ROUNDTABLE: The new normal

It is the last working day of October. There is a crisp coolness in the Hong Kong air signaling the onset of winter. We are gathered on the 28th floor of the Shun Tak Centre, a red-striped commercial and transport complex on the northern shore of the Hong Kong Island next to the Macau ferry and helicopter terminal.

The climate in many of Asia’s private real estate investment markets is a little warmer. The last year has seen a continuing flow of global institutional capital into both developed and emerging economies in the region and several new pan-Asia private equity real estate funds have come to market.

However, macroeconomic jerks in the region, the chief one being China’s economic downturn, and uncertainty in financial markets globally has undoubtedly altered the pace and strategies of investing in Asia. There is a lot of liquidity in the region but the risk/return profile of the capital is changing, leading many people to question what the new normal for investing in Asia is.

“Asia always had challenges,” says Mark Gabbay, chief executive officer and chief investment officer, Asia-Pacific for LaSalle Investment Management. “It is the capital coming from outside Asia that changes its view of the ‘Asia’ risk premium. Now there is a rational reason not to invest in Asia given what happened this summer in China in the equity markets. There may be a short pause from European and US investors coming into Asia because of the longer term outlook for China. Having said that, the China market is already seeing signs of stabilization with additional liquidity being provides by the PBOC.”

The cautious stance and increasing preference for core and core-plus investing is also being driven by the fear of an impending sector-wide downturn.

“We are in a relatively benign economic environment at the moment. The overall market fundamentals are not that bad – there is moderate growth, low inflation and most company balance sheets are strong. But it has been eight years since the GFC and many investors feel a downturn is around the corner,” explains Eduard Wehry, head of investor services for CBRE Global Investors Asia. “There is a lot of capital being put to work, but investors are getting more defensive in terms of strategies, deal structuring and leverage, anticipating a possible down turn in the next two years.”

What’s on the menu?
The general view among the roundtable participants is that Asia is no longer considered a one-time investment destination, but one that requires a more consistent strategy so as to have a globally diversified portfolio. But given many of the long-held assumptions about investing in Asia no longer apply in the current environment, fund managers and investors are having to change their investment approach.

Before the global financial crises, Wehry says most investors went into Asia with a view to getting a return premium, but after getting burnt in the crisis there is a preference for more de-risked strategies today.

Michael Chan, managing director, private capital markets for Macquarie Capital, echoes the same view: A lot of investors have to be in Asia but looking historically they are still seeking a return premium. Previously they could get this even in core markets like Tokyo and Hong Kong, but now that’s more of a challenge. We are also seeing that a number of investors have made the jump and moved to development.”

Cuong Nguyen, head of research & strategy for Asia Pacific at M&G Real Estate, says some fund managers which have been trying to raise capital for private equity real estate funds are beginning to question if Asia is becoming an expensive real estate market because of current cap rate levels and the returns that can be generated.

“People need to realize growth in Asia is going to slow down as Asian economies mature. So you cannot go into Asia and ask for double-digit returns year-on-year. Now is the opportunity for long-term capital,” he says.

In his conversations with investors, Nguyen says European investors have a clear understanding that Asia is meant for long-term investing. On the other hand, US investors, he says, have been a little slow, but they are changing their perception now.

There are five pan-Asia core private equity real estate funds currently out raising capital in the region, according to PERE’s Research & Analytics. And the list is expected to grow. For instance, PERE has learnt from industry sources that Brookfield is among the firms plotting the launch of a core vehicle. The firm is understood to be targeting a $500 million first close for the $1 billion pan-Asia core fund.

At the same time, the participants all agreed that little capital has thus far been collected via pan-Asia core funds. The capital that is inbound is coming through different channels. Chan says he is seeing a steady inflow of European capital coming through the multi-managers, for example.

Bayerische Versorgungskammer (BVK), Germany’s biggest pension fund manager’s expansion in Asia is one case in point. In late September, PERE revealed that the Bavarian institution was planning to invest a total of €700 million via separate account mandates to three pan-regional investment managers. Two of these, Alpha Investment Partners, the Singapore-based fund management business of the listed-developer Keppel Land, and CBRE Global Investment Partners, the joint venture investment business of LA-property services firm CBRE, have been mandated to invest the equity in core and core-plus investments.

The tide towards core investing is also being driven in part due to the muted outlook for performance of other asset classes.

“Global investors have been worried that equities might be over-valued and have increased allocations to bonds. Now with low returns in bonds and outlook for increases in rates, there is greater allocation to alternatives,” says Gabbay.

In Wehry’s view, a structural increase in allocation towards real assets is also reflected in the fact that many private equity firms are positioning themselves as alternative asset managers, and not just private equity managers.

“A lot of investors are looking for fixed income proxies and how they can buy long duration income yielding assets,” he says.

Challenges of core investing
As market fundamentals change, investment managers find they need to spend time explaining how to access a core strategy in Asia, which may be different from that in the US or Europe.

