Finding value in Asia-Pacific real estate in 2016

Research briefing

Data on Asia-Pacific’s economies and real estate markets continue to produce conflicting reads. This is in part due to the fundamental heterogeneity in economic structure, demographics, fiscal, and monetary policy across the region’s main economies. But we have identified 10 key underlying trends for 2016 that we expect to shape the direction of the economies — and real estate markets — we focus on:

  1. Asia’s economic growth exceeds global average but faces headwinds as China slows; emerging market underperformance
  2. Disinflationary dynamics remain until over-capacity in manufacturing is reduced; wage growth softens
  3. Structural reform to continue with the service sector and domestic consumption to be more important for growth than exports
  4. Rental growth to generally slow relative to the last 36 months, though there will be pockets of exception
  5. Monetary Policy to remain accommodative and likely to loosen further in 2016
  6. US Federal Reserve (“Fed”) tightening to have a relatively limited impact on real estate pricing with the greatest risk in HK
  7. Little upward pressure on yields in most markets and prospect of further falls, particularly in Australia
  8. Regional exchange rates (“FX”) likely to experience weakening through 2016, with greatest uncertainty over the RMB
  9. Strong capital appetite for core assets; less crowded in different parts of the risk spectrum
  10. Demographically driven specialty asset classes become more attractive; increasing capital markets acceptance

In this report we outline the impact these trends may have on the region’s major real estate markets and strategic implications we expect to shape our real estate investing activity in 2016. In essence, this is how we expect to find value in Asia-Pacific’s real estate markets.

Macro-headwinds to remain…

In spite of seven years of extraordinarily accommodative monetary policy around the world, global growth remains tepid. Policy makers have not been able to stimulate a convincing recovery in aggregate demand; Quantitative Easing (“QE”) programs have boosted asset prices, but both corporates and consumers have exhibited remarkable reluctance to use increased wealth to invest/spend, instead preferring to hoard capital/save. In the aftermath of the Global Financial Crisis (“GFC”), Asia-Pacific’s largest economy, China, bolstered growth by expanding capacity — largely through debt — particularly in manufacturing and heavy industry. This supported regional growth, both through demand for raw materials from the region’s main commodity exporters — such as Australia, Malaysia, and Indonesia — and through increasingly complex trading networks with partners such as South Korea, Japan, Singapore, and Hong Kong. Of Asia’s exports, 25% go to China against 14% to the US and 11% to Europe. Australia, Taiwan, and Korea are the economies most exposed to China, accounting for 34%, 27%, and 26% of total exports, respectively. This is meaningful; 26% of exports, for example, equates to 10% of Korean GDP.

Figure 1: Asia’s Economic Performance 2015/16

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However, the lack of global demand for Asian manufactured goods in the current environment has led to overcapacity and, over the last 12 months, the impact of weak trade and exporting activity has started to meaningfully impact on Asia-Pacific growth. Over the next 12 months, these trends are likely to persist. Whilst US economic growth is accelerating, we do not expect a surge in demand for Asia’s exports. As a result, China and those markets most linked to it are likely to exhibit slower rates of growth and relatively low inflation. The markets with the higher components of domestic demand and less exposed to exports/trade cycle are exhibiting relatively stronger growth (see Figure 1).

…but beneficial structural change is underway

These economic challenges, however, are presenting opportunities for policy makers to restructure economies away from export-led growth models and to stimulate the contribution of domestic demand for growth. Households are being helped by monetary and fiscal easing. In Asia-Pacific ex-JP, real rates have been cut by an average of 117 bps over the last 12 months. Private consumption is slowly picking up due to a rise in real purchasing power. Generally, consumer balance sheets are sound, and current account balances are positive enough to allow for further cutting rates even as the US raises rates. The negative of rate differentials is potential for further FX pressure.

