Consolidation in Asian real estate

July 2008 - The real estate downturn has a different complexion in different parts of Asia. The overall mood, though, would have to be more positive than negative. In a recent (post sub-prime) survey of global investor sentiment, across the spectrum of M&A activity, IPO activity, funds under management growth and fund flows across the globe, Asia was the only region to rate positively in each category.

For real estate investors and financiers, 2008 is certainly a more challenging year. One Singapore-based executive contacted for this article could find little to cheer about, complaining: “It’s a tough year to be a banker in these markets.”

Yes, there is pain being felt by the bankers and developers, squeezed by the lack of liquidity. For the cashed-up investors on the other hand, this is a major buying opportunity. The likes of GIC Real Estate and Capitaland, Westfield and Sun Hung Kai have certainly not seen any slow-up in their activities.

The maturing of Asian markets is reflected by the growing number of core investors now looking to place funds around the region. According to the report ‘Emerging Trends in Asian Real Estate’, produced by the Urban Land Institute in association with PricewaterhouseCoopers, “This changing dynamic has a number of repercussions. For one, there are greater numbers of investors with more structured and conservative investment strategies, who allocate funds rather than just deploying it wherever they see good prospects.

“In addition, the competition has stoked what was already a red-hot investment market with substantial new capital. One investment bank fund manager noted ‘a unique situation in Singapore, where European core investors are bidding for similar products against Anglo-Saxon investment banks with substantially higher return profiles’.”

The overriding issue that is determining market sentiment in the first half of the year is a lack of liquidity. Investors are worried about the credit crunch and whether companies are going to run into refinancing problems. The question remains, have we seen the worst of the fallout from the sub-prime losses? As this article was being written, the talk was all about Citi needing additional capital. It is a major negative signal for the markets, because, if Citi has problems, no one will believe it is the only big bank in that predicament.

And while cap rates and stock prices in most markets have been depressed, investors are hesitant to move on new deals, because they know that whatever terms are on the table now, if they wait the deal will probably get better. This in turn exacerbates the liquidity problem.

Fortunately, Asia is not too deeply entrenched in the credit crisis - at least not directly. Market observers expect to see slower growth and the brakes being put on developers in China in particular. Those factors may result in a cooling off of markets. But that is a good thing because the exuberance in Shanghai and Beijing had to be brought under some sort of control. Overall, the credit crunch is only having an impact at the margins in Asia.

The liquidity crisis is in need of something to break the cycle. That may come after June 30. It’s fair to assume that companies will be managing their balance sheets very carefully until that time. Then perhaps people will be a little freer in their allocations. If, however, the US and Japan continue their slide into recession, that can only result in further tightening of liquidity. Valuations will fall and vacancies will creep up. The cautiously pessimistic outlook will have prevailed.

There is still concern that problems in the US and Japan will spill across the region and cause a major slowdown in China. But that sentiment may well be overdone. In China, they have steady growth in average incomes and steady demand for real estate. In Hong Kong, locals are talking up prices on the plausible premise of relative affordability and low interest rates.

In China, the government remains committed to keeping the property market under control. Shanghai-based real estate consultant Jim Zhang says: “The market has become much tougher for the smaller developers. The China Banking Regulatory Commission has warned banks to step up controls on lending to developers. My advice to foreign investors is to focus on venturing with local developers in China. They are under-funded now and will be willing to sell at bargain prices in the current environment.”

Stock prices have been heavily hit in Asia, some would say unreasonably so. Consolidation is expected in the REIT market as prices have been cut in half in recent months. Real estate stocks in Japan have also lost half their value from the highs in June 2007. So with listed real estate plays trading at significant discounts, fund managers are naturally finding bargains. Craig Turnbull of MacArthur Cook in Sydney says: “There are certainly plenty of opportunities out there. Obviously markets are down and real estate developers and REITs are all trading below 2007 levels. But in spite of the gloom, companies are reporting strong earnings.

Developers such as CapitaLand and Keppel Land have announced good results. Even the Japanese developers have been relatively strong. Mitsubishi Estate was slightly below estimates but they have said they will make it up later in the year. Singapore REITs have reported growth too. So the value of stocks is at attractive levels, when you consider that some of them have been trading at 40-50% discounts to NAV.”

Turnbull thinks the negative sentiment has been overdone: “You can expect to see a slowdown in Asia this year, but we also believe that, because Asia is better positioned now than in previous downturns, the region will show a great deal of resilience. Asia still has strong rental growth, which is good news for income investors. The office market across the region has been good; Tokyo is moving ahead. However, with the extent of the correction on stock markets, it would not be surprising to see this rental growth slowing.”

Generally, MacArthur Cook likes the developers in the region, with a focus on the office sector. Turnbull says: “We don’t see too much over-building, apart from certain areas of China’s residential markets, and Singapore retail. But overall supply is not that high and in the key areas of Hong Kong, Tokyo and Singapore, the supply outlook is quite modest. We are still positive in our outlook - we are looking at good developers with a good land bank and plans for expansion.

“We also like emerging markets but obviously there you have to be careful because, in a downturn, emerging markets tend to fall quite sharply. But we believe that in this cycle they won’t suffer unduly, investors will see the potential growth in these markets and we will not have a scenario like we had in the last Asian crisis.”

For example, the real estate boom in Vietnam shows no sign of slowing down, with some commentators predicting 20-30% growth this year. Among the new projects, CapitaLand is venturing with Citigroup to set up a $300m property fund in Vietnam and is looking to develop residential, commercial and mixed developments.

Jim Zhang expects China to continue to be a difficult market for overseas direct investors. “The problem is the Chinese government continues to make it hard for foreign players. But there are opportunities and, of course, China is a large country; each region performs differently. In much the same way as Sydney and Perth can have widely differing markets at a certain point in the cycle, so there’s always opportunity.

“Valuations in Shanghai and Beijing have fallen, but at the high end, prices are still reasonably strong. In the second tier cities, the most important element is rental growth, which has been very strong. I think that, whatever happens in Beijing and Shanghai, the secondary cities will continue to rise for the next few years.”

The other development that is awaited in China later this year is the creation of the first domestic REITs. Currently the situation is that China is expected to issue its policy on REITs by the end of the year. This may coincide with the issue of the first licences, although the exact process is far from clear. Zhang says: “When they issue a new policy, there’s normally a tentative period where the regulators are testing the water. During this period, one or two promoters will get the go-ahead to launch products. But it might be another year before any more licences are granted. I don’t think this will be the case with REITs, but we don’t know for sure.” Zhang believes that two groups with Australian connections are in the frame for the first REIT licences. One is National Australia Bank, which has a 20% stake in Chinese group Union Trust. Another group in the frame is Citic.

APREA’s chief executive, Peter Mitchell, is less bullish on the issue of China REITs. He says, “Everyone’s pretty confused about it. There is no expectation that it will happen any time soon. You have disparate private groups working in an uncoordinated way to devise models for presentation to the Chinese government. But we can’t discern any interest from the government. It is inconsistent with their objectives of cooling the market.”

One major cloud on the horizon is the suggestion that Basel II guidelines pose serious threats to both real estate lending by commercial banks and the viability of the entire industry.

Morgan Laughlin is managing director and head of real estate finance for Asia Pacific at RBS. “Under Basel I, banks had a great deal more flexibility in pricing risks deeper in the capital structure, whereas under Basel II, there is a very significant capital cost for taking the  subordinated and higher leverage positions,” he says.

“This is going to have long term ramifications on both senior and junior pricing as banks will have much less appetite for higher-risk debt.”