Research article

Where next for Asia?

As the Asian property market slows, investors need to look further than tier one cities and at new types of asset to make profits

© Alamy – Ginza, Tokyo

Introducing Asia and summarising 2016 is an almost impossible task because the region is so huge and diverse, encompassing some of the most sophisticated real estate markets in global cities alongside emerging markets with very little investable real estate.

The main markets that we cover in Asia and Australasia are very mature markets with assets that have been traded by global institutions across borders for decades. Added to this is the fact that Asian markets were among the first to recover from the ‘global financial crisis’ of 2008. Many investors in Asia called it the ‘North Atlantic debt crisis’ because it impinged so little on them. China’s recent slowdown has arguably had a much bigger impact on some markets in the East.

Some real estate sectors in certain countries grew continuously over the period that US real estate crashed and burned. Real prices in Australian residential property saw continuous growth before, during and after 2008. Other markets wobbled and then very quickly recovered. Capital values in cities throughout the region have reached record levels in recent years.

Therein lies a problem. Rents have grown to a level and yields have compressed to such lows that it is difficult to see how they can be sustained. Our researchers in Hong Kong, for example, can see very little upside in any but the most opportunistic sectors because core rents in most of the main asset classes are static or falling, and investment yields are beginning to move out – or at the very least are not moving in any more.

The name of the game is to pin the cap rate tail on the real estate donkey. Cities such as Singapore may still have some scope to squeeze more before capital values peak and even first tier Chinese cities look high yielding compared to others in the wider region, though not by the standard of PRC interest rates. The sheer weight of money pointed at Shanghai and Beijing could yet send cap rates lower.

Other investors will be wondering where to place emerging markets such as Vietnam, Malaysia, the Philippines and Indonesia on the risk and yield curve. Is a city where the rental growth prospects are aligned to double-digit GDP growth in an emerging economy really a much worse risk than some of the very low yielding ‘core’ assets with limited rental upside in the mature, developed cities of the region? Does the 600 basis point difference between Hong Kong and Ho Chi Min City office yields (net effective) reflect a real difference in likely future performance?

Some of the answers to this question, not just for the Asian region but also for the world, may lie in one particular East Asian country. Japan has gone through over two decades of extremely low interest rates, fully valued, low-yielding real estate, falling prices and depreciation.

The way the Japanese real estate market has matured is instructive. There is a case for investment, which comes not from fast-growing populations or burgeoning economies, but from stability. The capability of sound real estate markets to generate the secure income streams that an increasing number of global investors seek has made some sectors in key Japanese cities look attractive. Liquid, transparent and open markets in themselves provide value to global investors and this is something that an increasing number of real estate markets throughout Asia and the world will discover.

The long-term success of many new and emerging markets in the region will depend on them being able to offer the same tradability, openness and transparency for investors that the core gateway cities currently do. Corrupt and closed systems are unlikely to continue seeing the investment flows they enjoy in a high growth phase if they can’t shift toward low risk in a lower return environment by delivering stability and security.


James Macdonald – China Research

© Getty Images – East Nanjing Road shopping area of Shanghai, China

The Chinese real estate markets are all about opportunistic strategies, with relatively little money targeting core investments. A recent report by Preqin, from 2007 to September 2016, says that only US$1.2 billion was raised for core assets compared with US$5.5 billion for value added and core plus strategies, and US$26.3 billion for opportunistic investments. This pressure of demand further up the traditional risk curve means that certain ‘more alternative’ asset types are increasingly priced at core asset values.

Many of the more traditional asset classes look very fully valued. This is especially the case given the cost of credit and market fundamentals expected in many cities over the next three years. Most opportunities, where they present themselves, are in some of the more niche sectors.

Core: Premium Grade A offices in first-tier cities

As with many other markets, office projects tend to contribute the lion’s share of investments in China. This is because these assets are typically easier to manage and more liquid, while the market is more transparent with a greater variety of potential buyers.

China’s first-tier city office assets have attracted a significant amount of interest from both international and, more recently, domestic investors. International investors tend to target older, Grade A property in core locations with value-added potential. Meanwhile, domestic investors seek forward purchases of Grade A office assets for a combination of self-use and investment, as well as stabilised core assets for pure investment.

The emergence of new forms of capital in China, as well as stricter controls limiting capital outflows, mean that the weight of capital chasing safe investments has skyrocketed. Office yields in most first-tier cities are now at all-time lows. But the continued influx of capital could mean that they fall even further in the face of limited rental upside. This means that a correction may be on the cards over the next 2-3 years in some cities with rising vacancy rates and excess supply.