Country dynamics to vary

In China, we do expect a gradual economic slowdown rather than a meltdown. Structural shifts are underway in the economy away from commodity-intensive manufacturing to services with the service sector and consumption holding up well; retail sales remain up by over 10% year-over-year. Policy ammunition remains relatively strong despite 140 bps policy rate/200 bps RRR cuts in 2015; the currency remains a wildcard as the RMB is now expensive relative to trading partners (see Figure 2) but a strong RMB helps consumer purchasing power. Growth around 6.5% with one or two policy cuts in 2016 seems a reasonable assumption.

Figure 2: Regional Real Effective Exchange Rates

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In contrast, Abe’s JPY depreciation strategy aided Japan’s exports at the expense of real domestic demand. Given the broader global macro environment, this has proven problematic. Japanese purchasing power in USD has fallen sharply and, given this comprises 60% of Japanese GDP, it is not a surprise that the Japanese economy has bounced in and out of recession over the last 12 months. Wage growth remains disappointing despite a tight labor market and without solid income gains, we believe there will need to be more concerted policy action to stimulate necessary domestic demand improvements. Although recent data on Australia has been more encouraging, we expect 2016 to be another below-trend year for growth as weaker demand for commodities means exports weigh on growth and terms of trade soften. Consensus expects growth around 2.5%–2.6% with rates on hold; we see some downside as wage growth remains lackluster and the contribution of housing is likely peaking as macroprudential measures bite. We are certainly not seeing data reads to suggest recession, but there is the possibility of a further rate cut.

Factors that were supportive for Hong Kong from 2009–2013 — China’s economic expansion, tourism and retail spend, negative real rates, rapidly rising residential prices — are all unwinding in different ways as we go into 2016. Labor markets are currently solid and the economy seems structurally sound, although headwinds outweigh tailwinds; nonetheless, there’s a prospect of improvement later in 2016 if China holds up. As an open trading economy strongly linked to China, Singapore unsurprisingly experienced slower growth in 2015, and this is likely to continue into 2016. However, we remain positive on Singapore’s longer-term direction as population growth and economic upgrading will support growth.

Figure 3: Asia is becoming older, richer, and more urban

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Secular demographic shifts continue apace

In the absence of above trend economic growth in the region in the short term, we continue to analyze and identify longer-term secular demand drivers. There are key demographic shifts in the region that will play out over the next five to ten years that will have a profound impact on economic activity and structure. We have summarized these trends as a simple mnemonic: Asia is getting older, richer, and more urban. These shifts will impact on real estate markets through increased demand for non-traditional
“specialty” types of real estate including senior living, student housing, and self-storage, as well as changing demand for residential, logistics, and retail assets.

Regional1 occupier markets remain solid though supply is on the increase

Through the course of 2015, there has been a significant improvement in regional office demand over that of 2013–2014, though total absorption for the full year is likely to only hit long-term averages. There has been a strong recovery in Sydney and Melbourne, with 125,000 sqm of net absorption year-to-date2 in Melbourne after zero total in the three-year period 2012–14 and 120,000 sqm in Sydney, two-and-a-half times the long-term average. Part of this is clearly catchup, but there’s been solid new demand, especially from technology and media tenants, an indication of underlying changes in the Australian economy. Shanghai has been the stand-out in terms of total demand with over 350,000 sqm year-to-date (20% up on full-year 2014), and Hong Kong has also surprised on the upside this year with Chinese financial firms continuing to be active acquirers of space. Despite the negative sentiment on China through 2015, this illustrates the areas in the economy that continue to experience growth. Less positively, we saw only the fourth negative quarter of absorption in Tokyo since early 2010 as the Japanese economy cooled, while Singapore has had two consecutive negative quarters as tenant demand is dominated by churn, not new requirements.

