Asian real estate – bubbles over here, downturns over there

Institutional Investor, December 2011

Asian real estate represents a series of different stories, each with their own dynamics. There are bubble worries in China, inflation pressures and stalled growth in India, softening markets in Singapore and Hong Kong, and questions about the robustness of REITs across the region. But one question that unites them all is how they will respond to a global downturn or recession.

“Major external shocks from Europe or North America would make it very difficult for Asia to be totally immune,” says Peter Mitchell, CEO of the Asia Pacific Real Estate Association (APREA). “I don’t think Asia is necessarily decoupled from the full effects of what’s going on.”

Paul Guest, a real estate specialist at fund manager LaSalle Investment Management, notes that “the medium term growth story for this region hasn’t changed,” but says the region is unavoidably affected by global malaise: it hits exports, it reduces the hiring of multinational corporations, and most importantly reduces market confidence. The impact, though, varies. “We bucket property markets into several categories,” he says. “At one end, the most affected are the small, open, volatile economies like Hong Kong and Singapore, prone to short sentiment-driven cycles. There is a group where the impact is mainly macro, where a significant share of GDP is driven by exports to more advanced economies: Korea is the biggest example. And the third category is strong internal growth dynamics, including China, India and Australia.” Here, domestic demand shields economies and housing markets from global shocks.

Worries about market declines are reasonably new; until recently, there was a lot of concern about bubbles forming in Asian real estate. “I don’t think there are bubbles in the region except perhaps China,” says Mitchell. Even there, there’s progress. “The government measures to cool the real estate market in the last year or two seem to be paying off and creating a softening; if there as a bubble there, hopefully that means a soft landing.”

‘Soft’ is open to interpretation, though, and some analysts do expect significant declines in China. Patrick Ho, head of equity and credit research at UBS Wealth Management estimates a 10-15% decline in property prices in tier one cities, with lesser declines elsewhere. It’s a question of balancing the influences. “We think there are strong demand factors such as urbanization, demand for an upgrade in living quality, income growth, and strong household balance sheets,” says Ho. “However, affordability is stretched, especially in tier one cities.” With liquidity tight, developers may lower prices to boost sales and generate cashflow, while tightening measures from the state have also depressed demand and land prices have started to fall. “These reasons might contribute to a decline in property prices, but we do not expect a crash,” Ho says.

It’s important to notice how clear a distinction there is in China from one property market to another. “We don’t see a nationwide property bubble in China,” says Raymond Ngai at Bank of America Merrill Lynch. “We see a bubble in certain cities, particularly tier one such as Beijing, Shanghai and Hangzhou. Similarly, property affordability is at a reasonable level nationally: it takes six years of annual income to buy an ordinary-sized apartment in China. But in Beijing or Shanghai, the figure is 10 to 13 times, about the same as Hong Kong.” And while the government has been heavily interventionist, it’s hard to quantify exactly what it wants to see. “The central government’s objective is to see property prices come down to a more reasonable level – but Premier Wen Jiabao didn’t say what is a reasonable level,” says Ngai. “Is it 10, 15, 20% down?”

China’s view on how much moderation is enough – at which point it will presumably stop intervening in the market – will be crucial. In future in China, “we might see some measures not being as rigorously implemented,” says Christopher Gee at JP Morgan. “But at the end of the day, policymakers are unlikely to retract too far from their current stance on the sector: it’s too politically sensitive for them to be making a rapid reversal of policy so soon.”

There are, though, some broader changes on their way to Chinese real estate. Ho says there could be a consolidation of property developers. “Given the current funding constraints, the small developers will be acquired or run out of funding.” That’s better news for bigger, stronger developers who have better access to credit and lower funding costs. For example, as of late November, state-owned developers’ bonds were yielding around 5%, while some smaller developers were over 20%. This clearly has implications for the banks too, though Ho argues that even if property prices decline by 30%, banks will remain profitable.

It’s also worth remembering that China’s whole property market will evolve from its residential dominance. “The development of commercial real estate in China is still in its infancy, and we think there will be a greater flow of funds away from basic home building, from a build and sell business model to a real build and own business model,” says Gee. He notes that home builders account for about $120 billion of enterprise value in China, compared to $40-50 billion in the USA.

While they wait, though, investors have been voting with their feet. “International investors have already been reducing exposure and taking out active short positions in this space,” Gee says. “A number of high profile hedge fund managers have taken that view.”

China grabs the most attention, but property is also a mainstay of local conversation (and international investor interest) in the established hubs of Singapore and Hong Kong. Both have enjoyed considerable increases in property prices, particularly in residential; both are experiencing softening now. In Singapore’s case, so far it’s more a slowing of growth rather than a decline – growth momentum has slowed for eight consecutive quarters in private residential property, according to the URA price index – but there is a growing feeling that a decline is on the way. “Our forecast is that we could see 5-15% declines in Singapore private residential real estate prices over the next 12 months,” says Tan Chin Keong, Singapore equity analyst at UBS Wealth Management.

