Market Perspective. Prudential Real Estate Investors. Asian Market Outlook First Quarter 2005

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1 Prudential Real Estate Investors Asian Market Outlook First Quarter 2005 Market Perspective After an upbeat end to 2004, with a record annual GDP growth rate of 7.7% for the year in Asia (excluding Japan), the macroeconomic and real estate outlook for the region has tempered. GDP growth is expected to moderate to 6.6% in 2005 and 6.5% in In China, one of the region s key growth drivers, GDP growth slowed to 8.8% in 1Q05 compared with a historic high of 9.5% in 4Q04. The Chinese government intends to slow the country s GDP growth to 8% for the entire year. Export-led growth was slower during the quarter after an appreciation in currencies against the US dollar, higher oil and commodity prices, and concerns over potential interest rate hikes following the US Federal Reserve s moves to curb inflation. Most dramatically, the Korean won hit a seven-year high against the dollar, although the dollar rebounded against most currencies in late March. Malaysia, China and Hong Kong may review their currency pegs, while other Asian currencies are looking at decoupling from the Japanese yen. Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ USA Ph Fax Web prei.reports@prudential.com According to Lehman Brothers, Asia s short-term rates have fallen to their lowest levels since In March, the US Federal Reserve raised the federal funds rate for the seventh consecutive time, resulting in a 50 bps rise since the beginning of the Asia did not follow suit, with short-term rates in most countries yet to react to the Fed s tightening, except for Hong Kong, where the three-month HIBOR rose from 0.3% at year-end to 2.7% in March. This rate is still low compared with historic levels of about 5%. Due to intense competition among banks, the increase in Hong Kong mortgage rates is expected to be limited and lower than the rise in the three-month HIBOR. In the rest of the region, a gradual increase in interest rates may occur, as local governments keep rates low to encourage the high levels of domestic demand required for continued GDP growth. Also in Hong Kong, after the March resignation of Tung Chee Hwa as chief executive of the Hong Kong Special Administrative Region, former Finance Secretary Donald Tsang became acting chief executive. The highly popular Tsang is unlikely to introduce any controversial reform that would negatively impact the Hong Kong economic recovery during his term, although the tenure of his term is still uncertain.

2 Regional REIT markets continue to develop. The Singapore government announced several new tax incentives for REITs, resulting in increased acquisition activity by existing REITs. In Hong Kong, following an unsuccessful listing of its first REIT late last year, the government has announced plans to lift geographical restrictions, so locally listed REITs can invest abroad; the government is also considering raising the gearing limit. New REIT guidelines in Malaysia include the liberalization of borrowing limits, the relaxation of regulations on acquisitions of leasehold properties and flexibility in acquisitions of real estate encumbered by financial charges. In Korea, details of a new hybrid REIT structure are expected in the second quarter. According to JP Morgan, given the large supply of investment-grade property across Asia, even if Asian REITs achieve only half the level of market penetration seen in Australia, the Asian REIT market could grow to over 10 times its current size. During the first quarter, Singapore REITs outperformed both the Singapore Straits Times Index and the Stock Exchange of Singapore Property Index, with prices rising by more than 11% on average. At their current prices, the implied yields for the five S-REITs range from 4.4% to 5.2%. (The yields on Japan REITs are now below 4%, from a high of 6% two years ago.) Despite the compression of yields as prices rise, yields are still attractive compared with bond and deposit rates. Property Markets Office With steady demand from multinational firms setting up new offices or expanding in China, rents in Beijing and Shanghai continued to rise by 3% and 5%, respectively, during the quarter. Capital values in the two cities also increased by 3% to 5% in the same period. Notably, foreign investors have returned to the Beijing office market, accounting for half the transactions during the first quarter. In Hong Kong, leasing demand was buoyant, with continued interest in expansion and relocation leading to a four-year low in vacancies. Rents for Grade-A properties rose by 15% to 20% during the quarter, with an expectation that rents could jump a further 30% due to the shortage of supply in the next two years. In the investment market, the first auction of land for commercial use in three years attracted tremendous interest, with fierce competition among all the major local developers. The accepted price of HK$1.82 billion ($233 million) was three times higher than the reserve and 50% higher than the most optimistic analyst s expectations. A 10% to 15% increase in capital values occurred soon after the auction. Some strata-titled, Grade-A office assets recorded their highest prices in seven years, although the average price of Grade-A offices is still 70% lower than in Yields remain low at between 2.5% and 4.0%. With demand starting to rise, the Singapore office market is also looking up. Although increases were limited during the first quarter, rents are likely to grow over the next few years, given limited new supply in the market. The news was better in the investment market, but capital values generally remained flat. First, an unsolicited bid was made for a 3.55 hectare Business and Financial Centre (BFC) site in the CBD at S$165 per square foot on potential gross floor area. The bid was lower than expected but is still higher than bids for the last two government land 2