Figure 4: Trailing 12 Month Rents vs. Vacancy Across Asia-Pacific’s Major Office Markets

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Generally speaking, office markets remain well-balanced, but we are starting to see a turn in the direction of travel. 2014 clearly marked a low in the office supply cycle; the pipeline picked up in 2015 and will accelerate further into 2016. We expect about 5% to be added to total stock; the biggest increases in CBD stock over the next two years in % terms are Shanghai (24%), Singapore (11%), Beijing (9%), and Tokyo (9%). The lowest are in Melbourne (2.9%) and Hong Kong (4.4%). Shanghai and Singapore will see the bulk of 2016’s completions, with a surge in Tokyo in 2017.

The biggest surprise over the last 12 months had been the resilience of Hong Kong office rents; a weaker mainland economy was expected to hit demand and lead to increased cost-saving decentralization. Instead, mainland companies have continued to be active in Central, causing very low vacancies and net effective rents up 11% year-over-year. Singapore has followed the reverse trend and, after seeing rents up 15% year-over-year in late 2014, rents are correcting as demand remains soft and tenants are aware of major supply competition coming through. Tokyo rental growth has been pretty range-bound at around 5% year-over-year, and our expectation is for rental growth to fall more into a 2%–3% channel as supply increases. Sydney and Melbourne are starting to see some improvement and, given how high incentives3 are, it doesn’t take much to start to see some meaningful upward net effective rental moves. Whilst we don’t expect the Australian economy to grow much more in 2016 over 2015, the major Australian office markets do seem to be positioned for an upswing into 2017.

Given softer domestic consumption trends, retail markets have increasingly been influenced by the pattern of Chinese tourists. Singapore and Hong Kong, for a combination of political and economic reasons, have moved out of favor with Tokyo gaining share. Rents in prime Hong Kong districts are down by 20% year-over-year with equivalent in Tokyo up as much as 30% year-over-year. There is little significant new retail construction outside of Australia, most of which consists of extensions to existing centers, in-line with population growth trends. In warehouses, we see a likely record year for new supply in 2016, driven primarily by greater Tokyo (two million sqm in 2016–2017) and China. Much of this supply is demand-driven with ecommerce/3PL businesses growing and will take tenants out of older space, but it is having a rental impact and we expect this trend to continue into 2016. In Shanghai and Beijing, warehouse rental growth has fallen from 5%–6% year-over-year in 2012/2013 to 1%–2%, and while Tokyo rents have been growing at 6% year-over-year through 2015, we expect this growth rate to rapidly fall.

Whilst capital appetite remains strong, especially for core assets

When analyzing cross-border capital flows in Asia-Pacific, there are two dynamics that are important to appreciate: demand from outside the region for real estate and intraAsia flows. In the main, capital from outside the region has taken a barbell approach; whilst perhaps something of a generalization, capital has tended to either allocate towards core income-producing assets to diversify/complement their domestic portfolios or towards higher-risk development/opportunistic strategies in order to capture the perceived growth in the region. Given the slow-down in regional growth, it is unsurprising that the former category has captured a greater share of allocations over the last 12 months with a rapid growth in core/core-plus commingled vehicles combined with Sovereign Wealth and pension fund money pursuing a limited pool of assets.

Figure 5: Aggregate Regional Yields

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The combination of increased international capital and falling policy rates/cost of debt has placed downward pressure on yields for core assets and, by our calculations, yields are at all-time lows across the region across the three major asset classes. We estimate yields for high-quality assets have tightened by 50–60 bps in aggregate over the last 12 months, with the largest moves in the higher-yielding sector/countries of warehouse and Australia. Within Asia-Pacific, there has been a relatively clear rotation from Hong Kong and Singapore into Australia and Japan. S-REITS have been active acquirers of income-producing Australian assets through 2015, with Chinese capital focused on development/redevelopment opportunities.