“We have been breaking down a core strategy in three ways: investors can either be income-oriented which will lead to Japan or Australia or they can be more comfortable with capital appreciation over the long term which can lead to markets such as Tier 1 China, Hong Kong or Singapore; and if an investor is more focused on accessing high quality assets, we recommend, you take development risk and execute a build-to-core strategy,” says Gabbay.

“Looking back, a return of 8 percent to 10 percent was considered core in Asia. Now, a 7 percent return is core,” adds Nguyen.

But within the commonly accepted definition of core in Asia lies a key challenge: the lack of investable stock. A big chunky office building in the region is considered as core, a contrast in comparison to the West where cash-flow generating and smaller office properties in secondary cities also form part of a core fund’s portfolio.

“A core fund in Europe or the US is typically well diversified across the spectrum whereas in Asia it is still heavily weighted towards the office sector and concentrated in few countries like Japan and Australia,” says Wehry.

He goes on to add: “The challenge in Asia is that the investable stock is still relatively small. According to estimates, Asia would comprise 40 percent of the global investable universe by 2025. So this growth will provide more investment opportunities, but currently much of the core assets do not trade and are held long term by real estate operating companies and/or conglomerates.”

Nguyen says one of the most difficult challenges for core funds raising capital currently is its deployment, since it is difficult to invest anywhere else apart from Japan and Australia at the moment.

Funds are also having to compete with institutional and domestic capital for assets.

Rai Katimansah, director and head of Southeast Asia Investments & Asia Structured Debt Investments for Hong Kong-based private equity real estate firm Phoenix Property Investors, points towards the global sovereign wealth funds, many of which are cutting big checks for direct real estate deals in the region. He gives the recent example of the Middle Eastern state fund Abu Dhabi Investment Authority (ADIA) which signed a HK$18.5 billion (€2.24; $2.39 billion) deal with New World Development in April this year to acquire a 50 percent stake in three prime hotels in Hong Kong. ADIA’s deal to partially acquire the Grand Hyatt, Renaissance Harbour View, and Hyatt Regency stands unrivalled as the biggest hotel deal in Asia in a decade.

According to Wehry, there has also been a huge accumulation of domestic pools of capital within Asia. He talks about how the government and private institutions in many Asian countries began to restructure their balance sheets after the Asian financial crises and started actively deploying also into real estate after the GFC.

The challenge on the buy side, however, means growing opportunity for investment managers looking to sell into the market.

The participants talk about the constraints posed on institutional investors by the “denominator effect”, a phrase used to explain how institutions are required to pull back from investing in real estate to maintain their target asset allocation when the total value of their investment portfolio falls due to the performance of stocks, bonds and other asset types.

“If you can hold investments across cycles you can do fine but institutions are often forced to sell because of the denominator effect,” says Wehry.

He adds further: “For managers, if you know there is a structural demand for core real estate in Asia, an interesting strategy is to manufacture core and sell into that strong demand instead of competing. This strong demand for core assets reduces the exit risk for such strategies.”

Nguyen says M&G, which runs Asia’s largest open-ended core private equity real estate fund, is not actively selling at the moment but trying to buy more with a focus on portfolio construction and relative values across markets.

“What would you do with the capital after you sell? It is tough to take a view on the market cycle particularly when you take into account the transaction cost involved to re-deploy the capital in highly competitive market conditions. M&G has been focusing on investing capex on assets already in the portfolio and consider such strategy as a more efficient approach to deploy capital and enhance returns,” he says.

Macro deal-breaker
Investors and investment managers factor in macroeconomic risks while deciding the regional spread and asset allocation targets of their portfolio. With the uncertainty in financial markets globally, that risk is getting compounded.
All eyes are currently on the US Federal Reserve and a near-term decision to increase the benchmark interest rate. The last time the rates were raised was 2006. Since then, the levels have been near zero.

“Historically speaking, we are in very benign interest rate environment, which is likely to stay accommodative for some time. The yield curve is likely to stay quite flat,” says Wehry. “You need to ask yourself, from a valuation perspective, what is the risk premium investors are getting over risk-free when buying core real estate? That is still comparatively high, somewhere around 200 basis points to 300 basis points.”

“The risk for core investors are global risks in the financial markets or geopolitical risks that are extremely hard to predict,” adds Gabbay.

Within Asia, the stock market crash in China that first began during the summer has been the main source of financial turbulence in the region, ripples of which were felt in markets globally. A third of the value of the stock on the Shanghai Stock Exchange was lost in June, followed by multiple aftershocks. A series of market interventions by the Chinese authorities were soon initiated to abate the panic, including a 3 percent currency devaluation over a three-day period.

Don’t write off China
None of the roundtable participants however are too perturbed about China’s economic rumblings, especially since the Chinese yuan has appreciated back to sustainable levels in the months following the August devaluation.

Katimansah reminds everyone that in the last ten months to twelve months even the Japanese yen too has also declined against the US dollar.

“The dollar yen rate has weakened significantly from its recent high (below ¥80 in 2012) to what it is trading today. In contrast, the dollar renminbi rate has weakened less than 5 percent from its recent high.”

