not as sceptical now."

The logistics facility sector has experienced growth due to the increases in demand from the retail sector. China appears to have the greatest opportunity for growth in that sector. As one person said, "I struggle to see how you can go wrong with logistics in China: there's going to be a real boom in the sector over the next five years."

Though the survey shows investors will continue to look at Asia Pacific real estate, certain topics are still of concern, including an oversupply of foreign exchange reserves, rising occupancy and staffing costs, market transparency, and the interventionism of regional governments. Another big issue of concern is the direct exposure Asian markets have to the US credit crisis in mid-2007. Many believe that even though leverage can be high with Asian property investors, it is normally financed through banks from their own balance sheets, and that securitised financing such as commercial mortgage-backed securities and collateralised debt obligations (CDOs) are still in the early stages of development.

Regardless of these views, facts on many big investment groups continue to appear. The Bank of China reported that over $9bn, or almost 4%, of its portfolio is in sub-prime asset-backed securities and CDOs. The largest bank in Asia, DBS Holding Group, announced CDO holdings of $1.58bn, more than originally reported. Global debt markets will continue to watch the repercussions of the US credit meltdown.

Chuck DiRocco is managing director of industry trends and analysis, Urban Land Institute.  John Forbes is UK real estate industry leader at PricewaterhouseCoopers