Figure 6: Regional Transaction Volumes (USD)

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In China, softness has been much more evident in second-tier markets, with Shanghai in particular showing strong year-over-year growth in volumes. Although the data suggests a slowing in total regional transaction volumes in 2015, it is important to note these data are in USD. The Australian dollar, for example, has fallen roughly by 20% vs the USD through 2015 vs 2014, and the Japanese yen has fallen by 15%. In Australia, volumes in AUD are likely to be similar to 2014. There is, however, a clear decline in transaction volumes in both Hong Kong and Singapore, and in the latter that is now starting to feed into pricing. Figure 7 shows the adjustment in Singapore values over the course of 2015 and Hong Kong clearly has vulnerability.

Figure 7: Prime Office Capital Values in USD

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As we look forward into 2016, we continue to expect to see some further yield movement in Australia as new benchmark prices have recently been set in office and industrial. Figure 7 shows that in spite of +/- 200 bps of inward yield movement, the price of prime office assets in Sydney and Melbourne in USD terms are still lower than in 2012. Figure 8 shows the extent to which yields in Australia still stand out.

In Japan, it is difficult to see yields tightening much further from here, given the practical constraints on monetary policy. Rather, further asset inflation will have to be driven by rental growth, which in turn will rely on policy makers to drive meaningful spending increases, a function of wage growth. In China, yields do not stand out as particularly attractive in a regional context, though some reconciliation between the prices of debt and equity are an encouraging sign.

Strategies in focus

As we piece together this broader economic and real estate background, there are some key implications for investment strategies for 2016. Perhaps the most resonant is to be cautious on leveraged strategies on growth. Although we are not characterizing regional core assets as clearly overpriced — indeed they are generally more fairly priced given where rates are — when cap-rates are low and rental growth prospects are softening, care needs to be taken in deriving return assumptions. We retain our focus on demographically driven investment themes that we believe can prosper whether strong growth materializes or not. We continue to identify select strategies where there are tangible imbalances between fundamental supply and demand, which may generate some rental growth and higher-yielding sectors which appear mispriced, which includes the specialty space. In addition, we continue to see the mid-risk space in the market least crowded as capital competes either for low-risk income-producing opportunities or for development opportunities. Incremental location risk appears attractively priced, whether it’s over B over A markets or suburbs vs CBD, as do assets requiring capital expenditure for repurposing and repositioning. This profile of asset, requiring professional management expertise, but not fitting the requirements of higher-return oriented capital is receiving lower bidding attention than core assets right now. Given it is likely there is increasing volatility in the interest rate environment, we recommend greater prudence in leverage strategies.

Figure 8: Transaction Yields for +$100m Assets Traded in Asia-Pacific in 2015

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Higher-returning opportunities may be present in emerging markets but in our judgment, risk-adjusted returns favor more liquid developed markets. China’s size means it cannot be disregarded, but we are cautious with economic restructuring. We continue to focus on Australia, Japan, Hong Kong, and Singapore. In Australia, yields have tightened across asset classes by +/- 100 bps through the last 12 months. This clearly affects relative value, and though assets remain relatively cheap in USD terms, a simple buy for yield compression approach is largely played out. A more focused strategy is needed. In Japan, the asset inflation story is increasingly dependent on earnings (rents), not multiples (cap-rates). Office rents have had a good 18 months, but the cycle is now slowing; we prefer residential. Singapore and particularly Hong Kong are vulnerable to US rate movements and pricing adjustments. Residential prices have softened in Singapore over the last 24 months and this has seeped into commercial pricing; we expect similar dynamics in Hong Kong as residential markets soften in 2016. In Singapore, industrial assets remain high-yielding; converting to complementary use is very accretive if you have the ability and partnerships to manage this complex process. In Hong Kong, non-discretionary retail is much more stable than discretionary forms, but may start to experience pricing pressure as demand for luxury retail weakens. Given the speed of execution required in Hong Kong, it is important to be prepared for opportunities.

