Featured in Institutional Real Estate Asia-Pacific’s February 2022 issue:
If the pandemic has taught us anything, it has highlighted the need for investors to future proof their portfolios. To this end, many institutions are reassessing their portfolio allocations. For real estate investors, this includes an investigation of alternative property types because these sectors can enhance portfolio returns in three key ways. First, alternatives can lessen portfolio volatility by providing stable and predictable income across the economic cycle, given their defensive characteristics. Second, because the returns of alternatives and traditional property types are not perfectly correlated, introducing alternatives can mitigate portfolio risk. Third, investors can participate in the institutionalisation of these sectors, potentially earning outsized returns as yields compress.
Institutional investment in real estate in Asia Pacific has historically focused on office, retail and industrial properties. These traditional property types account for more than 95 percent of the value of the MSCI APAC Property Index, with the office sector alone at 43 percent of the total. We do not expect this to persist, having watched sector rotation occur elsewhere in the world. The pandemic underscored the cyclicality of office and the seeming conflict between operational volatility and sharp pricing, given historically low office yields. That dynamic in the United States caused investors to shift capital elsewhere. Office now represents only 30 percent of the NFI-ODCE Index, down from 39 percent a decade ago. Similarly, although some investors have reallocated capital to industrial, they have been challenged by the sector’s tight cap rates and in getting to their target weights. Pre-pandemic, retail already faced structural pressures due to ecommerce; the pandemic pushed it further out of favour with many investors. Multifamily or build-to-rent (BTR) is gaining traction, but its geography is limited largely to Japan.
The alternative sectors, which include data centres, self-storage, healthcare and student housing, have become increasingly common elements of institutional portfolios in the United States and Europe. Rising investment volumes since 2015 speak to heightened interested in Asia Pacific alternatives.
The focus here is on self-storage, purpose-built student accommodation (PBSA) and healthcare. Although each of these sectors is unique, they share some characteristics:
Tenant demand is less linked to or delinked from macroeconomic trends, deriving instead from dynamics such as ageing and urbanisation. PBSA benefits from countercyclicality — occupier demand for US and UK PBSA rose during recent recessions (though not in the COVID recession because of travel bans). Self-storage is not immune to the economic cycle, but tenant demand tends to recover ahead of other property types. As a result, portfolios with exposure to alternatives have more-resilient, more-predictable income streams.
Alternatives initially trade at higher yields than traditional sectors, with yield compression occurring as investor familiarity grows, resulting in outperformance. As shown in the table on page 25, this dynamic is under way in Australia. While yield compression occurred widely over the past two years, it has been particularly strong for logistics and alternatives — yields tightened by 100 basis points for healthcare, PBSA and self-storage between the second quarter of 2019 and the second quarter of 2021, slightly exceeding the 90-basis-point compression for logistics.
Finally, alternative assets are typically smaller than those in traditional sectors. As a result, for the amount a single office or retail asset costs, an investor can acquire multiple assets, heightening diversification. When sufficiently aggregated, portfolios of alternatives trade on premiums to individual assets, given their highly fragmented nature in the marketplace.
Continued migration into Asian cities is among the factors boosting user demand for self-storage over the past decade. Given the region’s small average home size, households seeking to store seasonal or infrequently used items regularly look to self-storage. Although households account for most storage use, demand also comes from ecommerce companies and startups, as the cost of a storage unit is lower than that of office space. Storage vacancy tends to rise in recessions, as users look to cut expenses, but Heitman’s Asia Pacific storage portfolio experienced the opposite. Occupancy increased between November 2019 and the middle of 2021, and effective rents rose, exceeding November 2019 levels by 20 percent, on average.
The two most-advanced Asia Pacific markets for self-storage are Australia and Japan, followed by Hong Kong and Singapore. Although storage ownership remains fragmented, institutional investment is rising. At the start of 2020, three entities vied for control of one of Australia’s largest publicly listed storage operators, including a US-listed self-storage REIT and two separate private-equity players. This transaction fell apart due to COVID, but it is indicative of growing institutional focus.
