Finding core in Asia

The Centropolis Towers, two connected glossy 26-story buildings, are a prime commercial property in the center of Seoul’s downtown business district. When the property was brought to market a few months ago, there were ten bidders, with several foreign managers including New York private equity firm KKR and London-based asset manager M&G among them.

At press time, M&G Real Estate, M&G’s real estate platform, was chosen as the preferred bidder to purchase Centropolis for around 1.1 trillion won ($1 billion; €860 million) after discussions with KKR fell through, making it one of the largest ever single asset deals set to be closed in Seoul, according to people involved in the transaction. One source says M&G intends to finance part of the purchase with capital from its Asia open-ended core fund.

The deal has the hallmarks of a classic core acquisition, except for one key element that’s missing: the tenants. The property carries a 100 percent leasing risk since it will only be fully completed in August.

As such, the property could be categorized a speculative investment, out of reach for a manager investing core money. Part of the retail is pre-let, and as far as the vacant office space is concerned, perceived strong office demand is expected to actualize relatively quickly, according to one person involved in the sales process.

M&G declined to comment on the deal. However, irrespective of what percentage of the M&G Asia Property Fund ends up being invested in the asset, having to lease up such an investment for a core vehicle raises a fundamental and long-unanswered question: what is core in Asia?

“Core fund managers will need to think carefully about their core investment strategy. It could either invest in core markets (i.e. Australia, New Zealand, Japan, Singapore, Korea and Hong Kong) or invest into core assets across Asia Pacific to deliver core returns – in the range of 6 to 8 percent,” explains Henry Chin, head of Asia Pacific research at property services firm CBRE.

The problem is that the two things – investing in core markets and getting core returns – are not always mutually exclusive, especially in the current cycle.

“If you look at the major core gateway cities in Asia, including Hong Kong, Singapore, Shanghai and Beijing, cap rates are in the 3 to 4 percent range, if not lower, and so you are not going to be able to generate high current cash returns,’’ says Alfredo Lobo, partner at Hodes Weill & Associates. “You do need to adopt a multi-faceted approach to portfolio construction.”

For M&G, Centropolis would not be its first ‘develop-to-core’ deal, if closed.

Last year, the firm acquired an old warehouse in Japan from the Asia Property Fund, with a strategy of “rebuilding it to create our own core”, says Chiang Ling Ng, chief executive and chief investment officer of M&G Real Estate Asia.

Ng says that fund’s investment mandate has always included a 10 percent development bucket, and such a clause typically exists in US core funds as well.

“Until the fund is of a relatively large size, the manager will not undertake development because it could go the wrong way should markets dislocate,” she explains. “But we are so large already that a $100 million logistics development will not be that impactful and the returns will far outweigh the risk.”

What also helps, in her view, is the fact that logistics properties can be delivered within 12 to 18 months, compared with office stock which takes three to four years. That way, the manager is able to quickly deliver an income-producing asset, even though it might not be generating income for some time.

At a time of strong competition for conventional core assets in the region, such asset management initiatives have helped M&G actively deploy capital and generate returns. The fund has a net asset value just north of $3.7 billion and has generated a rolling 12-month local currency total return of 13.7 percent as of last December. Last year alone, the firm invested around $600 million in the region.

Soon Lau, managing director for Asia-Pacific at Invesco Real Estate, which operates the second-largest pan-Asia, open-ended vehicle in the region, agrees that creating core is a better proposition than buying core outright in some markets. But he argues there should be a limited sleeve for core-plus and value-added deals in a core vehicle.

The Invesco Real Estate Asia Fund, with a net asset value of $1.48 billion as of March 31, has investments in five markets across the region, but the pace of deployment in each market depends on the pricing metrics.

“We bought some initial assets in Japan for the fund, but the market has gotten more expensive. So we have leaned out from Japan for both weighting and economic reasons,” Lau notes.

Like the M&G fund, Lau says his vehicle has also outperformed initial expectations in terms of total returns. The firm had set a 9 to 11 percent gross total annual return target for the fund when it was launched around four years back, which Lau says have been exceeded.

Core fundraising

For a region like Asia, largely considered an opportunistic market by European and US investors prior to the global financial crisis, the past few years have seen increasing allocations to lower-yielding strategies, even though the number of core funds remains limited in comparison to the US.

According to the latest capital raising survey published by industry body, Asian Association for Investors in Non-listed Real Estate Vehicles (ANREV), $1.8 billion in equity was raised by six pan-Asia, core, open-end, diversified, non-listed real estate funds last year, a 63.6 percent increase from the $1.1 billion raised by four funds in 2016.

Invesco, for instance, initially aimed to raise $1 billion within five years for its open-ended vehicle but exceeded that target last year. The Los Angeles County Employees Retirement Association, California State Teachers’ Retirement System and the New Mexico State Investment Council are some of the North American investors in the fund. Meanwhile, the California Public Employees’ Retirement System has backed JP Morgan Asset Management’s pan-Asia open-ended vehicle, Asia-Pacific Property Fund, with a $250 million commitment.

Denmark’s largest commercial pension fund, PFA Pension, anchored Morgan Stanley Real Estate Investing’s offering, Prime Property Fund Asia, with a commitment of between $150 million to $200 million.

However, while the likes of JP Morgan and Morgan Stanley look to replicate successful core fundraising capabilities in the US, it could be more challenging for other first-time managers without such a track record, sources say.

Hodes Weill’s Lobo says that while there are 10 or more managers trying to raise open-ended vehicles in the region, over time there will be consolidation, with 5-6 leading to consolidation in the market.

“The challenge that most managers have is how to get their fund up to a size, when it is open-ended and most investors looking to participate will want to take a wait and see approach. It is a catch 22 situation,” he explains. “Managers need liquidity and diversity but because of the size of asset values in the region, that can only happen when the portfolio is in the $2 to $3 billion range, and ideally much closer to $4 to $5 billion. But most investors want to see what assets have been assembled before they make a commitment. So, it is critical to get initial support from anchor investors that usually get preferential economics and are compelled to stay in for a longer term.”

What will further drive institutional investors to commit to core strategies is improving market transparency. ANREV took a significant step in that regard in March when it launched the pan-Asia open-ended diversified core fund index, the first such index for the region. The pan-Asia ODCI has been launched with gross asset value of $8 billion, comprising four open-ended vehicles. The index has produced a value-weighted one-year rolling return of 17.36 percent.

In time, ANREV also aims to offer asset-level performance data to give further transparency to this index, according to Amélie Delaunay, director of research and professional standards at ANREV.

On further improvements that ANREV is planning to make as to how returns are calculated, she tells PERE: “ANREV is planning on building more transparency around the performance of the core funds in developing a performance attribution model, enabling managers and investors to break down the returns into unleveraged property returns plus the impacts of leverage, currency, fund costs, and so on.”

Such an initiative underscores the case for institutional investment in in Asian core strategies getting stronger. Successful implementation should also go some way to answering the strategy’s key question of what constitutes Asian core in the first place.