An Industry in Transition

Implications: What is not necessarily appreciated by those both within the property sector and without is that we are in effect an industry in transition and that recognising and responding to the challenges and opportunities that this presents will differentiate the future market leaders from the rest of the pack.

Analysis: First and foremost we are seeing significant shifts in the dynamics of the market place involving a greater degree of diversification of both geography and product than we have ever seen before. Secondly, we are seeing the financial institutions, many of which regarded the emerging Asian markets as too opaque, risky and difficult, beginning to stamp their authority on the market place.

Who, for instance, would have anticipated that the Hong Kong developers would have largely turned their backs on Hong Kong, except for the luxury residential sector and prime sites in the urban areas? To be fair, they have, they have some excuse in that 15,000 residential units a year, which is where demand and supply currently sit fairly comfortably, is unlikely to keep them fully occupied. Who would have predicted that over a matter of months the Hong Kong developers have amassed land banks and development rights in the Mainland in excess of those that they own here in Hong Kong. A lot of the sites have been purchased in the open market, at auction or tender, and therefore the land price is fairly full but clearly they see greater potential upside in the Mainland than they do in applying for sites to be released from the Application List in Hong Kong - as strong reason as any I would have thought for expanding the number and range of sites available through that process.

The arrival of the financial institutions is also interesting, driven again by pressure to diversify, to be in Asia and to secure improved returns, but more particularly by the increased allocation of investment funds to real estate, linked to the recognition of the inherent qualities of real estate as an asset class. Many insurance companies, pension funds and similar institutions have significantly increased their allocation to real estate and this has led to yield compression and increases in capital values across most markets to the extent that many ask whether, for instance, office rental returns of 2-3% are sustainable. The answer, of course, is that it depends on the amount of growth in capital values that is anticipated will take place over the similar period but the reality is that growth in capital values is closely correlated to the anticipated growth in rental values and you will need to see continued steady growth in the latter if overall returns to investors are to be sustained at double digit levels as in the past.

The most challenging aspect of the huge weight of money trying to find a home in real estate, particularly in Mainland China, is that it is forcing hitherto conservative institutions to take development risk. Ideally, financial institutions like to purchase completed developments with a settled rental income stream but now, because of the competition for investment grade product, they are having to buy into projects long before completion of construction and leasing. Initially the institutions sought projects which were at most 18 months or so from completion which limited their exposure to construction and market risk. However, more recently, because such projects are not always easy to secure, the institutions are buying in even earlier and as a result exposing themselves to the whole gambit of risks associated with property development. This is something to which they are not accustomed and for which, quite frankly, many are not equipped.

The challenge for them is now one being faced across the region, namely how effectively to achieve delivery of these projects and it is, of course, a major new opportunity for those with development experience. It will be interesting to see who stands up to be counted and sets out their stall as the project deliverer of choice in Asia.

Another more subtle change that is occurring is in the ownership pattern of real estate. In the more mature markets of the world, the majority of prime real estate in owned by financial institutions and developers effectively act as “delivery agents” and develop with a guaranteed exit route and price for the completed project. Hitherto in Asia such exit opportunities have not existed and the developers have been left to strata title or to hold. Now there is a clear exit route available and over a relatively short period of time I believe we will see the institutions owning most of the prime buildings in our major cities, which will free up a large amount of the capital that developers currently have tied up in finished buildings. This in turn will put pressure on the developers to make better use of the capital resources at their disposal and not just to sit and let the market do their work for them.

With the greater presence of the institutions will come pressure for greater transparency and a more open dissemination of information together with production of reliable and independent indices which accurately track market performance. All this is positive to those who look for an efficient and effective market place but there are those, of course, who prefer markets that are imperfect and opaque and the opportunity to exploit these weaknesses, but that is a story for another day.