ASIA RT: Waiting for the storm

It is late September and the uncharacteristically hot weather in Hong Kong seems to be forewarning the arrival of a tropical cyclone expected to skirt the island city. Three days later, Typhoon Megi will make landfall in Taiwan, leaving Hong Kong unscathed.

The global real estate industry has warded off a similar storm for almost eight years now. Observers call this period a prolonged bull run with a staggering amount of capital chasing alternatives in the hunt for better returns in a low bond-yield environment. Total inbound property investment in Asia touched $9.6 billion last year, a surge from the $1.4 billion in 2009, according to the property consultancy CBRE’s Asia In and Out report published last month.

But what goes up must come down and continuing unpredictability in the global economic and political environment – the impact of Brexit, US elections, and China’s economic health among other events – is making some people wonder if the next correction in the real estate sector is around the corner.

“The world is probably due for a correction,” says Jon-Paul Toppino, group president, PAG, and managing partner, PAG Real Estate. “I have been amazed at what investors will shake off … what doesn’t make them nervous. There is instability in the Middle East, Brexit, and a crazy election in the US – a lot of things are happening that just continue to be ignored or shaken off and this is because the interest rates are so low. Real assets are popular because there is still a dividend yield and cashflow is king. That said, there will likely be a correction, but that is more likely to happen because of something outside the real estate sector.”

Mark Gabbay, chief executive of Asia-Pacific at LaSalle Investment Management, echoes the view: “The backdrop is set for physical assets to go up in value. So being able to predict when a correction is expected to occur has become complex. Markets have already had so many different negative events that one would have thought that risk would have been repriced. But it hasn’t happened.”

For gateway Asian real estate markets, one of the biggest global events this year, Brexit, may turn out to be a blessing, even though it is yet to be reflected in transaction volumes. Nonetheless, Gabbay says investors have a much more constructive view of Asia this year compared with 2015 and some have put a temporary stop on investing in Europe.

Even then, all the participants at PERE’s annual Asia roundtable are conscious about the impending correction and risks of misallocating capital and being over-leveraged in the region.

“We are working hard, globally, to ensure we have the capacity to hold through whatever the next bump is,” says Richard Price, chief executive of Asia-Pacific at CBRE Global Investors. “Whether that be options to extend debt or a more critical examination of lease expiration profiles. Many of these things were missed in the run up to the previous crisis.”

Changing risk appetite

Other risk mitigating measures have been put in place by managers to avoid a repeat of the 2008 financial carnage. LaSalle Investment Management runs an opportunistic fund series and is currently on the fundraising trail for LaSalle Asia Opportunity Fund V. The vehicle was launched in August with a $750 million target and a $1 billion hard-cap. Around $400 million is expected to be raised in the first close.

Speaking about the lower leverage norms in opportunistic funds these days, Gabbay says the new fund has been capped at 65 percent leverage.

“You can debate whether that is truly opportunistic or closer to a value-add risk profile,” he says. “It all depends on how your product or fund navigated that last crisis and the adjustments that have been made. Given where we are in the current cycle it will be important for managers to stay away from style drift investing at this point of time.”

PAG Real Estate, the Hong Kong-based investment management firm, is in the market for its sixth opportunistic fund with a $1.5 billion target. In Toppino’s view it all comes down to having a disciplined investment approach.

“One thing we have to guard against is taking more risk for less return. That would be a disservice to our investors. Quite frankly many of the investment risks that value-add funds continually take on are risks that I wouldn’t tolerate even in my opportunistic funds,” he says.

The opportunistic managers around the table say they are targeting 16-18 percent returns from their funds currently, not an easy feat if leverage is capped at around 65 percent.

“The only way I have found to hedge real estate is to buy it for less than its worth,” says Toppino. “It sounds like a hedge fund-type of approach, but fundamentally that is the safest thing for your investor. If you are buying good real estate at an attractive basis, you have long tenured debt, you haven’t over-levered, and you are a good manager so you can maintain your cashflows, you generally shouldn’t lose money over time even if there is a serious correction.”

The conservative approach is not limited to debt levels. PERE has been told by several managers that they are not factoring in any exit cap rate compression while making an investment in Asia.

Kenneth Gaw, president and managing principal at Gaw Capital Partners, the Hong Kong-headquartered real estate investment manager, agrees. “If you leave the cap rate the same as in today’s market that is reasonable if you have an underlying income level growth at the property level.”

Gaw Capital has raised approximately $900 million for Gaw Capital Real Estate Fund V, its fifth opportunistic vehicle, for which it is targeting $1.3 billion in equity.