The advantage of core offices are that they will show greater long-term stability than other asset classes and are a mature and large-scale sector capable of absorbing large scale deployments of capital.

Core-plus: Retail assets and platforms focusing on first-tier cities and prime locations in second- and third-tier cities

There are a number of international investors looking very closely at the Chinese retail segment despite the fact that the market is faced with oversupply, slowing sales growth and increasing competition from ecommerce platforms (which captured an estimated 17% of B2C sales in 2016). Several investors have already deployed large sums of money into joint ventures with local operators. Others have invested in retail developers at a corporate level. Their rationale is that, although the market is faced with a number of challenges, there is still a lack of good operators and good retail centres in China. The vast majority of shopping centres and retail outlets were designed for the consumer market of a decade ago with outdated management reflecting this. By partnering with a local or international operator who understands changing consumer behaviour and is adapting to it, investors believe they can unlock significant returns at the project, portfolio or corporate level.

In addition, ongoing urbanisation and rising income levels continue to underpin growth in Chinese retail markets. For international investors, the retail market has the added bonus of being less fiercely contested by aggressive local investors. This makes operators more welcoming of the capital and experience brought by certain international investors.

Opportunistic: Project conversions

Some investors are exploring opportunities to convert the use of less productive assets. Significant upfront costs and a limited cash flow for the first two years after investment means full-scale project conversions are not for everyone. Nevertheless, with land costs exceeding the value of many of the older buildings occupying potential sites, and the lack of conventional development opportunities in downtown locations, an increasing number of investors are looking at the redevelopment alternative.

Redevelopment has taken many forms. Some conversions involve changing the upper floors of a large mall or retail podium into office space, especially in submarkets where the office market is relatively tight. Recently, we have also seen the introduction of a number of co-working office space providers into these types of locations. Larger floor plates, fewer columns, lower rents, a central location and access to retail are all attractive to co-working space providers. There have also been instances of hotels being turned into boutique office spaces, and more recently co-living spaces, while offices have been converted into apartments both for sale and for lease.

Project conversions are not widespread and are not very straightforward processes. Before commencement, they require developers to address land title, ownership, land premiums and a project’s physical constraints. However, China has changed significantly over the past three decades and there is a real need to repurpose old, outdated developments to meet the needs of modern society. Where that need exists, there is the potential for money to be made.

Alternatives: For-lease residential, aged care facilities, data centres

As was the case last year, we continue to see opportunities in hitherto niche sectors driven by demographic and technological change. These include for-lease residential, aged care facilities and data centres.

Two of these sectors are still fraught with difficulties, especially for overseas investors. Aged care has been spoken about for a long time. But the regulatory framework is currently not robust and operators are immature, so risk is perceived as high and few investors are confident to invest large sums of money, so it is still a sector for pioneers. Data centres hold great appeal given the exponential growth of online services and cloud-based computing, but the market is tightly controlled and international participants are required to partner with local enterprises. Residential lettings look most promising as they are currently supported by the government as a means of providing accommodation for individuals priced out of the for-sale housing market.


Tetsuya Kaneko – Japan Research

© Getty Images – Tokyo, Japan

Japan is perhaps the one real estate market in the world that is a genuine diversifier. The country has for some decades now wrestled with many of the monetary conditions with which the West now grapples. Japan is no stranger to very low interest rates and bond yields, and real estate took on the role of an income-producing asset many years ago.


Core-plus is without doubt the most competitive segment of the market, as it has expanded to encompass multiple asset classes, including residential, retail, office and logistics. It also covers the multiple geographies of Tokyo, Osaka, Nagoya and Fukuoka. Access to inexpensive financing has pushed down yields considerably in 2016 and this is most poignantly felt in the multi-family sector, so further cap rate compression seems unlikely. However, there may still be some scope for yield compression in offices, station-front retail, high street retail and possibly even logistics.

Value add

The phenomenal growth of inbound tourism to Japan has resulted in a hotel sector boom. Cap rates have been compressing rapidly in this sector. Having said this, the fundamentals of this sector look sound. Underlying growth in the industry is still robust and some hotels have room for operational improvement. Also, hotels in outlying regions should be able to attract more tourists from megacities such as Tokyo, Kyoto and Osaka.


Regional office property could offer attractive returns at lower prices. While many investors are concerned about a large upcoming supply in Tokyo, leasing agents in regions such as Osaka, Nagoya and Fukuoka are much more worried about no future supply and the fact there is little available existing space. Leasing activity has been improving and vacancy rates are very low, so the expectation of rental rises is increasing.

