Asian Real Estate in Transition – Anticipating and Responding to the Outcome

Implications: What we are seeing is neither a boom nor a bubble – but rather a series of markets in transition. These are all being impacted by and responding, to a greater or lesser extent, to the same influences, be it weight of capital, repositioning of property as an asset class, the introduction of new real estate investment structures, rising community aspirations or the ever increasing attention being paid to Asia by financial institutions, multi-national corporations and investors in general. Whether it be boom, bubble or indeed bust will depend on the extent to which markets recognise and react to these influences and the level to which and the pace at which the markets can accommodate the changes they bring.

Analysis:

According to a recent report by DTZ, the current total value of real estate stock in Asia amounts to some US$9.5 trillion of which some 50% is located in China, just under 20% in Japan and 12% in India. With the exception of China, where stock is growing at close to 15% per annum, growth across the region is more modest averaging 6-7% per year. By contrast institutional investment about which we hear so much, whilst doubling since 1997 still amounted only to some US$200 billion in 2006. Similarly in 2006, the amount of overseas investment in the Asia property markets only amounted to some US$50 billion compared with a global transactional total of almost US$700 billion. It is still therefore largely a local game.

Whilst the quantum of institutional investment in the overall context therefore does not yet appear to be of overwhelming significance, there is no doubt that the institutions are playing, and will play, a major role in shaping the future of the marketplace here in Asia, driven by a combination of factors including the wish for:

• Diversification of property holdings
• Superior returns
• An expanded portfolio
• Access to a wider range of real estate stock
• Diversification from other asset classes
• Response to investor/Board expectations

Their concerns centre primarily around the liquidity of the real estate investment markets, availability of information, the size and maturing of the local property markets as well as land tenure, taxation and currency risk amongst others.

Traditionally the institutional preference has been for completed product with an established income stream but over the last two or three years, due to the dearth of product of appropriate investment quality, institutions, and indeed investors at large, have been forced to buy into projects during the development phase. Initially, the target was to buy into projects nearing completion and thus only assume construction and marketing risk. However, more latterly, because of the competition, investors have been becoming involved as a much earlier stage in the development process and as a result are assuming land conversion and land use planning risk as well as those risks associated with construction, marketing, etc.

Obviously this presents the opportunity for these particular investors to stamp their authority on the project in terms of mix, design and construction standards but it is an area in which many institutions have not had previous direct experience and exposes them to a far wider risk spectrum than hitherto. One argument put forward is that early entry to development projects affords the opportunity to secure higher returns but does 10-12% IRR for a commercial development in Beijing or Shanghai with entry at the outset of the project really fully reflect all the risks?

In terms of regional trends, the story of the past five years, particularly in the commercial sector, has been one of rental growth with annual rental growth across the Asia averaging over 8%. Shanghai, Bangkok and Hong Kong have significantly exceeded this average and many other cities were not far below with only Taipei in negative territory. If we look forward to the next five years, however, this level is unlikely to be sustained with average rental growth predicted to fall to 5% per annum. Only Singapore and Tokyo are expected to exceed this level and many cities will see much more modest growth over the period. The reality therefore is that in order to maintain overall growth rates capital values will have to increase to compensate and the question must be, will this occur? My sense is that we will continue to see rises in capital values notwithstanding the reductions in rental growth partly because of the weight of money seeking to acquire real estate is likely to increase and partly because institutions will further adjust to the risks of investing in real estate in Asia and accept lower overall returns.

Interestingly I see one of the key challenges going forward being project delivery, a topic which surfaces at every Board on which I sit. With markets not just in Asia but in many other jurisdictions moving forward at a pace, the sourcing of human talent with experience of delivering large projects is a real issue and indeed, if not a direct constraint, could potentially impact on many projects in terms of delay and cost over-runs. As a consequence I foresee the creation of many strategic alliances with contractors and service providers where investors and developers alike will seek to secure the allocation of dedicated resources and a professional capability by guaranteeing a certain stream of work. Indeed, for those who aspire to be the project deliverer of choice across the region and are willing to provide what is in effect a turn-key service, I believe they have a bright and remunerative future.

