Over the past two decades, institutional investors from North America, Europe and the Middle East have focused on Asia’s property markets as a way to achieve higher returns from their global real estate portfolio. They gained exposure to the region primarily through opportunistic closed-end funds.
For true core returns, those same investors stayed away from investing directly in the region’s core assets and generally placed their capital in the growing REIT markets of Australia, Japan, Hong Kong and Singapore instead. That gave them good dividend yields from high-quality assets in the major one or two cities within those countries.
While the Asian REIT markets have generally done well, a large number of the higher risk opportunistic funds have underwhelmed investors. Consequently, outside of certain big-name GPs, over the past few years since the GFC, Asian fund managers have found it a very difficult period to raise capital for opportunistic funds.
In recent years there has instead been a flurry of fund managers seeking to raise capital for core funds to be invested into the Asian markets. At the same time, most gateway cities in Asia are currently experiencing peak asset values and some of the lowest historical cap rates on record.
So I ask: is the shift towards core in Asia being driven by market fundamentals or overweight capital looking for core yield returns globally?
We’d better first define core real estate. Firstly, property characteristics: high quality properties in major gateway cities in developed economies with high credit quality tenants, often multi-tenanted with staggered lease expirations. Second, leverage from zero percent to 30 percent. Third, return characteristics: high un-leveraged annual yield (70 percent to 80 percent of total return from income) with total return (IRR) potential of 7 percent to 9 percent. It has low volatility, bond-like cash flow profile and is least correlated with other major assets. It offers diversification and inflation hedging benefits and high degree of liquidity.
By this definition, most core investors in Asia would only look at Tokyo, Hong Kong, Singapore, Sydney and Melbourne. Given the size of their major cities, some investors may also consider Beijing, Shanghai and Seoul. However, with true ‘net’ cap rates or un-leveraged first-year yields for core assets at between 2 percent to 4.5 percent in Japan, Greater China, Singapore and South Korea, does Asian ‘traditional’ core really exist? Even in cities like Sydney and Melbourne, where cap rates of 5.5 percent to 6.5 percent are at least closer to the levels of cap rates in North America and Europe, given the withholding tax and cost to hedge the currency it has also been a difficult market for international investors to achieve core returns using zero percent to 30 percent leverage.
Given the low-interest rate environment and abundance of debt in the Asian real estate capital markets, core assets are instead being acquired by foreign investors with higher non-core leverage of 50 percent to 70 percent. It is the leverage that is allowing managers to generate the annual 5 percent to 6 percent post-tax, post-currency hedging, off-shore dividends that foreign institutional investors require. The increased leverage has also allowed foreign investors to outbid domestic owners of core assets in each of these countries.
Domestic investors, like insurance and pension funds, looking at core assets are generally asset-liability matching with a lower target return and have no currency risk. But they are still losing to foreign investors at a record pace. It should be no surprise therefore that over the past two years several life insurance and pension funds from Asia have left the local bidding for core assets in their home markets to the foreigners. They’ve opted instead for higher, un-leveraged yields in the US and Europe.
As we all remember, the heightened use of leverage during the boom years pre-GFC rendered virtually any properties which had leverage more risky. But we may have forgotten from the previous cycle that using excessive leverage on core assets simply turns them non-core.
It may be there is just too much capital chasing yield in the core space. Yet this demand may continue to drive prices to even higher levels, at least in the short term. What is clear, however, is some assets in Asia are being dressed up as ‘traditional’ core with a strong running yield, but many are non-traditional core properties being acquired with increased leverage. As the chase for yield continues, there are also supposedly core acquisitions being completed in the capital cities of emerging markets or secondary cities of developed economies within Asia, again pushing further up the risk curve.
At this point in the cycle, as most economists agree, it is no longer a question of will interest rates increase, but when. That could well cause core assets acquired at peak levels today to achieve core-minus total returns in the future.