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Asian real estate market grows up

19 Sep 2006

Asia's real estate market has woken up from its slumbers. Increased transparency, liquidity and a liberalisation of regulatory regimes in the region have seen rapid developments in the size and depth of the market. However, with big variations from country to country, and the market still lacking the maturity of its European big brother, Asian real estate investment comes with a warning sign. By Sarfraz Thind.

The Asian real estate market has expanded at an exceptionally rapid rate over the past decade. From new modes of real estate financing, including securitisation, and non-recourse financing to the development of the real estate investment trust (Reit) market and the substantial growth of equity-linked real estate issuance since last year, Asian real estate is slowly catching up to the techniques and trends seen in Europe and the US.

Furthermore the prospects for market growth remain enormous. Total investable stock in Asia stands at $2.5trn of which only $1.4trn has thus far been tapped, according to RREEF, the real estate investment management arm of Deutsche Asset Management.

With the real estate securitisation business still developing, Reits still only two or three years old in most Asian countries and the two regional behemoths, India and China, having only just opened their real estate markets, market participants have been rubbing their hands in anticipation of future developments.

And there are clear signs that the markets are seeing progress. The traditional view of property as a bedrock commodity, second only to gold, is changing, with property owners increasingly applying the same financial acumen to real estate as other financial assets.

"Real estate is close to the heart of Asia — it is on the whole prized and held dearly, more so than in the US for example," says Anthony Ryan, managing director and head of real estate investment banking, Asia, at JP Morgan in Hong Kong. "In Asia, companies have traditionally wanted to own their head office as a symbol of the company, whereas in the US companies will sell this to improve the return on equity and recycle capital for their core business. But this mindset is now changing."

Asian property accounts for some 14% of the $475bn of global real estate allocation, a jump from 8% in 2003.

With the changing tide in the market, foreign investors, hit by poor returns in the traditional European asset classes, have been increasingly lured to Asian real estate.

Of the $67bn investment in Asian real estate last year, $20bn was cross-border, up from $5bn in 2003. This is a similar trend to that seen in Europe five or six years ago.

"Real estate in Asia is increasingly being recognised as an investable asset class within international capital markets," says Chris Reilly, director of property for Asia at Henderson Global Investors in Hong Kong. "As the market accelerates it is now a viable alternative for pension funds in Europe which have traditionally looked to bonds and equity. In relative terms, prices look good value for foreign investors."

The market has been helped by regulatory improvements and increased transparency in many Asian countries. This has enabled investors and developers to become more adept at analysing the different levels of risk premium applicable for the diverse regions.

But despite the growth and increased maturity in the region, Asian real estate continues to be riskier than in the West. Real estate returns can be volatile, and regulatory standards are still far behind those in Western economies.

Investors in Hong Kong Reits, for example, have been hampered by stringent regulatory oversight which has prevented the market from developing as quickly as in other regions. On the other hand China is liable to change regulations at short notice, and often without market consultation.

Many of the region's markets remain hampered by the limited availability of robust performance measures and the lack of widespread reporting of transactions.

Furthermore, the countries with a less developed real estate industry can be open to political and economic machinations and corruption can often creep into the financial sector.

With such a big and diverse market, finding homogeneity in Asia's real estate business is a struggle. Perhaps the one consistent theme across Asia is its diversity. With this in mind, EuroWeek examines the different trends prevalent in Asia's many different regions.

China and India

China and India, with their vast economic potential, are the biggest targets for investors looking to Asian real estate. "Real estate is a size issue," says Kiran Patel, global head of research and strategy at Axa Real Estate Investment Managers in London. "European and US investors are looking to diversify into Asia but generally they prefer to go into larger markets, like China and India, than the smaller ones like Thailand, Indonesia or Malaysia where there is little real estate debt."

With a burgeoning middle class, and GDP levels forecast to hit $8.5tr by 2035 from current levels of around $746bn, India's economy is set to be a leading force in the global financial markets with in the next 20 years. And the economic development in the country has been the catalyst for a big increase in domestic real estate.

The boom in India's IT and services sectors over the past five years has seen an explosion in office property developments across different parts of the country.

India offers some of the most attractive yields on prime office real estate of any country in the world.

Mumbai has seen the highest yields of any Asian city in recent times, with commercial property returns at around 11%. To date only $4bn of the total $300bn stock of commercial property has been tapped, says Henry Chin at RREEF, highlighting the country's exciting future potential.

Furthermore the growth in India's middle class over the past 10 years has precipitated a huge increase in demand for residential housing and leisure property developments. According to a 2005 survey by Merrill Lynch, organised retail, which accounts for just 2% of the $200bn housing and leisure sector, will grow from $4bn to $15bn by 2010.

And in February this year, the Indian government opened the doors for foreign direct investment in single-brand retail trading. According to consultancy firm AT Kearney the retail business in India is expected to reach $60bn by 2015, with India developing into the leading destination for retail investment in the future.