1) Singapore self-storage4

Singapore is rapidly restructuring its economy away from low value-add manufacturing and, as a result, has a significant supply of older-generation factory buildings. Converting these to alternative use is complex due to several policy restrictions but creating self-storage in these buildings is possible. Singapore is significantly undersupplied with good quality storage assets (see Figure 9) and we expect this to persist as Singapore’s population grows. Self-storage rents are roughly double those of industrial rents in the same type of building; conversion to storage is therefore very accretive. Currently, pricing for industrial buildings is softening due to lack of demand from end-users; this presents an attractive opportunity to buy and convert.

Figure 9: Singapore Self-storage Supply vs US Top-25 MSAs

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2) Hong Kong non-discretionary retail

Hong Kong’s retail market is going through a significant adjustment phase. Rents in Hong Kong’s prime retail areas almost doubled between 2009 and 2013 as demand from Chinese shoppers for luxury goods surged. As this spend has retreated, so have rents and, therefore, sentiment on the sector. However, this comprises a relatively limited portion of the HK retail market. We believe that the Hong Kong economy remains fundamentally sound, with an affluent resident base, steady population growth, low unemployment, and, therefore, retail sales growth in the 4%–5% year-over-year range. Over 50% of retail spending in Hong Kong is non-discretionary, with relatively high spending on food services. We continue to evaluate and price opportunities to buy and upgrade outdated retail podiums in select neighborhoods. Hong Kong is continuing to benefit from significant infrastructure upgrades, and locations linked to new transport are particularly attractive.

Figure 10: Hong Kong Economic Fundamentals Forecast

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3) Tokyo residential

Japan is one of very few developed markets to see limited rises in house prices, despite enacting perhaps the most aggressive post-GFC monetary policy measures. This is not just a demographic issue; as Figure 11 shows, prices in Germany relative to incomes have grown rapidly as the sector has experienced significant structural change. Germany now has house prices relative to income in Q2 2015 that are 10% beneath the long-term average; in Japan they are more than 30% beneath the average. Fundamentals in the rented space are solid with high occupancies; rents, however, have showed limited moves post-GFC. If the recent direction of Abe to grow wages, potentially via fiscal policy, gains traction, this should feed through into rents and ultimately into prices. Our focus remains on well-located assets in Greater Tokyo, due to demographics.

Figure 11: Select OECD Countries House Price Indices

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4) Sydney suburban office

We continue to favor Sydney. The New South Wales economy is strong and well-diversified. Land constraints and infrastructure improvements should be supportive of general property performance. In office, we see solid potential of a rental upswing given supply/demand fundamentals. Premium Grade CBD office is expensive now, but we see opportunities in suburban markets as stock continues to be withdrawn for residential conversion; in the last 11 quarters, there were 17,000 sqm of completions but 71,000 sqm of withdrawals in the key inner-suburban markets. As CBD rents rise more rapidly, certain tenants will look for more affordable fringe space. Pricing remains relatively attractive; see Figure 12.

Figure 12: Sydney Office Sub-Market Yields

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Conclusion

Whilst Asia-Pacific’s economic growth is facing headwinds and core yields for traditional asset classes are to be bid down to new lows, we continue to identify select opportunities that we believe can generate attractive risk-adjusted returns. These opportunities are clearly linked to some of the long-term secular demand drivers that should shape economic activity over the next five to ten years and can prosper even in environments of slower growth. In addition, over the last 10 years, we have seen specialty asset classes in particular gain investor acceptance in the US, with a sharp reduction in the required premium expected to purchase these type of buildings. We expect similar dynamics to play out in Asia-Pacific and advocate the attractive characteristics of these assets.



1. Regional Real Estate Analysis from here on refers to aggregates of our market coverage: Australia, China, Hong Kong, Japan, Singapore.
2. Year-to-date data is as end-Q3 2015 unless otherwise stated.
3. Currently over 35 months on a new 10-year lease.
4. A comprehensive white paper on the prospects of the Singapore self-storage market and additional research on each of these strategies is available on request.

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