3 parcels on adjacent sites. The Singapore government is expected to award the BFC land later this year. Second, in the REIT market, Singapore-listed CapitaCommercial Trust (CCT) agreed to purchase the HSBC building in the CBD for S$158.5 million ($96 million), representing a property yield of 5.1%. Other office landlords intend to set up their own office REITs, given the lower yield requirements and new tax incentives. With vacancies still falling from a high of almost 40% in 1999 to about 16% now, the Bangkok office market has also seen rents rise by 5% to 7% over the quarter. Capital values grew by over 10% in the same period, and yields have compressed to below 7.5%. With less than one million square feet of new office supply under construction over the next two years, a resurgence in the development of previously suspended projects is likely. As rents and capital values have remained stable over the past year, the office market in Kuala Lumpur has entered into a new construction cycle, with three proposed projects totaling 1.2 million square feet to commence in Tenant demand remains subdued in Seoul. A slight increase in vacancy occurred in the Yeouido submarket, but overall vacancies remain low at 4.6%. Rents have generally remained flat, although in the more active Gangnam submarket they continued to rise 2% to 5%. Yields for office space are falling, but investor interest remains strong, as Seoul continues to offer the highest office yields in the region. Prudential Securities sold its headquarters building in Yeouido to LG Securities for KRW 102 billion ($101 million). Using the current average market rent for the Yeouido district, the implied cap rate for the deal, assuming 100% occupancy, was about 8% to 9%. Prime rents for Tokyo offices rose 2% to 5% during the first quarter. Analysts expect rents will continue to rise, prolonging a trend that started in 4Q04. Rising rents and record low borrowing costs are offering investors greater returns, leading to more foreign investors entering the market. Following its $1.3 billion purchase of an office building in Tokyo, Morgan Stanley continues to dominate the investment market, with the reported purchase of $2.5 billion worth of commercial properties and property-holding companies in Tokyo and Osaka during the quarter. Commercial values in the five main districts rose for the first time in 15 years, with the capital value of prime offices growing roughly 7.5%. Industrial China is the world s seventh-largest economy and the third-biggest trading nation, with $1.5 trillion in imports and exports in Thus, many multinationals are looking for industrial space there, particularly in the three main industrial and trading centers the Beijing-Tianjin corridor in the north, the Yangtze River Delta near Shanghai and the southern Guangdong province near Hong Kong. For example, FedEx announced the move of its regional headquarters to Guangdong in December. An ever-tightening supply of land available for industrial use is expected to result in higher rents and land prices. The loosening of restrictions between Hong Kong and mainland China via the Closer Economic Partnership Arrangement (CEPA), introduced in August 2004, has increased the number of 3