There’s more to Singapore than housing: it has sophisticated listed sectors, including REITs, in office, retail and logistics besides residential. Office is especially vulnerable, and Tan says he sees “potential cyclical weakness” since office space demand is particularly sensitive to the economy and macro uncertainties. That said, it won’t fall 60% as it did in 2008-9, largely because it has never regained that ground; today rentals are still 40% below the previous peak in 2007 and the supply of new office space on its way is expected to be below average in the next few years, Tan says. Industrial, on the other hand, is generally more resilient. “While Singapore industrial production activity is slowing, we could potentially see some office tenants downgrading to business park and hi-tech space in order to save on rental costs,” Tan says. Retail, too, holds up well in downturns, especially retail property rentals that cater for consumer staples.

“We see a plateauing of real estate values in Singapore, particularly residential, but there is unlikely to be a collapse,” says Gee. “There is still significant demand in the mass market space, the result of pent-up demand that built up when Singapore had a significant pro-immigration policy.”

Hong Kong is slightly different, in particular because Hong Kong has much less control over its own currency (which is pegged to the US dollar) and therefore monetary policy. “I think that the cause of overheating in the real estate market in the early 1990s, and in the last two years, was that our currency was linked to the US dollar but our economy is tied more to the Chinese economy,” says Ngai. “Unlike Singapore we don’t have any opportunity for currency revaluation, which makes the situation more difficult.”

Gee agrees. “In Singapore the strain is taken by the currency; in Hong Kong it obviously has not adjusted because of the peg,” he says. “Hot money flows from China and elsewhere have been a hugely powerful driver of the real estate market in Hong Kong.”

This is one reason the Hong Kong market tends to turn very sharply, and at the moment most people think the likely direction is downwards – indeed, in residential, it’s already falling. “We expect the Hong Kong housing market to continue to correct, for two main reasons,” says Ngai. “First, we are starting to see more land supply coming onstream.” The Hong Kong government has pledged to supply land upon which 20,000 units of housing can be built, each year, compared to a recent average rate of about 15,000 in terms of annual takeup. Additionally, new clauses in land sale documents require developers to build more small-size units, which will likely lead to an oversupply within three or four years. “The other is demand. Next year we expect the economy in Hong Kong to slow down, unemployment to move up, and the mortgage rate to rise. When you add these supply and demand effects, we are looking for a 10 to 20% drop in housing prices.” In the fund management community, Guest at LaSalle says he has seen predictions everywhere from no change to a 30% decline. While he is not that bearish, he notes: “When Hong Kong declines, it’s never single digits.”

As Gee puts it: “It’s a hugely volatile space: as soon as people think the next move in prices is down, it compounds on itself, and the inflexion point is very sharp. You go from extreme optimism to extreme pessimism in a heartbeat.”

The other national market worth taking a close look at is India. Again, the outlook depends on the sector. “We are more bullish on the commercial side than the residential side,” says Jyoti Jaipuria, [TITLE BEING CHECKED] at Bank of America Merrill Lynch in Mumbai.  “In commercial, the demand is still fairly decent and supply overhand will ease off.” That’s in contrast to residential (retail, in India, being a small and niche market so far). “On residential in general, we are quite negative. We think there will be a lot more supply coming up, and demand has been fairly weak.”

India has spent recent years battling inflation pressures, a key priority of the Reserve Bank of India. “When the boom was taking place, the Reserve Bank did caution banks against lending to real estate companies,” notes Jaipuria. “For example they don’t allow lending for land, just for real estate. That semi-cautious stance may not change in a hurry, because the central bank thinks this is a relatively risky segment.”

Investors are positioning themselves for a decline, at which point opportunity might arise. “The crux is we are seeing a slowdown in demand, but nobody is cutting prices,” Jaipuria says. “From a strategy perspective, the decision the developers have to make is: do they roll back their plans, not develop and not reduce prices; or do they go ahead with new projects and reduce prices? Then you have a chance of volumes coming back, but the margins may be lower. The builders have to decide what to do.”

From a regional perspective, one market to watch closely is real estate investment trusts (REITs). These are supposed to be stable, steady generators of yield, yet in the global financial crisis the REIT market in Singapore – the biggest in Asia outside Japan – underperformed the broader market, exactly what it’s not meant to do. However, many feel that it is in far better shape today. “Going into the heart of the GFC at the end of 2007 there were a number of REITs that had levered up on the expectation that cheap credit was here to stay forever,” says Gee. Others had committed to large acquisitions that needed to be funded, had bullet repayment loans due, and a concentrated debt maturity profile at a time when the debt capital markets closed. “Today the situation is rather different. The number of outstanding and unfunded acquisitions was far fewer, REITs have recapitalised post financial crisis, and in general they are in a far healthier state than in the previous cycle.”

Any market downturn will hit REITs, and they generally do need access to capital markets to sustain them, since they need distribute their taxable income and need new capital to expand. “But Asia’s banking system has proven to be quite resilient, having reformed itself as a result of the Asian crisis, so access to debt didn’t totally dry up here like it did in the US in 2008-9,” Mitchell says.

“The Asian REIT market has been impressively resilient,” he adds. “It has some positive features post-crisis that are not shared in North America and Europe.” For a start, its market cap today is higher than before the crisis, and it has sustained capital raisings, including new IPOs. Mitchell adds that regulators in Singapore, Japan and Malaysia in particular have been supportive of REIT markets and intervened swiftly where necessary; they also insist on openness. “There are a lot of REIT regulations here which make them very transparent,” Mitchell says.

“People used to say they were boring products before the crisis: they are restricted as to what they can invest in, the gearing is limited and there are other investor protection rules that don’t apply to operating companies. That has held them in good stead.”