Fundamentals drive growth
Diversification into Asia’s recovering real estate securities market will provide higher returns for investors, according to our analysis, because of increased demand for real estate in the region.
This is being driven by economic fundamentals such as rising personal incomes and
the search for investment products, strong economic growth and expansion opportunities associated with the relative immaturity of local markets.
Although distribution yields are low in some markets, the spreads over local interest rates are relatively large, creating strong demand for real estate investment.
For instance, a yield on real estate that might seem low to an Australian investor might still be attractive to a Japanese investor given the extremely low yields on Japanese government bonds.
The low proportion of securitised assets compared with Australia suggests that the number of new REITs will continue to expand, enabling a profitable initial public offering (IPO) strategy for real estate investment companies.
Established real estate companies will continue to exploit the situation by incorporating best practices from the mature listed property trust (LPT) and REIT markets in Australia and the US. Dividend yields are similar to or lower than in Europe and North America, but the capital growth potential is much higher.
Real estate cycles are significantly more pronounced in Asia than those generally experienced in Australia, western Europe and North America.
In Hong Kong, office rents fell by 78% from their peak in 1994 because of a variety of factors, such as the handover to China, the dotcom collapse and the SARS outbreaks. The market bottomed out in the middle of 2003 and has since recovered by 158%. However, rents remain 44% lower than 11 years ago.
Our research indicates that rentals will continue to grow by 40% until 2007 because of unmet demand, with the vacancy rate expected to fall to 3% from 5%. New developments and refurbishments are unlikely to address the shortage of office space until 2008-10.
In Japan, office rents fell by 7% during 2003 when new supply entered the market, but vacancy rates have subsequently halved to 4% as the oversupply was soaked up. UBS estimates that asking rents in Tokyo have grown by 25% from the bottom of the slump in the first quarter of 2005.
In Singapore, the outlook is also improving. Rentals have picked up by 16% in the year to September after a seven-year slump because of rising demand and a shortage of supply. However, a large quantity of new space in 2006 will dampen demand and restrict rental gains until the supply is absorbed.
In China, rentals in the key mature market of Shanghai are booming, with growth of 46% in the year to September 2005 and expectations of double-digit growth in 2006. However, rentals in Beijing have been flat because of oversupply. This is being taken up slowly, but it is unlikely that rents will start to rise again until 2007.
Although property capitalisation rates are low in most Asian markets, the spread over the cost of capital is relatively large, providing an attractive margin between dividends and interest repayments even before factoring in potential capital gains.
Gearing levels for many REITS are low but they are rising to international standards. This allows acquisitions to be funded mostly by low-cost debt, creating excellent earnings-per-share figures.
One example is the Tokyo-listed Japan Retail Fund, one of the first of what are called J-REITs. It has enjoyed debt costs of only 0.6%, yet it has been able to buy retail property on a cap rate of 6%. This explains why it has expanded from four shopping centres when it was set up in 2002 to 32 in 2005. Because of accretive acquisitions, funds from operations after tax have risen from ¥15.6bn (e150.2m) to ¥22.4bn, despite the fact that comparable-store sales have been flat.
There is huge demand for real estate in the region, particularly residential and retail real estate. This is being driven by commercial considerations, plus rising personal incomes and a corresponding increase in consumer spending and demand for income-producing investment products.
Development activity is strong in all of the region’s emerging countries, and much of it is focused on China. Many businesses report problems and frustrations when doing business there but real estate companies based in Hong Kong, Singapore and Australia have demonstrated the ability to produce solid returns from their investments, especially in Shanghai.
Many are now diversifying into second-tier cities - China has 30 cities with more than five million people - and there are plenty of opportunities for investors, especially in office and retail sectors.
Similarly, there is potential for strong redevelopment returns, particularly for retail property in such markets as Japan and Singapore, where assets have traditionally been owned by small, private landholders.
As the big trusts buy shopping centres, they are finding ways to reallocate space and remix the tenants, which is contributing strongly to rental growth.
A growing number of IPOs are being offered to investors through Asian stock exchanges. In the past four years, 23 REITs have listed in Japan and seven in Singapore.
The next wave of supply is likely to come from Hong Kong, where two REIT offerings worth more than $2.7bn, were recently completed. Units in one of them, the Link REIT, rose more than 15% in their first few days’ trading. Several more offerings are likely to follow next year, including one from Macquarie Goodman and another from Keppel Land.
In Japan, the average performance for the first 10 J-REITs is 62% growth since listing about four years ago. But some of the more recent offerings (many of them residential funds) are down from the initial price.
The first Singapore REIT appeared three years ago. The average first-day rise has been 9%, and the average price gain from listing to date has been 57%.
There is also a regular supply of secondary issues to help fund expansion. Pricing of these issues is generally at a 2-3% discount to the market price.
In the year to date, the Japanese real estate stock sector has leaped 60.5%, and Singapore real estate stocks have jumped 32.3%.
Rising interest rates are a threat to all real estate markets because they increase the cost of debt and narrow margins, making foreign investment less attractive.
However, Asian markets have the advantage that real estate security yield margins over government bonds are relatively large - typically 2-2.5% - and it’s feasible that interest rates could rise without affecting property security valuations because of rental growth and yield compression.