Aiming high with Asian real estate

Although economies across most of Asia have been buoyant, if not overheated, transaction volumes in real estate markets across most of the region fell steadily during last year, with prices beginning to fall in some economies.

Since the region’s recovery at the beginning of 2009, local real estate markets had been enjoying fair returns and a generally positive outlook. But the prospect of a global relapse into recession in mid 2011 showed once again that Asian economies remain closely linked to developed markets via trade and financial channels.

However, in some of Asia’s biggest economies, real estate reversals have occurred in part because local regulators, in order to control property prices and address rising inflation, have choked off bank lending to developers after four years of loose economic policy, which caused prices to balloon.

In Hong Kong, Singapore and Taiwan, authorities have introduced macro-prudential policies to combat rising home values, while base rates in India have shot up to an unprecedented 9 per cent in response to rising inflation.

But it is in China, in particular, that these policies have played a major role in market dynamics. The risk of a Chinese property crash or real estate bubble has significantly grabbed people’s attention of late. This is understandable as China’s housing market forms the single most important sector not only inside the country but in the entire global economy.

“Somehow the property market is like the temperature of the Chinese economy,” says Karine Hirn, founding partner at East Capital, “which is why so many want to keep measuring it and draw conclusions for the health of China. China is the place where the equivalent of one Rome is built in two weeks.”

Last year, China’s construction sector accounted for 13 per cent of its GDP, 20 per cent of global steel production and was the dominant consumer of the world’s iron, copper and cement, according to this year’s Wealth Report from Knight Frank and Citi Private Bank.

To cool down the overheated property market, in early 2010 the government introduced a number of demand-side measures. Transaction taxes were increased and banks’ loan to value ratio was reduced, negatively affecting mortgage supply. Home purchase restrictions which forbid people to buy more than two properties or, depending on cities, not more than one, were also introduced.

At the same time, the ambitious plans launched in late 2010 to build 36m affordable or low-income housing units by 2015 were part of the government’s efforts to stabilise runaway property prices.

“But China is a big country and the price differences between cities could be huge,” says Thomas Au, head of Asia real estate research at Invesco Real Estate Asia.

While affordability did deteriorate in first tier cities such as Shanghai and Beijing, in smaller second or third tier cities, affordability has actually improved, he says. “In those markets where prices have increased so much that they go beyond affordability, we believe they are going to correct and are correcting already, but I do not agree with the idea of a crash of the Chinese housing market,” says Mr Au.

While there might be some softening of the residential market in China, the Chinese government will not let it collapse, agrees Alistair Meadows, head of International Capital Group in Asia Pacific at Jones Lang LaSalle. “With the change of government this year, the last thing they want to see is high levels of distress in the Chinese residential market.”

Moreover, leverage is not particularly high in China and mortgages have always been controlled to the 60 to 70 per cent range, unlike in some Western markets where it can go up to 100 per cent or in some cases, it is possible to repay interest only, says Invesco’s Mr Au.

Fundamental factors such as urbanisation and demographic trends still make China an attractive long-term story. In the next 15 years, about 220m people will move from rural to urban areas in the country, which will drive growth in the residential and commercial property sector.

However in the short term, there are some headwinds exacerbated by the uncertainties in the global economy and the eurozone debt crisis. One impact that could come from disorderly default in the eurozone is the reduction of bank liquidity. “Investors should be prudent about their leverage level, and should not get overleveraged,” believes Mr Au.

But how can foreign investors, in particular, benefit from the Chinese real estate development story? “There is definitely a credit squeeze on Chinese real estate developers,” says Alistair LaSalle’s Mr Meadows. “That is creating opportunities on the funding side for private equity companies and other foreign sources of capital.”

But rules introduced in 2007 allow foreign investment in domestic real estate only with government approval, which often is arbitrarily denied, making difficult getting capital into the country, according to this year’s Emerging Trends in Real Estate Asia Pacific report by PWC and Urban Land Institute.

Chinese law currently limits the ways in which foreign capital-related distress deals can be structured. Because offshore debt is not allowed, investors are often forced into mergers and acquisitions marriages at either the entity or the project level.

In this environment, picking the right partners and sectors is more important than ever.

“The biggest challenge in China is selecting the right partner who ticks all the boxes,” says Greg Penn, executive director of investment properties in Asia at CBRE. Particularly when doing developments in China, partners need to be regulation compliant. “Also, partners need to understand mutual objectives and how an international foreign investor expects any particular project to be managed, for example in terms of reporting,” he says.

Even buying and selling existing properties in China is also very complicated for foreign investors, with many aspects to consider, such as the ownership structure, land holding, taxation structures and cash flow.

