‘Worst likely over for Asian real estate’

The investment climate of late has thawed somewhat since the cold snap that saw economies contracting and nations scrambling to avoid sliding into recession. Although there have been casualties, many countries have been quick to inject stimulus packages to jumpstart economic health.

Although the effects have taken some time to show, there are positive signs that the recession is now beginning to bottom out.

Cushman & Wakefield’s Quarterly Investment Report on the Asia-Pacific, published in August, sees the region poised to emerge leaner, fitter and stronger although the path to full recovery remains rocky.

In the report, the international real estate services firm states that the worst is most likely over for the Asian real estate market, thanks to the sharp correction in values that has invigorated the private investor market. This is aided by a surge in liquidity and a drop in deposit rates that have investors looking at hard assets.

On the flip side, developers and businesses are accepting slower growth, narrower profit margins and smaller asset returns, given the shortage of credit and soft rental outlook. The report adds that the pains of debt refinancing may roll over until end-2010 and the tough lending situation for construction projects may be a damper.

Except for China, other nations have to put up with a disproportion between increase in money supply and bank lending, with the latter largely elusive and usually expensive.

However, the overall prognosis is that markets will experience stabilisation followed by increase in activity. Any form of sustained recovery in asset pricing is however unlikely until early 2010, says the report. Investors should thus remain cautious and prudent about where they park their money and give careful thought to the funding and timing of their commitment.

Property pricing forecast
Markets corrected much faster than initially predicted in the first six months of 2009, and a more horizontal movement is expected for the rest of the year. Across Asia, rental yields have been affected. Between March and June this year, the bid-ask gap for major cities contracted by between 50 and 150 basis points. With the poorer underlying income profile of most core assets, commercial real estate values are estimated to fall by as little as 0% to 5% in Seoul and an incremental 10% and 15% in Singapore and Tokyo respectively.

There is also evidence that the Asian high net worth investor market will be able to fund investment of assets valued below US$50 million (RM176 million) through large equity positions. This will help form a floor to valuation, which is currently 30% to 40% below the peak of 4Q2007 on average.

Banks, stock market and private equity
In the heydays of 2006-2007 when banks competed for business, loan-to-value (LTV) ratios ballooned. Combined with low interest rates, real estate assets enjoyed the liquidity characteristics of quasi-listed securities. As markets deteriorated, banks started to impose strict limits on lending ratios, at an average of between 150 and 200 basis points higher for core markets and between 400 and 700 basis points higher for emerging markets. The paradox of banks lending less on assets valued significantly below peak pricing reflects the new view on real estate seeking higher margins of safety.

The results have been sobering for investors wanting to leverage their purchases. The combination of low LTV lending and higher costs requires a higher quantum of equity, ranging from 15% to 25% in core markets and 30% to  40% in emerging markets. Hence, the average equity on deals has increased from 35% to 50% in core markets and 45% to 65% in emerging markets.

“Governments’ rush to extend sovereign guarantees to deposits and raising additional Tier 1 capital helped banks survive. As a result, secondary and shadow banking sources of funding are left aside as the net impact is an almost complete domination of the lending environment by traditional banks,” says the report.
The two sources of private equity that will help in the future are stock market performance and the outflow from bond and bank deposits. This is assuming that banks will not decrease their risk weighting on commercial real estate loans.

Real estate sponsors and developers have made smart moves to shore up their financing needs. According to the report, office investment sales across Asia grew by 177% (about US$5 billion) in 2Q (April to June) compared to 1Q2009. Developers across Asia tapped into favourable equity sentiments, raising significant sums of capital to address short-term refinance risks and fortify their balance sheets.

However, Cushman & Wakefiled believes the downside risks remain inherent. Unless consumers on a global basis regain confidence in a secure future, markets will struggle to stabilise. Capital markets will therefore not be fully supportive of higher valuations or increased leverage from current levels.

The real estate services firm expects 2010 to be a big year for institutional investments in large direct asset and portfolio purchases in core markets. Many believe that market activity will return to 2005-2006 levels provided that, in the absence of sustained rental growth, cap rates will move up marginally, although volumes will definitely increase y-o-y.

Key indicators for office investment market — 2H2009
•    Job hiring trends: The current projection of over 45 million sq ft of direct office supply coming online in the Asia-Pacific market by mid-2010 will require an additional 250,000 to 350,000 jobs to fill, leaving a healthy residual vacancy of 5% to 7%. Vacancies above these rates will keep the pricing of real estate soft over the next 12 months.

•    Performance of the US dollar against local currency: For economies pegged to the US dollar, a weaker US dollar would equate to higher commodity prices with a beneficial effect on current deflationary trends. At the same time, weaker exports and a shift toward increased investment in hard assets will have an opposing effect. Real estate investment volumes will increase whereas job creation may remain under pressure. Portfolio investments by institutions in Asian markets are also likely to witness an upsurge by 4Q2009 or 1Q2010.

Occupier action — effect on office investment market
Occupiers have been cautious in their growth plans. The report states that there are two possible actions taken by occupiers that will influence the market: monetisation of real estate assets and increased pressure on Grade B assets via trade-ups to cost effective Grade A stock.

“The owner-occupied buildings have the advantage of monetising their property in this period, resulting in the sale and leaseback market coming back to life. It’s expected that corporate owners paying 300 to 600 basis point premiums over local 10-year treasuries on their bank loans will realise the gold mine they are sitting on,” it says.

As cash flow becomes tight, the next 12 to 18 months could lead to a deluge of assets into the market. The analysis by Cushman &Wakefield  shows that on average, corporate action to monetise assets at market prices that satisfy yield demands linked to adjusted lower rentals will deliver maximum positive NPV (net present value).

In markets that are likely to be oversupplied going into 2010 (particularly South Korea, China, India, Singapore and Vietnam), tenants with fully amortised leases and lease improvements will increasingly trade up on the quality of their occupied space to take advantage of low rents. “We anticipate that this will cause Grade B assets and fringe space to experience a decrease in rental rates and overall attractiveness amongst investors,” says Cushman & Wakefield in the report.

“The bottom line is that owners of non-core Grade B assets need to take a very hard look at their expectations of real estate performance and answer a key question: what will it take for them to survive this cycle of short-term flat growth? Our recommendation: reduce rents-to-market as quickly as possible, or add value to your asset if surplus funds are available. If these are both unfeasible, then look at disposing of the asset at the best available price, as soon as possible,” it advises.

Asian governments pumped in great amounts of liquidity into their economies when the global slowdown hit the Western financial world in 4Q2009. Now, they have to do more in the coming quarters to maintain a steady course. Countries like China (under 3% fiscal deficit of GDP) and Australia (4.6% fiscal deficit of GDP) are certainly better positioned to deploy more resources to ease the financial pressures of this slowdown.

For opportunity investment seekers looking for a quick in-and-out (12 to 36 months) approach, the risk-reward window will likely remain open and then shrink rapidly in the next two to three quarters.
Although there are positive signs of a recovery in the real estate markets in the Asia- Pacific, investors are advised to still take cautious steps in moving forward with investment decisions. The delicate balance in knowing when to buy and when to sell is critical to reduce the chances of getting burnt.

This article appeared in City & Country, the property pullout of The Edge Malaysia, Issue 773, Sep 21-27, 2009.

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