While the huge demand for Indian real estate has seen juicy returns, the market is still in its infancy and the risks investing in India remain high. Transparency is low and India is beset with infrastructure problems.

"India is essentially several different countries in one," says Axa's Patel. "In the long term it looks a fantastic play, but it is still lacking a solid infrastructure. Furthermore, despite its obvious positives, India's democratic politics can get in the way of development, unlike in China where there is one government which holds all the cards."

Another factor in India is the scarcity of land near big cities, reflected in surging prices in recent times. Of late, many Indian property developers have been turning to second or third tier cities for future growth.

Foreign investment in domestic real estate is constrained by tight investment controls. With a three year lock-in period for property investments, many foreign investors have had to invest in real estate development projects or otherwise form joint ventures with local companies to access the market. Foreign investors have also been looking to invest in the market through domestic property funds. There are currently 25 real estate funds in India aiming to raise a projected investment target of $3bn, says Axa's Patel.

Participants expect the market to open up in the next two to three years, with new regulations coming in to boost real estate development — for example there have been rumours of the Indian government passing Reits legislation within the next year or so to enable the country to catch up with its Asian counterparts, many of which have already enacted Reits laws (see Reits article on page 8). Regulators have also been working to relax the rules on foreign direct investment enabling lower investment thresholds and capital requirements.

Despite these efforts there is still work to be done before India can compete on a global scale, and the country still remains behind Hong Kong, Singapore and South Korea in the development of its real estate business.

China has been Asia's fastest growing economy in recent times, and it shows no signs of slowing down. The country's GDP is forecast to grow to $29.5tr by 2040 from $1.9tr, overtaking that of the US.

And Chinese real estate returns have been nothing short of spectacular. Chinese property stocks recorded a 56% total return in the first quarter of this year, according to the JP Morgan property universe index. This comes on the back of a 101% total return recorded for 2005.

House prices in Shanghai, the country's most expensive market, have doubled in the last five to six years.

And retail property in Beijing is expected to see a boost in rents over the next few years as it benefits from rising tourism, growing household affluence and, importantly for the city, the 2008 Olympic Games.

The rapid rates of growth seen over the past few years have, however, led to the authorities seeking to impose increasingly stringent measures to prevent the market from overheating.

Over the past year the central government has been tightening monetary supply to the real estate sector — the lending rate was increased by 27bp in April this year — to prevent the property market from overheating. And in May this year the Chinese regulators passed stringent laws to further cool the market. Firstly new rules were imposed preventing investors from using offshore holdings to access mainland property. In future all foreign investors will need to establish a domestic legal entity to access the mainland real estate market.

Furthermore foreign investors are now required to hold property for a minimum of five years or they may be subject to a taxation penalty. The regulations also increased mortgage down payment ratios on new property purchases from 35% to 50%.

The news has dismayed many foreign investors looking to tap China's potentially lucrative real estate sector.

"While India's recent regulatory changes have opened the market to foreign investment, China is going the other way," says Ryan at JP Morgan. "The government has sought to impose additional measures to restrict capital inflow into the real estate sector, to prevent it from overheating."

Overall, foreign real estate investment in China has dropped off this year — there was some $1.1bn of cross-border real estate investment in the first half of this year, compared to $2.8bn in the whole of 2005. And given the tightening of regulations in May, participants expect this figure to drop off even further in the second half of the year.

The main purpose of the new rules has been to restrict speculative real estate investment in China. However for foreign investors the rigidity of the regulations has proved a setback.

"China is essentially an emerging market like Russia and remains risky," says Axa's Patel. "China does change the rules as and when it feels like it — not once but several times. Furthermore investors are not buying freehold but leasehold — all land is held by the People's Republic of China."

Hong Kong

Historically Hong Kong has been one of the most transparent and mature Asian property markets. However, it also remains one of the most volatile real estate markets in Asia. Between 1999 and 2005 the region saw huge return dispersion, with office rental return dipping to a low of -13% in 2000 to a high of 61% in 2004.

The property market cycle in Hong Kong is much shorter than in other regions, with the market coming full circle every four to five years compared to eight or nine years in mature Western economies. Following the Sars crisis in 2003 office returns plunged to -7%, shaking the domestic real estate market.

However over the past couple of years the market has rebounded spectacularly.

Overall, Hong Kong saw the strongest rental growth in Asia in 2005 with a record increase in prime rental levels of around 80%, according to RREEF. Rental growth for 2006 is forecast at 37%, well below last year's gain, though still indicative of the region's comeback. In the first half of 2006 there was around $4.6bn of investment activities in Hong Kong, exceeding the amount for the same period last year, according to RREEF. Furthermore, cross-border investment has also exceeded the level in 2005, with office purchases by Macquarie Bank and Morgan Stanley totalling around $600m, demonstrating a vibrant real estate market.

However, with the substantial growth seen in this and last year, the market is expected to cool in the near future.

"We believe that the Hong Kong office cycle has now reached its post-growth period," says Henry Chin at RREEF. "With rising interest rates and rental growth slowing, we should not expect further yield compression. In other words, property is becoming more expensive."