“You need to be selective in China, in the cities and in the sectors you are investing in,” stresses Mark Fogle, managing director and head of real estate, Baring Private Equity Asia in Singapore. “It is very important that you don’t pick sectors or projects that are out of favour with the government.”

One example is the luxury residential market, which attracted many developers in key cities, but is now out of favour.

Residential and retail real estate are interesting investment opportunities as they are directly tied to the growth of the domestic economy and the Chinese consumers, says CBRE’s Mr Penn. Beyond that, offices continue to be a very attractive option as they are less management intensive. “With retail, not only you are buying into property, but you are buying into business,” he warns.

Going overseas

While wealth creation is booming in the emerging world with developed markets mired in debt and austerity, the economies that have benefited the most from the developing markets’ growth have been those in Europe and North America, according to The Wealth Report.

Capital flight from emerging economies to safe havens has been integral to the performance of the world’s luxury housing markets, driving growth in Miami, London and Vancouver. The relentless shift in wealth distribution towards Asia-Pacific continues apace: China, Southeast Asia and Japan now have more centa-millionaires, those with more than $100m in assets, than North America or Western Europe. The increasing presence of Asia’s ultra wealthy in global property markets is undeniable.

When advisers are asked which nationalities will become most important as prime property owners over the next five years the Chinese top their lists, followed by Russian, Middle Eastern and Latin American buyers, according to the study.

“Never before have wealth creation, economic risks and politics been so closely intertwined with the performance of prime residential and commercial property markets,” observes Liam Bailey, head of residential research at Knight Frank and one of the authors of the report.

“As wealth creation and luxury property markets become even more global, so the issues of exchange rate volatility, political risk and security concerns rise in importance for HNWs, competing with more prosaic motives such as investment and lifestyle. This has led to the hand-in-hand growth of capital flight and the concept of safe-haven location.”

The problem in so many emerging-world countries is governance. The newly enriched become aware of the potential impacts of corruption and arbitrary rule changes on their ability to plan for intergenerational wealth transfers, says Mr Bailey. Events such as the Arab Spring and this year’s Russian elections may be classic examples.

The Asian rich, in particular, are increasingly looking overseas for core, income generating real estate investments, while they continue to focus on their domestic markets for opportunistic type of products.

“Although they still have a very strong bias towards their domestic markets, Asian wealthy investors have significantly increased their allocation to real estate overseas over the past couple of years,” says Elisabeth Troni, Global Real Estate strategist at UBS Global Asset Management. The domestic regulatory changes aimed at slowing down the housing market, in particular in China, have been one of the drivers of investors going overseas, as they become bearish on residential property prospects in the near term.

Their main focus has been in liquid investments in global gateway cities. “They are often willing to pay a liquidity premium and pay quite high prices globally for relatively liquid real estate assets, which focuses them on cities like London, New York or Tokyo,” says Ms Troni. They have also taken advantage of attractive relative values in the US and Western European markets, since devaluation in 2009.

But Asian wealthy investors have also strongly supported core cities in Asia. “Looking at the top 10 global transaction markets from 2005 and 2011, the biggest change is the growth of the Chinese cities in that ranking,” she explains. Given foreign investors have difficulty in accessing the Chinese market, the transactions are led by domestic investors.

But it is a fact that Asia has very few truly core markets, such as Australia, Japan and to some extent Hong Kong and Singapore. Investors seeking long-term, steady, core-style returns have difficulties in finding them within Asia and look to US and Western European markets.

The structure of the market, the structure of the income stream and the structure of the ownership are the key elements defining a core-type market, explains Richard Johnson, head of business development Apac, global real estate at UBS Global Asset Management. Core markets tend to have very transparent legal systems, very little capital control and a good level of historical data, which allows to build a pattern of investment behaviour. Vice versa, in some Asian markets which are relatively new, there can be liquidity issues, currency controls and the legal system may not be so transparent, impacting for example the ability to rely on a legal title.

In core markets, such as the UK, leases tenants sign up to are long term, often 10-15 years or more, as opposed to three to five years on average in Asia. Longer leases create a longer-term, bond-like steady stream of income, which reduces the risk of having a void of rental income. Moreover, it is easier to asset manage properties with longer leases from abroad. In developed markets, core trophy assets generate up to 80 per cent of the total return from income.

Shorter leases can represent an opportunity to capture rental growth when economies are growing, and this is what investors look at when investing in Asian markets. “But growth patterns are not always predictable and are not always up,” says Mr Johnson. “At the end of the lease, there is always the risk of not finding a tenant.”

While in many European and US markets, institutional investors represent the majority of real estate holdings, in Asia wealth is controlled by private families and individuals. The structure of the ownership affects the cycles of development and the capital flows in a market.