Investors can invest in existing assets or, more commonly, create new ones. Although ground-up construction is a part of storage provision in Asia Pacific, most recent storage development has involved conversion of an existing building — often an obsolete manufacturing space — to storage. As an example, Heitman’s recent storage ventures in Singapore and Hong Kong have been portfolio aggregation strategies involving such conversions.
Purpose-built student accommodation
Institutional investment in PBSA intensified worldwide after the global financial crisis. The sector’s countercyclical attributes were in full view then in major US and UK education hubs. The pandemic interrupted steady growth in tenant demand for PBSA, though markets with strong domestic demand, such as the United States and the United Kingdom, have seen a strong rebound after the disruptions of the first half of 2020.
In Asia Pacific, the PBSA sector is small but was growing quickly pre-COVID. PBSA development has come in response to two major shifts in university enrolment. On the domestic front, student mobility has increased in Australia and Japan, meaning the number of students living at home has declined, resulting in greater demand for accommodations near universities. At the same time, the number of foreign students enrolling in Australia, Japan and Singapore was rising rapidly pre-pandemic, led by students from China and India. Asia Pacific universities offer such students closer proximity to home and greater affordability than universities in the United States and United Kingdom. With Japanese universities only recently increasing their English-based course offerings, Japan is a relatively new PBSA market. This focus on English-based learning led Global Student Accommodation to develop a 350-bed facility in Tokyo in 2018.
Historically, students seeking accommodation rented rooms in private homes or units in condominium buildings. Seeing a gap in the market, operators have begun delivering institutional-grade assets. Although COVID-19 dampened demand in Asia Pacific as international borders closed, user demand will likely resume as COVID recedes. In addition, we have seen domestic students becoming more receptive to the newer product.
Surveys of global investors show continued strong interest in PBSA despite the pandemic. This is evident in Australia, where more than A$3.0 billion (US$2.2 billion) of transactions occurred between 2019 and 2020.
The healthcare universe spans hospitals, medical offices, laboratories, clinics and aged-care facilities. The backdrop for rising institutional interest in Asia Pacific’s healthcare sector is the region’s rapidly ageing population — Japan has the highest median age in the world, followed closely by Hong Kong, South Korea and Taiwan. Based on Heitman’s US experience, demand for medical care starts increasing at age 65, fuelling growth in demand for hospitals, medical offices and clinics. Demand for aged-care facilities comes later, as individuals reach the age of 80 or greater. Home-based aged care has been the mode historically in Asia Pacific, but user demand for aged-care facilities is expected to grow exponentially over the next two decades. Tenant demand is already exceeding supply in Japan, for instance.
Meanwhile, the Asia Pacific region’s rapidly ageing population is posing challenges, as the cost to care for the elderly is straining public finances. Many countries were looking to share those costs pre-pandemic through asset sales to private investors, and COVID-19 intensified that quest.
This parallels the path taken by healthcare systems in the United States several decades ago. Investors in the US medical office sector have found it to be characterised by stability in tenancy, with tenants renewing leases at rates exceeding those of commercial office buildings. High tenant retention and long lease terms have translated into secure, predictable income. Stable income growth has been accompanied by yield compression, leading to outsize returns.
According to MSCI, Asia Pacific healthcare properties returns during the pandemic were second only to logistics. Australia is by far the most-active healthcare market in the region. Its biggest transaction was the 2019 takeover of a local operator by a Canadian institutional investor. September 2021 saw a listing of a healthcare REIT with a market capitalisation of A$555 million (US$401 million) and the sale of a 27-asset portfolio on a tight cap rate of 5.3 percent. More broadly, the portfolio of Asia’s largest listed healthcare REITs spans 50 properties across Singapore, Malaysia and Japan.
The bottom line
Given the pressures facing office and retail, two historical portfolio mainstays, its likely institutional investors will intensify their search for alternative assets. Investment activity in these sectors was trending up prior to the pandemic, and diversifying real estate portfolios with alternative assets can help investors enhance returns. Beyond the diversification and risk-mitigation benefits, there may also be early-mover benefits for investors in the region. Recent activity for such assets has resulted in yield compression relative to traditional real estate sectors, pointing to a rerating of alternative sectors and the potential for outperformance.
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