Asia Pacific economies race ahead
Sentiment throughout the Asia-Pacific region is swinging upwards, as rising markets and inexpensive debt provide a compelling combination for cross-border investors. Those with existing portfolios are now realising attractive returns. However, risk fundamentals such as transparency, liquidity and efficiency remain challenges, so investors in the region should fasten their seatbelts for the ride.
The economies in Asia Pacific are growing fast, and will continue to enjoy strong growth in the coming years. In some countries this represents growth off a low base, such as in China and India. Growing consumption in these countries has attracted impressive levels of activity from multi-national corporations looking for the most cost effective production base.
It is not just the emerging markets that are experiencing growth. As the Japanese economy returns to a growth phase, with local companies finally having restructured and resumed investment, the world’s second largest economy is entering an interesting phase.
The natural consequence of this growth is the resumption of corporate expansion, despite merger and acquisition activity, and an increase in occupational demand for office space, in both the services and manufacturing-based economies. Vacancy levels, which in some locations had reached historic highs in the aftermath of the Asian financial crisis in the late 1990s, have started to decline and as a result, rents have started to rise.
Supporting the positive outlook for investors is the limited supply in many markets after years of development inactivity. This will change as local operators spring back to life, supported by banks that are awash with cash, keen to lend to credible borrowers.
A significant focus of investment activity has been in Japan, with good reason, as it comprises about half of the total regional economy. In Tokyo, a rental recovery in the Grade-A office market began in mid-2003. After the burst of the IT bubble, rents declined more than 30% over three years, taking occupancy costs to levels that encouraged tenants to consider relocation or up-grade. Rents have bottomed out, but the significant pipeline of office developments will dampen prospects for rental growth and delay the recovery for inferior stock and some regional markets until 2005 or later.
Beyond Tokyo, the major regional cities of Osaka, Nagoya and Fukuoka stand out with a recovery in occupational demand in 2004 and signs of rental increases in 2005. Most major banks and insurance companies streamlined operations during the late 1990s, and closed non-critical local branch offices. Accordingly, stronger demand for office space in smaller centres will lag for a longer period.
Investment in the Seoul office sector has remained active, despite the weaker consumption and slowing economy. Market fundamentals continue to provide support, with low vacancies and a positive yield spread, although opportunistic investors are finding pricing more challenging, and core / growth investors are becoming more prominent.
In the China markets, a polarisation continues; the best buildings in Beijing and Shanghai are achieving rental growth, while the market at large is experiencing a gradual erosion of rental value amid competitive conditions for secondary product. While supply will remain at high levels in the coming years, demand is expected to keep pace and we expect the government will manage an economic slowdown and avoid a slump, and expansions will continue, albeit more steadily. Rents in Guangzhou have bottomed out but new supply will ensure rental conditions remain competitive.
Among second tier Chinese cities the outlook is more varied, although most have high levels of supply. Some markets will experience more distress than others, and this may present possibilities for opportunistic investors. Looking further ahead, the current efforts to curb excessive real estate development will produce more constrained supply in three to five years, allowing growth and value add investment strategies to take hold.
Corporate expansion has resumed in Hong Kong, producing rental growth. Local investors were quick to act, driving prices up and yields down to very low levels. At current prices investors need to factor in significant capital appreciation for investments to make sense. Expansion by service sector occupiers in Singapore finally seems to have taken hold, but the government’s commitment to preserving a low cost operating environment by maintaining plentiful supply has impaired rental growth in the past and will weigh on investors’ minds when looking at point-forward returns.
The more mature Australian markets may offer opportunities for core investors, with rents having bottomed out in Sydney and Melbourne after three years of decline amid higher vacancies. Tenant demand has also improved, with occupiers relocating to better quality stock, taking advantage of lower costs. Even with vacancies remaining in double-digits, capital markets have been fiercely competitive for all investment grade opportunities in both cities, and as yields have tightened, investors have to work harder on their homework.
Among the Asian Tigers, Bangkok possibly has the more attractive fundamentals, mainly due to growing demand. Expansions in Kuala Lumpur have been limited and appetite for office investments in Manila and Jakarta remains low amid geo-political concerns. The small lump sum often associated with investing in these markets can also deter investors, taking into account the time required to consummate a deal.
The office markets for multinational occupiers in India have taken a different tack, with suburban office parks being commonplace. The corporate covenant at relatively high yields will appear attractive to some, but that yield is pricing the risks and the regulatory environment remains a challenge for cross-border investors.
Incoming capital will continue to flow but liquidity and deal flow remain variable. Moreover, acquisition is just the beginning of the journey; solid asset management capabilities that can combine international practice with local customs are required to make assets perform. Ultimately, successful can only be confirmed after completion of an exit. In this regard, thankfully, liquidity is improving, and will increase further with the establishment of liquid REIT markets. Consequently, the depth of capital markets is increasing, transparency is improving and the risks are declining. Perhaps…
Jack Chandler is regional CEO, Asia for LaSalle Investment Management