Since it opened up in 2005, Hong Kong's Reits business has promised great things. There were three Reits listed last year, including Asia's largest, The Link REIT. However, market expectations of a vibrant Reits business in 2006 have not been realised. Recent regulatory intervention by the Chinese authorities, as well as problems with the reputation of Hong Kong Reits, has dampened business this year.


Singapore's real estate market has been in close competition with that of Hong Kong over recent years. While regulations remain fairly liberal in investments such as Reits, the market has tended to suffer due to stringent government policies in the underlying property markets. Indeed Singapore's government has in the past controlled the supply of new land with a firm hand, releasing land whenever the market looks to be overheating.

In recent times Singapore has seen robust real estate performance with the office rental market increasing by 13.5% last year.

And investors remain bullish. According to RREEF, prime office rental growth should hit 38% this year followed by 15% in 2007.

Furthermore, Singapore has seen a strong foreign interest in its real estate business. Overall cross-border investment in Singapore real estate hit $550m in the first half of 2006, compared to $400m in total last year. A major part of this came from brokerage house CLSA which bought two buildings in Singapore in the first half of this year, totalling around $250m.

Anecdotal information suggests that more multinational companies have preferred to locate in Singapore over Hong Kong in recent times, in part to escape the growing pollution problems in the latter.

Growth in Singapore will be dependant on a number of factors. Analysts expect rental growth to slow next year because of increased supply in the market, though at present demand remains higher than supply.

South Korea

Along with Hong Kong and Singapore, South Korea falls broadly into the second tier category of Asian real estate markets. Nonetheless many foreign investors would suggest that it is not yet as developed as these two regions, due primarily to the lack of financial transparency in the country.

On a performance basis the market looks stable. Following a flat 2005, the real estate market bounced back in 2006, with limited new supply driving rents higher. Dividend yields in the Reits sector are around 7.5% — attractive when considering the underlying treasury rate of 5%.

And the market has been gradually opening up to foreign investment, which has increased both transparency and liquidity in the property business. Total cross-border real estate investment reached $224m last year. This year looks much stronger with around $700m of foreign investment in the first half of 2006, including a $123m property purchase by Macquarie Bank earlier in the year.

Furthermore, domestic investment has grown rapidly this year as pension funds and insurers, which previously had less than 1% allocation to real estate, have sought to increase their real estate holdings.

Indeed, 2006 has seen some big domestic deals, such as the purchase of SKC Building by Samsung Life in a deal totalling more than $100m. The prospects for commercial property expansion look good. With total real estate stock at around $400bn, according to RREEF, South Korea has the second largest commercial real estate stock in Asia (ex-Japan), just behind China.

On the other hand, residential property in South Korea has experienced something of a slowdown in recent times as the government imposed strong taxation measures to cool the business.

There has also been more traction seen in the K-Reits market, signalling the development of a maturing market. South Korea is certainly one of Asia's most interesting property markets, with big future potential, and it remains to be seen if this will be realised soon.

Thailand, Taiwan and Malaysia

Thailand, Bangkok and Malaysia remain behind their Asian peers in terms of size and market maturity. Nonetheless, real estate returns in these countries have been strong in recent times and, with developing regulations, the prospects for growth look good. In general, the emerging countries have not seen the downturn in the office markets experienced in many of the mature countries in Asia. Furthermore regulators have been aiming to promote a healthy real estate market by liberalising the regulatory regime, as is evidenced in the growth of the Reits market in these countries.

But, while these countries have been moving forward, the influence of politics remains a potential inhibitor for the market's development.

In Thailand, Bangkok saw the highest rate of prime rental growth of the emerging Asian markets in 2005 at 26%, with particularly strong demand from the IT and financial services sectors. However, this year the market has moved slowly as the political concerns which eventually forced prime minister Thaksin Shinawatra to step down forced real estate participants to adopt a wait-and-see stance with regard to Thai real estate investment.

With political uncertainties easing in the country, analysts forecast that the investment market will pick up in the latter part of 2006. Indeed JP Morgan equity analysts have identified Thailand as the most attractive market in the region for the next year, citing an average of 23% core profit growth expected on real estate stocks.

In Taiwan the office market has not shown as strong rental growth as in the rest of the Asia region, but participants remain positive. The persistence of low interest rates in the country has led to both local and overseas investors continuing to search for viable investment properties in prime locations. In recent times the central bank has been lifting interest rates, though until now these rate hikes have not had a big effect on the long term interest of institutional investors. Whether continued interest rate increases will affect the country's Reit business as rental yields fall, on the other hand, remains to be seen.

The Malaysian market has evolved over the last couple of years, with regulators removing many of the stringent capital controls to allow foreign investors in. In recent times the government has been trying to promote cities such as Kuala Lumpur as a Muslim shopping destination which has led to strong retailer demand and consequent positive rental growths.

For the near future real estate development remains strong in the country's major cities which may see rents falling in the next few years.

19 Sep 2006