Unlocking Asia's Potential
Investors have rarely questioned Asia’s promise as a rich source of real estate investment opportunity. Dynamic and diverse economic growth drivers and powerful demographic forces make a compelling case for a broad range of Asian real estate investments. The challenges for investors, particularly foreign ones, have always been how to execute and how to evaluate potential risks.
Although access and transparency still have far to go in many Asian countries, structural changes in the real estate capital markets have significantly reduced many of the impediments. The timing couldn’t be better. Positive cyclical forces are creating
opportunities for investors to participate in the ongoing recoveries in the Asian economies and property markets and to capitalise on the favourable long-term trends that should create healthy demand for all types of real estate as well as for direct and indirect property investments.
Factors influencing Asia’s growth While China and India have overshadowed the growth of other Asian countries over the past decade, other Asian countries, both developed and emerging, have obviously participated in and contributed to the region’s dynamic growth. Multinational corporations are either expanding or establishing operations in Asia, usually in the more developed countries and financial centres, such as Hong Kong and Singapore, which are vying to establish themselves as Asia’s financial hub.
Demographic forces underpin Asia’s favourable near-term and long-term economic
trends and should continue to drive demand not only for property but also for property-related investments. The region’s population will grow significantly over the next decade. Even modest annual population growth in China and India, the two most populous countries in the world, produces significant increases in absolute terms. Together, the two countries will add about 228m people over the next 10 years, roughly equivalent to adding the population of Australia each year for a decade.
The urbanisation trend, together with increasing affluence in emerging and developing countries, is already creating growing demand for all types of property in and around major Asian cities - from more and better quality housing to modern retail malls and shopping centres and networks of distribution facilities.
At the same time, Asia’s ageing population should create demand for investments that offer secure cash yields, characteristics that are normally associated with property-related investments. Between 2005 and 2025, the share of Japan’s population aged 65 or over will rise from 19.5% to 28%, while the total population shrinks by more than 7.2m. The combination of these two trends will increase the burden on workers as the ratio of working-age people to those over 65 falls from about 3.1 times in 2005 to just two times in 2025. Although Japan is the only Asian country that will experience a declining population over the next 20 years, all countries will see significant growth in the over-65 cohort.
As China’s booming economy makes very clear, the near-term cyclical economic forces in Asia are also quite favourable. Most Asian economies have been enjoying a cyclical recovery for several years as the global economy has rebounded from the US-led downturn in 2000-01. More important, the massive Japanese economy finally appears to be recovering from more than a decade of stagnation and deflation. Japan has been a significant drag on the Asian economy until relatively recently, and while real GDP growth in Japan remains fairly anaemic by Asian standards, even modest positive growth and rising asset values are welcome signs that the world’s second-largest economy is expanding again.
Property and capital market factors While the demographic and economic trends clearly provide a solid foundation for healthy long-term occupier and investor demand for property, historically, investing in Asian real estate has been difficult, especially for foreign investors. In many countries, regulations precluded non-resident capital sources from making meaningful investments directly or indirectly. The lack of transparency and limited liquidity has further complicated investors’ ability to execute, even in markets where foreign capital has been allowed to invest, and has exacerbated concerns about exit strategies and repatriation of capital.
The recent introduction of REITs throughout Asia, along with other structural changes, is transforming the real estate property and capital markets, making the Asian markets much more accessible to all types of investors - domestic and foreign individuals and institutions. Asia has a long history of listed property companies, including many large developers and conglomerates with massive property holdings throughout the region. However, Asian property shares have done a relatively poor job of replicating the investment characteristics of direct property ownership, and the listed property market has done little to improve transparency or liquidity in either the direct or listed markets.
The lack of private investment benchmarks makes it impossible to measure the correlations between direct and listed property. However, the basic investment characteristics that Asian property shares have exhibited differ substantially from those of direct property investments or REITs. Most notably, because ordinary property comallowing a REIT to pass income earned from investment properties directly to shareholders without paying tax at the corporate level, there is considerably less incentive to distribute income to shareholders or, for that matter, to invest in stabilised, income-producing properties.
