Picking through the wreckage of Asian real estate

Institutional Investor, May 2008

Like much of the world, Asia’s property sector – and in particular its listed property sector – has been hit by the turmoil in global credit markets. But there are pockets of interest for well-positioned investors across the region, and it’s certainly the case that things are worse in other parts of the world.

Asia’s REIT markets, so promising in recent years, have been hit hardest. “Last year, in the first seven months we saw US$25 billion come into the public equity markets in Asia ex-Japan,” says Mark Ebbinghaus, managing director and head of Asian real estate at UBS. “In the following seven months starting August, we saw about $45 billion leave. When you have 25 go in and 45 go out in an equivalent period, it puts a lot of stress on liquidity to the broader market. And REITs and property developers have been hit more than most.”

That’s because of a combination of factors: a lot of issuance in the run up to this credit crunch; asset and liability positioning; the composition of Asian REIT registers; and in some cases, corporate capital management practices.

“REITs are classic long dated assets, but have shorter dated liabilities in their balance sheet debt,” explains Ebbinghaus. “Also in Asia, compared to other REIT markets in the world, you’ve get less representation of retail and of hardcore long-only real estate funds, and a greater representation of macro or country money and of hedge funds. So it’s a more volatile REIT market.”

On the capital management side, “some REITs have got in the habit of gearing up and then retro-equity financing,” says Ebbinghaus. “It was a strategy which worked for a while, when the market was short REITs and liquidity was abundant, but as most conventional REIT markets around the world operate, it doesn’t last forever.”

That said, while REITs have seen their stock market performance battered, that doesn’t mean they are in perilous situations. “All market commentators would say that in the last real estate crash, in the mid to late 90s in Asia and the late 80s in Australia, there was a market fundamentals problem in the property market,” says Peter Mitchell of the Asian Public Real Estate Association. “That is certainly not the case here. There has been a problem of sub-prime working its way through and contaminating the rest of the market, but the fundamentals in Asia remain really good.”

Mitchell argues that for the right groups, this environment can be an asset. “Those players who are well capitalised and conservatively geared, are not totally reliant on credit, who have a cost of capital advantage – it will be a year of opportunity for those investors and property companies. Participants who are not well capitalised, or are more heavily geared, will find it harder to compete, so they will face some difficulty.”

Asian REITs are going to have a hard time expanding any time soon, since they’re generally at or close to regulatory gearing limits which stops them raising more debt, and it would be a foolhardy time to go out looking for more equity.  But there has been nothing to compare with, say, the turmoil that Centro Properties has faced thousands of miles to the south in Australia. “On average, REITs [in Asia] aren’t geared nearly as high as in Australia,” says Ebbinghaus. “The risk free rate and cost of debt are much higher there. The long bond is going in the opposite direction to Australia. Banks are still willing to lend in this part of the world.” There are other factors too. “Generally real estate players in this part of the world learned a lot in the Asian crisis. On average they’ve got reasonably deleveraged balance sheets.” Additionally, the Australian market is about 50% cross-border, in that Australian LPTs (listed property trusts, the local equivalent of REITs) hold more than half of their assets overseas. They have more financial engineering and, with many assets in the US, the decline of the US dollar against the Australian dollar has not helped them.

Asia has had its own fair share of financial engineering, generally concentrated in Hong Kong, where many REITs pushed back interest costs to later years in order to boost up front yields. There has been a hint of change here: Champion REIT recently announced plans to unwind its financial engineering, although Ebbinghaus is cynical. “With respect to Hong Kong, all we’ve really seen is replacing one sort of financial engineering with another of sorts,” he says. “In the main across the region the only equity of magnitude raised this year has been convertibles. By definition a convertible is a hybrid type instrument which, depending on the structure, borrows from the future to satisfy a requirement today – say, for example, in a zero coupon convertible – but raises future equity at a premium to today’s price level.”

Mitchell, though, thinks financial engineering is on its way out. “I think we’ve seen the end for the time being of this concept of financial engineering,” he says. “We are seeing already a return to the true fundamentals in the listed real estate sector. That is, ignoring mechanisms to crank up distribution yields for investors, and going back to the basics: in particular the quality of management and the quality of assets.”