“When markets such as the Asian are dominated by opportunistic investors, there are aggressive development cycles and acceptance of shorter leases, compared to Western Europe and the US, where there has been a support of core assets through the recent recovery much longer than it would have been, had the market been dominated by more opportunistic investors,” says Ms Troni at UBS.

Asian private investors have been focusing on both the commercial and residential sectors in London in recent years, in particular, attracted by its perceived status as a safe haven and the relative weakness of the sterling.

In addition to the financial aspect, the cultural aspect is also a big draw to the city, says LaSalle’s Mr Meadows, considering the historic ties with Singapore, Malaysia and Hong Kong, with first, second or third generation family members being educated in the UK. Familiarity with legislation is also another drive, which is valid especially for investors from Singapore. “Private investors in Asia look at markets on a global basis which they are familiar with or have an affinity to.”

The UK is also tax efficient for overseas investors, states Matthew Johnsons, regional director at Jones Lang LaSalle, Corporate Finance, in London.

Although March’s UK Budget increased stamp duty to 7 per cent for the purchase of residential property over £2m ($3.2m) and introduced a 15 per cent rate for residential properties over £2m purchased by “non-natural” persons, such as corporates, there is still little draft legislation available.

“The reality is that tax is only part of the picture for the super rich,” says Charles Douglas, a London-based property lawyer specialising in HNWs. “What they really value is the lifestyle that comes with an open, cosmopolitan environment, excellent education for their children and both personal and property security.”

There has not been the same degree of interest in real estate in Continental Europe, says LaSalle’s Mr Johnsons. “To date, the interest has been virtually solely in prime properties in London, but we are beginning to see private investors look at properties which present greater risks, as they generate higher yields.”

This broadening of investment horizons is what UBS’ Ms Troni recommends to the Asian rich. “Asian wealthy investors are still in a wealth generation mode and can more effectively use their capital by looking for value in cities such as small European cities, which still have values well below the peak or for some more value-add type opportunities in the US.”

Asian markets

Dynamic markets like Hong Kong and Singapore are likely to always be popular with many private wealthy Asian investors because of their gateway status and transparency, explains UBS’ Mr Johnson. However, they are small and very open economies where capital inflows or outflows can have a significant impact on the market and cause high volatility.

Both markets are today experiencing a correction, also due to the introduction of government’s measures to control prices.

According to the latest report from PWC and ULI, Singapore locks up the top spot for investment prospects in real estate in 2011 for the second year in a row since the research started in 2007. Rounding out the top five are Shanghai, Sydney, Chongqing and Beijing.

Interesting real estate investment opportunities can be found in some emerging market markets. One of the darlings of the emerging markets in Asia is Indonesia with a population of 240m people and GDP growing at 5-6 per cent per annum. The country has gone through a mining and resources boom and the middle class is significantly increasing, which is positively affecting consumer spending.

“We have seen emerging markets like Indonesia, along with others such as Vietnam, attracting more interest,” says LaSalle’s Mr Meadows. However, these markets, compared to places such as China and India, are much smaller and more volatile. In addition, there are often liquidity issues at the sale.

“Investors are looking at both Indonesia and Thailand as emerging markets,” observes Mr Penn at CBRE. “But you certainly have to go with your eyes open and have a clear understanding of what you are requiring and the associated risk of going into those markets.”

Private equity opportunities

Global economic developments are having a profound impact on Asian real estate markets. European banks have been heavy supporters of the real estate market in the region, providing liquidity to property developers or funds acquiring assets, which often used high leverage during 2007-2008 at cheap rate, but this source of credit has now finished.

This provides opportunity for private equity groups, explains Mark Fogle, head of real estate at Baring Private Equity Asia. “A lot of opportunities we are seeing right now are in the structured debt.”

The number of Asia-focused private equity real estate funds that closed in 2011, raising a combined $4.9bn, decreased to 25 from 51 raising a total of $29.3bn in 2008, according to Preqin research.

“The bull market of 2007-2008 when everybody was pouring money into real estate at exorbitant prices is over. There are less private equity funds chasing the same amount of assets,” he says, explaining that this is opening the doors to new entrants.

Having invested in the region for 15 years, Baring Private Equity Asia has entered the real estate space in Asia with the recent hire of Mr Fogle, who was previously CIO at RREEF, the alternative investments arm of Deutsche Bank and prior to that, managing director at AIG Global Real Estate, the large platform that was sold by the insurance giant to Invesco late last year.

“It’s almost the perfect storm, because you have got the capital markets not funding many of these property developers or distressed assets, at the same time assets are devaluing because of the over supply and lack of demand. It’s bringing some unique opportunities.”