Most REITs, on the other hand, are specifically designed as tax-transparent, pass-through vehicles for indirect ownership (ie, shares) of income-producing real estate. At a minimum, REIT regulations typically require companies to distribute a high percentage of their earnings, and limit the scope of permitted activities to owning and managing income-producing properties. As a result, REITs generally pay much higher dividend yields than listed property companies and, over the long term, should provide a much better proxy for direct investment.
Although the histories of the new Asian REITs are still fairly short, the evidence from the Japanese and Singapore markets suggests that investors
have embraced the new vehicles. Historically, shares of ordinary Asian property companies (mostly developers) have traded at steep discounts to the net asset value (NAV) of the underlying assets. As the charts show, J-REITs and S-REITs have traded at premiums to NAV throughout most of their brief histories.
More importantly, perhaps, the new vehicles appear to be having a dramatic effect on liquidity and transparency in the Asian property markets. Nowhere is this more evident than in Japan, where liquidity has improved greatly since the first J-REITs were launched in 2001. According to Jones Lang LaSalle, Japan accounted for more than half of the $94bn in direct real estate investment in Asia in 2006. In fact, direct investment in Japan more than doubled last year to $52bn (€35.5bn) from about $23bn in 2005.
As the Japan experience illustrates, REITs have injected liquidity into the Asian property markets directly, as another channel through which the industry can tap the capital markets, and indirectly, as a potential exit strategy for private investors. But in so doing, they have also imposed much greater transparency on the industry through increased analyst and rating agency coverage of the new REITs and the nascent CMBS market. According to JLL, property market transparency scores, which range from 1 for the most transparent markets to 5 for the most opaque, have improved dramatically in most Asian countries since its 2004 study.
While the new Asian REITs have provided investors with a relatively efficient way to invest in income-producing property, they create an opportunity to improve the alignment of interests between ordinary listed property companies (developers)
and investors seeking exposure to value creation activities. Several large Asian property companies have taken advantage of REIT structures to spin off portfolios of stabilised assets into new REITs while retaining development assets. In most cases, the process has rewarded the companies with a higher valuation for the stabilised assets, since the shares of the new REIT typically have commanded premiums, rather than discounts, to the NAVs of the underlying assets, and has left the company more streamlined and focused on value creation.
In theory, a better alignment of interests should benefit both investors and operators.
As the Asian REIT markets develop, investors will have the opportunity to create
and actively manage securities portfolios that provide exposure to core (REIT) and/or value-added (developers) property investments as the market cycle warrants. REITs and developers should be awarded a lower cost of capital.
The structural changes have come at a fortuitous time in the Asian property market cycle. Although space market conditions vary by and within countries, most major markets are still in the recovery or expansion phase of the cycle. Occupier and investor demand for office, retail and logistics properties continues to drive rents and asset prices higher in most major markets as the Asian economy expands and creates jobs. Not surprisingly, the combination of structural changes, strong capital flows and the cyclical recoveries of the economy and property markets has provided a tremendous lift to listed property shares over the past few years, especially to REITs. Listed property and REITs in the Asia Pacific region (including Australia and New Zealand) have significantly outperformed the broader equity and bond markets by a wide margin over the past one-, three- and five-year periods.
Over the long term, such outsized returns are not sustainable, particularly for the core assets that REITs typically own and manage. However, long-term returns for Australian listed property trusts (LPTs) and US REITs, which have much longer histories, have been very attractive on an absolute and risk-adjusted basis. Further, investor demand for assets that offer stable, relatively attractive yields and low correlations with other asset classes should continue to favour property investments. REIT dividend yields have compressed sharply as returns have soared in recent years, but continue to offer a positive spread over long-term government bonds in most markets, with greater opportunity for growth as the property market cycle advances.
Over the next two decades, Asia will see tremendous growth and development that will require major resources - from financial and human capital to all kinds of physical infrastructure. To be sure, the pace and magnitude of the economic and social changes occurring in parts of Asia and market deficiencies, including lack of transparency and inadequate legal and regulatory frameworks, pose serious risks that must be actively managed. But potential rewards warrant a careful examination of the diverse property and property-related investment opportunities.