Enough then on the influence of the institutions and on to a brief overview of the factors influencing supply and demand in the commercial and residential markets around the region.

Property markets in Asia have a reputation for being notoriously fickle and volatile. Others more knowledgeable than I will no doubt comment on whether the sub-prime turmoil of the past few weeks represents a freakish credit bubble which, whilst slowing the US economy is not likely to have other than a passing impact on the economies and the property markets in the region. Some predict greater pain for South Korea and Taiwan but the consensus view appears to be, worst case, that it might remove about 1% off an Asian GDP forecast to average 7-8% over the next several years. In reality, I believe that inflation is possibly the biggest challenge facing Asia this year and the consequence is that with inflation still untamed and liquidity still reasonably easy to access, there is little scope for interest rates to fall.

Dealing firstly with the commercial sector, I have already commented on the inadequate supply of investment grade product and the impact this is having on the risk profile of the institutions in Asia and on the skylines in several of our major cities. An interesting debate is growing as to the role of the Central Business District and the likelihood of bi- or even tri-nodal CBD’s emerging in what are in effect the large city regions which are now becoming common across Asia. In this context I am thinking of Hong Kong, Beijing, Shanghai, Mumbai, Seoul, Jakarta and Tokyo where urban planning and transport constraints mean that a single CBD is neither practical nor appropriate. Whilst this removes some of the historic and yield exclusivity, it widens the options from an investor perspective.

Yield compression and aggressive capital values are also something which has been aired widely at the conference already and whilst I believe, given the repositioning that has taken place in relation to real estate as an asset class, that the lower yields and higher values are largely now a fact of life, we have undoubtedly seen some froth and exuberance in the pricing of recent transactions. In this regard I do become concerned with what I would describe as the “rationalisation” factor, when what was previously regarded as a constraint which would have been be reflected in the pricing, for instance a half empty building, is now considered or argued to be an opportunity – in this case to secure a market rent and the pricing is skewed accordingly. This is when we move from boom to bubble.

In terms of the residential markets around the region, a lot of the media attention has been focused on record breaking prices in the luxury sector and the doubling, if not trebling, of values in Singapore. Whilst people generally across the region are better off and there are aspirations for improved housing quality, affordability is again emerging as an issue as the gap between have’s and have not’s widens in a number of markets. It was worrying enough when mortgages represented five or even ten time family income but a multiplier of up to 20 times is now not unusual. More particularly this has focused attention again on the provision of social housing and the role of Government in this sector. We have seen the Chinese Government attempting both to influence the size of units and to launch land sales where the units to be built are to a predetermined size and sales price and given the emotion that understandably surrounds the issue of home ownership, the possibility of further intervention, in particular in the residential sector cannot be ignored.

Another factor which is going to shape the future of the residential markets around the region is the changing demographic patterns in terms of aging, lower birth rates, population policies and urban migration. Nowhere is this more evident than in Hong Kong where we are seeing a hollowing out of the population and negative growth if inbound migration is excluded. The net result is that our housing production has declined to about 15,000 units per annum and our traditional residential developers have turned their attention to Mainland China.

With the emergence of a more educated and market savvy purchasing public, demands for mixed use, sustainable communities, rather than single category estates, are gaining ground and there is a growing focus on lifestyle and convenience. There is and will continue to be debate about sustainable development, urban planning and the shape and form of our cities.

It is perhaps worth spending a few moments considering the issue of sustainable development to which many have paid lip service to date but which undoubtedly is going to be a factor in the successful future growth and development of cities in the region. Indeed it is increasingly likely to become a factor which influences investor and occupier choices and the way in which cities respond and react to this challenge will very much determine how they are rated in terms of the regional pecking order.