“The western media is talking about the slowdown but consumption and wages are still seeing double digit growth,” he goes on to add.

“Since the GFC, there has been a lot of skepticism about the strength of the Chinese economy. But if you look at the GDP in absolute terms from 2008 until now, it has grown from $5 trillion to $10 trillion today, or put differently, China has added the size of the Japanese economy since the GFC. The growth rate might have slowed, but in absolute terms the growth has been huge,” says Wehry.

Irrespective of the weak fundamentals in certain sectors of the real estate market, demographic and urbanization trends continue to play up China as a favorable investment destination.

The advice from the roundtable participants: stick to Tier 1 cities and ignore the rest of the noise.

“The conversations now are not about China as a whole but about specific cities in China, and not just with investors who have been here for years but also with new participants,” says Chan.

Chan says outside of logistics, he continues to receive enquiries from groups looking to invest in office and retail assets in Tier 1 cities, the latter in particular requiring the right operator. In 2013, Macquarie advised on Brookfield’s investment into China Xintiandi, a subsidiary of Shui On Land, and the associated sale of Corporate Avenue II to China Life.

Wehry, meanwhile, sees mixed-use residential as a good investment opportunity.

“There are clearly areas of oversupply and bad fundamentals. But there are also many cities with strong fundamentals and attractive investment opportunities. One needs to be more granular in identifying the right markets,” he says. “We have been investing in China for a long time. Besides the investment objective, partner selection is obviously key.”

Japan and Australia
Elsewhere in Asia, Japan and Australia are attracting significant amount of overseas and Asian investors, many of them first-timers.

A key change being seen in Tokyo in the last 12 months is on the rental front. The common assumption among the participants is that the rental growth in Japan is going to drive valuations going forward since the cap rates have already compressed.

“One can be positive about Japan if you believe in Abenomics. From a real estate perspective, replacement costs have increased dramatically due to high construction costs. Rents have a good backdrop to grow based on macro and real estate fundamentals,” says Gabbay.

In response to the sizeable demand from institutional capital, LaSalle too is preparing to sell a portfolio of six retail properties for more than $1 billion and is understood to have appointed Savills to market the portfolio.

In Australia, a falling Australian dollar has triggered a surge of investments particularly into the commercial and residential property markets of Sydney and Melbourne. The country was at the centre of one of the region’s biggest property transactions this year: China Investment Corporation’s (CIC) acquisition of the Morgan Stanley Real Estate Investing-owned Investa Property Trust for A$2.45 billion.

However, as the wave of capital continues to invest in Australia, participants also advise caution.

“The real estate market is more reactive than other asset classes given our assets don’t trade on a screen. If you manage a closed-ended fund and if you invest more than 60 percent of the fund in a wrong vintage that is on the wrong side of a crises whether global, regional or country specific, it is going to take a long time to re-gain those potential losses,” says Gabbay.

Emerging and developing
Among the emerging markets, the Philippines has emerged as an attractive investment destination for investment managers on the back of strong economic fundamentals. In November, Baring Private Equity Asia Real Estate underwrote $75 million of a $150 million investment in an office development in Clark, an emerging business district in the country.

Phoenix Property Investors too is looking at residential development projects in the Philippines and recently invested in a Grade A office property in Manila. Katimansah says the large capital inflows received by the overseas Filipino workers (also known as OFWs) and the fast growing BPO industry are the main factors driving investments.

Some of the other markets such as Malaysia and Indonesia are plagued by geopolitical and currency issues, which are dissuading investors. Nevertheless, Chan says some of the opportunistic private equity real estate funds are starting to look for distressed assets in Malaysia.

For Katimansah, such emerging markets are “yield-enhancers” and can present opportunities for build-to-core. He adds that Southeast Asia continues to remain only a small part of Phoenix Property Investors’ portfolio.

Despite favorable demographic trends, India too does not emerge as a unanimous choice as a preferred investment destination. Chan says that the few institutions which are looking to invest in the country are doing so with greater nuance and caution than before.

“Some sovereign wealth and pension funds are going into deals where there is very strong alignment, for example 50 percent co-investment by the sponsor. Those who are in the market are cutting big cheques but there has been a lot more homework this time around. The underwriting has been very sensible.”

While one-off investments can be done in these markets, most participants felt these economies are a long way off before becoming deep investment markets. For Chan, while a central problem lies in the volatile currencies in some of these countries, making the case for the appropriate risk premiums is essential.

“For our institutional capital, I don’t see the rationale to go into less liquid markets, such as the emerging markets in Asia. We don’t believe investors are getting compensated for the incremental risk. There are ample opportunities in the developed markets that can deliver double digit total returns with moderate leverage,” says Gabbay.

The demarcation between developed and emerging Asian real estate markets is not new and neither is the type of capital that gets attracted to each. What is changing, however, is the lens with which the whole region is being seen by cautious investors which today want a risk-adjusted slice of Asia.