Having said this, cautious investors know that regional cities tend to suffer first when the economic cycle turns. If the economy contracts, large corporations tend to shrink their regional operations first and cover those activities from Tokyo.


More and more investors are discussing alternative investments as core investment opportunities become increasingly limited and cap rates continue to tighten, especially in Tokyo. Popular topics are self-storage facilities, data centres, student housing and health care facilities. Despite the advantages of being a first-mover in these sectors, these relatively new asset classes have some issues, such as scalability and lack of underlying infrastructure.

When health care facilities became an investable asset class in Japan during 2013 and 2014, NOI yields ranged from 6% to mid 6% plus and looked very attractive for those seeking income returns. However, these yields have already compressed to between mid 4% and mid 5%.

For those investors willing to focus on operations as well as real estate, self-storage and student housing should exhibit juicier yields through skilful operation than those of office and residential property.


Alan Cheong – Singapore Research

© Alamy – Infinity pool on the roof of the Marina Bay Sands Hotel with spectacular views over the Singapore skyline at sunset

These are strange days for the commercial real estate market in Singapore. On the one hand, rents have been falling for the past two years and are expected to continue coming off significantly for 2017. On the other, capital values of Grade A office buildings in the central business district are not merely holding firm, but are in fact rising. This behavioral mishmash between the rental and capital markets has come about because of the different objectives of the market players. Rents have been in decline for two reasons. Not only are tenants reeling from global economic issues, financial institutions are facing structural issues in their business models. Many have been giving up space, but the supply of new office buildings is high so rents have not been helped on that front.

Investors, particularly institutions and local developers, are aghast at recently transacted prices as they imply a significant degree of yield compression, not only using present passing rents, but even more so when leases are due for renewal and/or review. Yet in the latest transactions seen in 2016, it appears that buyers are undaunted by this fundamental measure of return.

Singapore CBD Grade A office building net yield

Source: Savills Research & Consultancy

So why have investors shelled out hundreds to billions of dollars in 2016 to acquire assets at prices above the previous high-water mark, but more crucially, buying when rents and thus yields are expected to compress further in the coming year? The reasons are twofold. First, Singapore should have a place in any well-balanced global portfolio and the number of buildings available is limited. Second, Singapore’s yields are not yet as low as others in the region, most notably Hong Kong, so there are good reasons to expect that yields will continue to move to these levels, especially if investors see Singapore’s long-term prospects as good or better than Hong Kong’s.

Buyers are motivated to take a position in Singapore in order to diversify from non-core (say developmental properties) to core holdings (say investment properties) or to de-risk politically by increasing their weighting to Singapore at the expense of their traditional markets.

Will this trend continue in 2017? We believe so. Even if interest rates are bumped up a little and headwinds continue to buffet Singapore’s economy, this set of long-term buyers are quite undeterred and have additional capital waiting for deployment, not just here but also in key gateway cities as well. Therefore, even though yields are compressing due to weak rental reversions at a time when the market is facing a not insignificant amount of new supply coming on stream, they can, in all likelihood, come down even more. Future yield compressions will come about from a combination of falling rents and rising capital values

Core – Grade A Offices in Singapore CBD

On the face of it, this sector does not look a good prospect for 2017 as we expect rents to contract further during the year. However, we expect investor yields to compress further, too, so capital values may even rise slightly in some circumstances.

There are a couple of possible reasons for this economically non-rational behaviour. One is that the number of CBD offices buildings on sale are few and far between. Vendors are keeping their asking prices high and are hardly budging. So the fundamentals of investor supply and demand are sound, given the fact that there is still a considerable amount of global capital looking for a home. Office space in one of the world’s top global cities will still be on their shopping list.

Second, those in the current market paying record prices are mostly non-private equity buyers. This is because, at current prices, given the stage of the lease reversion cycle and the risks of further interest rates increases, institutions find it difficult to make a case for investing at all. What are left are sovereign wealth funds and ultra-high worth individuals who purchase for the long term. When these two reasons come head to head the result is a ratcheting up in prices, upsetting the normal tripartite relationship between the rents, interest rate and capital values.

The risk of a sharp mean reversion to the 4-5% yield levels is low because sellers have holding power and buyers have the wherewithal to pay. In fact, with noises in the market that a Trump presidency may bring about changes to the Dodd-Frank act, then banks, being less fettered by regulatory restrictions, could start to expand again. In these circumstances, the surprise on rents could be on the upside.

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