It’s certainly going to be a while before we see any new issues in this area, though. Things had already slowed down in 2007, when the region saw 18 new REITs (including two in Japan), compared to 35 in 2006. The $80 billion market capitalisation it hit at the end of June 2007, again including Japan (more than half of the total), is so far the peak. Several new measures underway to help the development of the sector look rather redundant for the moment: Japan is soon expected to allow J-REITs to invest in overseas property, while the Hong Kong Securities and Futures Commission has said that REIT managers can expand into other markets or sectors without having to go to the SFC for re-authorisation first. When the dust settles on the current credit crunch, these will no doubt be useful additions, but they’re unlikely to see any utility soon.

“Asia’s REIT markets have entered into a contraction phase,” says CBRE Research in its latest study of the REIT market. “However recent and proposed revisions to REIT regulations across the region indicate that the authorities are adopting a more aggressive approach to developing their REIT markets. Though many investors are likely to remain cautious in the current environment, the regulatory changes are likely to result in attractive opportunities during the recovery phase.”

By the time the REITs market is back on its feet again, it will have a lot more venues than it used to. In addition to the nascent markets in Korea, Taiwan, Malaysia and Thailand, there are moves to develop a REIT code in markets as far afield as Pakistan and the Philippines. In China, the Tianjin-Binhai New Area, a coastal area near Tianjin in the north of China that has been earmarked for the same priority status as Shenzhen and Shanghai’s Pudong have enjoyed in the past, is likely to involve some pilot efforts to develop REIT structures for the mainland.

Outside of the REIT area, the picture does look broadly healthier for property markets generally, and therefore for developers. “If you look at the underlying supply and demand dynamics at a physical level, the most mature markets in Asia are under control,” Ebbinghaus says. “You don’t have an abundance of cranes around the place, nor an abundance of speculators. If you look at the established CBDs, there is not excess supply; it is more demand led. It’s a market that hovers closer to equilibrium rather than wild swings between demand and supply.” There are pockets of concern: parts of India, some parts of regional China – but by and large there is little cause for alarm.

Within Asean, Macquarie Research, for example, is overweight Thailand, Malaysia and Singapore; its top five picks are Capitaland in Singapore, Ciputra Development in Indonesia, Central Pattana in Thailand, Ayala Land in the Philippines and Mah Sing Group in Malaysia. In north-east Asia there is opportunity too. Analysing 25 Hong Kong and China property stocks’ results in April, Macquarie analyst Eva Lee concluded that “most companies posted strong results” and “while short-term drivers may be difficult to identify, we believe the market has priced in too much pessimism at current levels.” Her top picks are Kerry Properties, Sino Land, China Resources Land, New World China, Hong Kong Land and the Fortune REIT. Like many analysts, she doesn’t doubt there is pressure in the sector but believes the sell-downs of these stocks in the market are overdone. “China property stocks have consolidated significantly from their peak, down by 40% on a weighted basis,” she says. “We believe the stock price corrections have more than factored in the slowdown in China property sales and volumes the market has experienced since October 2007.”

Other Macquarie analysts see an opportunity emerging in Taiwan following the election of new president Ma Ying-Jeou and his pledge to invest NT$3.99 trillion in a series of priority projects, most of them related to infrastructure. The broker reckons listed commercial property developers like Radium, Prince, Farglory and Ruentex. And then there’s India, where DLF, one of the most widely followed Indian property stocks by foreign investors, is now at a 30% discount to net asset value. “We see clear upside as stock prices seem to have overcompensated for risks and do not fully reflect growth prospects,” says Unmesh Sharma, an analyst in Mumbai. “However, the lack of immediate triggers implies that value is unlikely to be realised in the next three to six months.”

One of the more bullish researchers out there is the Citigroup Global Markets equity research team, which in April said it expected a 12 month total return of 20 to 40% in China and Hong Kong, 20 to 25% from Singapore, 10 to 15% from India, 10 to 30% from Malaysia, 15 to 20% from Taiwan and 20 to 40% from Japan. Some top picks include China Overseas Land and Investment, Kerry Properties, Allgreen, DLF, KLCC Property and Chong Hong  Construction.

Global property managers have mixed views on whether it is time to buy REITs. As one fund manager says, “it really depends on what your reference point is in terms of assessing value. If you’re looking at the discount to revalued NAV, western markets look pretty cheap and Singapore doesn’t. If you look at the yield, and the spread to the sovereign, Asia has the widest spread of yield to the risk-free rate because the risk-free rate is so low.” This fund manager has not yet been convinced to buy heavily into Asian REITs, finding better value in the UK.

The outlook, then: a difficult time but probably not a lethal one for most Asian property developers and REITs. Still, after a period of share price decline and perceived weakness, a second step usually follows fast: acquisition. It may be that, a year from now, there are less REITs in Asia than today, not more.