All the major cities around Asia are struggling to devise an acceptable model for the revitalisation and rejuvenation of ageing city centres and suburbs that strikes the requisite balance between renewal as against redevelopment, maintaining as against dispersing established communities, low versus high densities and social and economic priorities. Just as we have found in Hong Kong, communities around the region are seeking to be engaged at the planning stage of projects rather than consulted on pre-determined options and whilst this lengthens the lead period it is something that the authorities are learning to accept rather then face objections during the implementation process.

More cities are approaching their urban planning on a comprehensive, city-wide basis rather than site by site. Even in China and Vietnam, Asia’s latest real estate investment destination, wholesale demolition and clearance of older properties can only be achieved after negotiation with local residents and business operators and the payment of compensation that at least enables purchase of alternative accommodation, albeit not in the same location. Finally, there is generally less and less focus being given to the “hardware” and more importance is being attached to the underlying software, such as diversity, education, employment opportunities and quality of life as an increasing number of cities in Asia aspire to be regional centres, if not ranked worldwide.

What then are the immediate issues to be reckoned with?

Unfortunately one of the prices that is to be paid for what many Governments see as the potentiality for “bust” is increased Government intervention, particularly, but not restricted to, the residential sector. In most markets around the region land is vested in the state and seen to belong to the community – hence the leasehold/land use right nature of tenure. Traditionally there has been and still is a strong emotional attachment to land and in many countries it is still a major contributor to the national economy. The supply of new land is essentially controlled by the state and the release of that land is likely to be policed more closely in the future. We have seen the move to auction and tender in China and the impact that has had on land values and more recently Vietnam has announced a move to an open sale approach. The risk with Government involvement, as we have learnt in Hong Kong, is that in trying to second guess the market, Government frequently either gets the timing wrong or under or over reacts. Similarly the ability of Government to influence and even decide bank lending policies and to misunderstand the motivation of foreign investors is going to be an ongoing factor during this transitional stage.

Furthermore, regionally we have not really moved, although some claim that we have, from a trading to an investor mentality so far as the local players are concerned and many still regard real estate as a commodity which is to be bought and sold simply as a means of creating wealth. We should not anticipate therefore the demise of the speculator or trader who will continue to influence the scale of the upward and downward swings in the market.

With the increasing investment by institutions in Asia, there is also the need to develop enhanced asset management skills, particularly as they impact on real estate and the whole way that we manage and administer property portfolios. One of the positive aspects of the advent in greater numbers of the institutions, is that they bring with them the demand for transparency, greater accountability and a much a more pro-active and professional approach to real estate investment. Similarly I am sure we will see the development of new investment products, the creation of reliable indices and the use of derivatives as a hedging mechanism, all of which will drive the requirement for more open and sophisticated management skills.

What therefore of the medium and longer term future?

Whilst in theory investment flows know no boundaries and there will continue to be boardroom and investor pressure to invest in Asia, I believe concerns over the rapid rise in capital values, affordability concerns and the sensitivity over real estate will result in increased intervention by Governments at least in the medium term. Whether action is taken to restrict land supply, lean on the banks, impose taxes or just generally slow down the process, unfortunately foreign investment is still perceived by many as a threat as well as a benefit. In this regard I believe there is the need for a major two way education initiative to ensure that both investors and potential recipients alike understand both the advantages and the sensitivities involved.

Longer term I believe that we will see the institutions assuming a greater and greater role in the marketplace and just as in other major mature property markets of the world they will become the principal holders of completed real estate and bring with them the discipline to which I have previously referred. The developers for their part, in the case of investment property, will largely become “pre-order” or “build to suit” delivery agents with a pre-agreed and pre-determined exit route. Unfortunately, given this scenario, I see the opportunities for extra-ordinary gains being the exception as the market matures and becomes more measured.

In conclusion, boom – certainly in a number of cases, bubble – a risk in some sectors - and a major transition for sure, the effects of which should not be underestimated.