But opportunistic fundraising is rarer than it used to be, something which tallies with the conservative message around the table. PAG, LaSalle, Apollo Global Management, and Invesco Real Estate are the only managers to have launched opportunistic funds in Asia this year, according to PERE research. Since a five-year peak in 2012, fundraising for opportunistic strategies has fallen 75 percent (see chart).

The reduced appeal of high risk-and-return strategies in Asia could be seen in September when Aetos Capital Real Estate cancelled its latest opportunistic fund, Aetos Capital Asia V, opting to launch a Japan-centric value-add vehicle instead. Days later, Forum Partners, the London-based investment manager, told PERE it had decided not to launch its third fund in Asia because of investors’ wariness of deploying capital in a blind-pool commingled fund.

In addition to strategic changes, there have been few new entrants to the marketplace. “It is very hard for new managers to start right now given where we are in the cycle. Five years ago, when people were looking to back new or emerging managers it was a different environment. Those people who raised money back then are now established with their second or third fund in the series if their maiden fund performed,” says Gabbay.

According to Price, this is compounded by the fact most institutions are reducing the number of managers they are working with.

Some traditionally opportunistic managers are also beginning to straddle different strategies and venture into core and core-plus investments. SC Capital, the Singapore-headquartered investment manager led by Suchad Chiaranussati, is in the market for its maiden pan Asia core-plus fund. And in June, PAG held a $1.3 billion final close on its PAG Real Estate Partners Fund, its first-ever core-plus offering.

Is this simply a response to investors’ demands? PAG’s Toppino explains his firm’s rationale of moving down the risk curve. “There are lot of transactions in Asia that can generate good risk-adjusted returns but have been shoehorned into opportunistic deals. It is easy to take a 12 percent IRR deal and make it a zero by trying to turn it into a 20 percent IRR deal by overleveraging and becoming overly aggressive with your assumptions.”

He adds: “For us, opportunistic and core-plus investing are two very distinct businesses. In the case of opportunistic, we may fully reposition a hard asset, we will buy non-performing loans and distressed debt or even a company to get to the assets that way. That is different from our core-plus strategy which is a hard asset business – that business is still about buying correctly at a good basis but it is about really managing your buildings and maintaining and hopefully growing your long-term cashflows.”

Gabbay agrees launching lower-risk vehicles is a function of the market. “There are more investors coming to Asia that are looking to fill that core, core-plus bucket. But there are limited products with a track record in Asia. If you look at the evolution of products here they have always been opportunistic going back to the late 1990s and early 2000s.”

But the core investing strategy is not without its share of challenges either. Price thinks the open-ended core and core-plus funds model is a fundamentally tricky business in Asia.

“I don’t know if having an open-ended fund structure in which you are commingling many Asian markets together makes sense. Unless these funds can reach a scale of between $3 billion and $5 billion of gross assets it is challenging to provide the diversification and liquidity that investors look for from these types of vehicles,” he says. “In a closed-ended structure you can make it work because you are managing the fund to a finite timeline. You can manage your currency exposure, you have got tactical bets relative to specific markets and sectors rather than trying to provide consistent market exposure over time.”

He also points to another missing piece in Asia – the lack of Asian institutions willing to commit capital to open-ended funds.

“If you look at the big open-end core funds in the US they are very successful products with a long history and track record. These products are overwhelmingly supported by domestic capital. As a business proposition until you have a product here that Asian institutions really stand behind and back these funds will always remain at the margin and be dependent on global capital.”

There is also growing evidence that many investors would rather commit to a co-investment vehicle or on a deal-by-deal basis than via a fund. Forum’s decision to invest in Asia only via a global investment vehicle seeded with capital from an institutional shareholder is the latest example.

There is unanimity around the table that ultimately it all comes down to the performance of the vintage funds in case of experienced managers but it is different for emerging managers.

“We built our business that way too,” says Gaw. “By doing deal-by-deal investments and giving co-investment rights. It was five years before we raised our first fund.”

Toppino adds that for first-time managers it is easier to raise co-investment capital where investors have the discretion. “You can use those deals to build a track record. But if you are in the funds management business you really cannot operate that way. It is counterproductive to the rest of your business to have a bunch of managed accounts alongside your funds,” he says.

Having co-investment relationships also helps in case of billion dollar-plus investments that cannot be made via a fund alone. Gaw cites the acquisition of the Pacific Century Place in Beijing in 2014.

“Certain types of investors are good with co-investments, so they are particularly good to have in the fund if you want to target large deals. When we purchased the PCP for $928 million plus renovation cost – we would have needed a fund that was around $3 billion to $4 billion in size aside from dealing with concentration risk. So we put in $150 million of the fund capital and rest was all co-investment capital,” he says.

Investors have also become more willing to invest capital in funds as well as the side cars – a welcome change from the previous crisis, Price says.

“It used to be that investors negotiated for co-investment rights but never used them as they were not organized to take advantage of those rights. Now managers know the investors that can perform and they are happy to give those rights,” he says.

This change is partly because a number of international institutional investors now have local teams in Asia, Price says, allowing them to make quicker decisions.

However, participants also advise that fellow managers carefully select the investors in funds. They cite anecdotal evidence about funds raised immediately before the financial crisis that had an investor base consisting of large institutions and high-net-worth investors. Having investors with varying appetites for risk and return became a huge challenge because the structure of the funds at the time was such that it required everyone’s consent for any fund restructuring.

“It is important that you raise a fund with like-minded investors. It’s best to have investors that view a downturn in the cycle as a buying opportunity versus having to pull back on risk,” says Gabbay.

Predicting the downturn

As the participants point out, it is hard to predict the timing of the next downturn, especially if you believe claims that external macro events are more likely to cause the correction. And it is the movement of interest rates that is believed to be the biggest determiner of what will happen in the future.

“When interest rates do turn the risk of them going up further and faster than people think is likely underestimated. If there are some external shocks that spook people, then you may see central banks playing catch-up with the bond markets and that could be really worrying. For now that looks like a low probability outcome,” says Price.

Nonetheless, all four managers in this roundtable, each of whom agree to having learned valuable lessons from the 2008 crisis, believe in certain dos and don’ts for the property industry professionals in this uncertain environment.

“Performance over the next few years will further distinguish the quality of the managers in Asia, because we are at least in the midpoint or latter in the cycle,” says Gabbay. “So staying away from value traps will remain critical where transactions that are done in the market require incremental risk without the incremental return. The next couple of years are going to be important in terms of what kind of deals you do. We always talk about how this business is a marathon not a sprint and one has to have a long-term mindset.”

Mark Gabbay
Chief executive for Asia-Pacific
LaSalle Investment Management

Gabbay joined the organization in 2007 to lead the management of the business in Asia, initially as managing director and subsequently as co-chief executive. In June 2015, he became sole chief executive after Phillip Ling announced his retirement.

Richard Price
Chief executive for Asia-Pacific
CBRE Global Investors

Price is responsible for the firm’s business activities in the region and chairs the Asia-Pacific regional management board and investment committee. He joined the organization in 2008 from ING where he worked in several senior roles.

Jon-Paul Toppino
Group president

Singapore-based Toppino, who is also managing partner of PAG Real Estate, joined the organization formerly known as Secured Capital in 1993. He relocated to Japan in 1998 and has been responsible for building the organization’s hard asset business, including both acquisitions and asset management.

Kenneth Gaw
Gaw Capital Partners

Gaw, who is also managing principal, member of investment committee and co-founder of Gaw Capital Partners, has more than 20 years of real estate investment and management experience in Thailand, Hong Kong, and China. He was previously managing director of Pioneer Global Group and has also worked in the structural finance group at Goldman Sachs.

Country focus
Two countries dominate the thoughts of investors in Asia, and the challenges only grow in markets that don’t follow the economic rules.

Of all the key gateway markets in Asia, China and Japan are the two that dominate the roundtable discussion owing to their uncertain macro environment.

Rising asset prices in Japan, fuelled in part by negative interest rates, have prompted analysts to draw parallels to the pre-crisis levels. According to Toppino, however, valuations in Tokyo are still 25 percent off the March 2008 peak, while Osaka is 35 percent to 40 percent lower. Rents too, he says, are 30 percent lower than those in 2008.

But managing investments in the current environment, where markets do not always follow standard economic theory, is a challenge, especially when deciding the appropriate hedging approach. The negative interest rate announcement made in January ought to have prompted a fall in the value of the yen, but it gained strength because of external factors including the perception of the currency as a safe haven currency in the aftermath of Brexit.

Currency swings coupled with volatility in the equities market were also the reason why many international investors chose to pause investing in China last year, although Gaw Capital’s experience demonstrates otherwise.

“Despite talks about China being a risky market it still remains an important destination for global investors. It is only a matter of how much they want to invest and with whom,” says Gaw. “Investors initially ask for 20 percent returns for investing in China because of the risk, but ultimately they are fine with 16-18 percent returns if you offer them co-investment opportunities alongside investing in a fund.”

He cites Gaw Capital’s Fund V, which intended to invest 50 percent in Asian markets beyond Greater China. However, investors asked for a greater allocation to China and Gaw increased the allocation to Greater China to 70 percent.

With the exception of Gaw Capital, which has taken a bet on Vietnam with the acquisition of a timed-out development fund, all three managers agree that now is not the right time to be “exploratory.” Investors will be better served if they stick to markets in which they have teams and prior exposure.