4 products with no import tariff and has expanded trade. In addition, the pending completion of an eight-lane highway, the Shenzhen Corridor, between Hong Kong and Guangdong province in July, should quadruple current capacity. The leap in output and re-export volume has fueled demand for industrial space in Hong Kong. After a decade-long slump, industrial rents rose 15% in 2004, while values grew by 30%. During the first quarter, prices continued to rise by 5%. Mainland industrialists may move part of their manufacturing bases back to Hong Kong, lifting demand for factory space. This increased activity and the potential for further expansion have prompted foreign investors, such as Macquarie, to acquire warehouse distribution facilities. Investors are lured not only by the rental yields of 8% to 10%, the highest among Hong Kong s property segments, but also by the potential to place these assets into REITs. Although the Singapore manufacturing sector showed some expansion, leasing demand for industrial space was slow, and rentals remained flat. Activity in the industrial sector concentrated in the investment sales market. Ascendas REIT (A-REIT) continues to build its portfolio, purchasing eight industrial properties at an aggregate value of S$374 million ($227 million), representing property-level yields ranging from 5.3% to 8.6%. With these purchases, A-REIT is the first to benefit from tax concessions announced by the government earlier in the quarter. Over the past couple of years, the trend for Japanese manufacturers and transportation companies to rent distribution facilities rather than own them has grown. Thus, foreign firms such as ProLogis and AMB have been buying and building distribution facilities around Tokyo and Osaka. (ProLogis has built one of the world s largest distribution centers in Japan a 1.7- million-square-foot facility in Osaka.) Several Japanese developers are following suit. In two other markets to watch, Thailand is planning to list two industrial property funds offering yields of 6% to 8% in the near future. India has lifted investment restrictions so that foreign investors may now purchase 100% of some real estate development projects, triggering increased interest in high-tech industrial/office parks in Mumbai, Bangalore and New Delhi. Residential Following a surge in housing prices in 2004, the Chinese government announced a further tightening of policies to cool the property market and curb speculators. The minimum mortgage rate was raised by 20 bps to 5.5%. In Shanghai, a 5.5% capital gains tax has also been imposed on properties sold within 12 months of purchase, and banks have raised minimum down-payment ratios to 30% to curb home lending. Despite these measures, capital values continued to rise by 5% to 10% in Beijing and Shanghai, driven by strong fundamentals a growing urban population, a rising middle class, pent-up demand for housing and low interest rates. The Chinese government may introduce annual property taxes as prices continue to rise. With more limited financing available, local developers continue to look to foreign capital as a source of funds for future developments. The Hong Kong luxury residential leasing market remains busy, with many expatriates in the financial sector relocating to Hong Kong for business expansion. Combined with limited 4

5 availability, particularly because as much as 20% of luxury premises are for sale rather than for lease, rentals have increased by 3% to 8% over the quarter. Some corporate landlords have raised asking rents. The investment market also remained active, although considerably slower than in 4Q04, with fewer projects launched during the quarter and slower seasonal buying activity due to the Chinese New Year holidays. Capital values increased by 2% to 7%, and prices for some exclusive developments have reverted to peak. Buyers consisted mostly of end-users from the mainland; institutional investors have shown little interest, as the residential sector offers yields of 3% or less. The increase in the cost of capital also dampened sentiment. After a further 5% to 10% increase in the first quarter, prices for high-end residential properties in Bangkok are also close to pre-crisis levels. However, the price appreciation appears to be losing momentum, especially with the removal of various short-term tax benefits and the potential rise in mortgage rates. Malaysia has seen stronger demand for residential properties, which has been boosted by the financial liquidity of local high-net-worth buyers and by foreigners who believe that the ringgit is undervalued. Interest is strong, particularly in the Kuala Lumpur city center. With excess liquidity of RM95 billion ($25 billion) in the country s banking system, the government has abolished all capital controls except the currency peg. Residential land prices in central Tokyo showed their first rise, albeit only 1.4%, in 15 years. Domestic demand was a major factor in the improvement. Historically low interest rates and favorable tax deductions for interest on housing loans have helped private consumption. However, the Japanese government is looking to implement a gradual removal of tax incentives over the course of the year. In any case, higher prices have attracted interest from institutional funds and REITs. With limited available supply, some investors, such as London-based Grosvenor Group, intend to develop upscale condominiums in central Tokyo. The Seoul government continues to introduce stabilization policies to rein in speculative activity, including heavier taxes for higher-value properties. Despite these measures, residential prices continued to rise 2% to 5% during the first quarter. The laggard among recovering economies in Asia is Singapore. The volume of transactions has remained stagnant, and only a modest 0.6% increase in prices occurred in the first quarter, although this represented the fourth consecutive quarter of growth. Confidence in the prime residential districts has grown, with over 50% of launched units in these districts sold during the quarter. Many of the buyers were foreigners taking advantage of the cyclical low. However, the substantial pipeline of new units ready for launch this year as well as the increase in home loan rates are expected to limit the rise in prices. Retail Retail sales in Asia s cities will likely continue to grow in the first half of this year. According to MasterCard International s latest bi-annual MasterIndex of Retail forecast, all 12 1 Asian-Pacific 1 Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, Taiwan and Thailand. 5

6 markets will see a positive expansion in retail sales in the first six months of Despite external shocks, potentially higher oil prices and an upward trend in interest rates, consumer confidence remains optimistic, as economic growth continues to expand, albeit at a slower pace than previously. When aggregated across the various Asian-Pacific markets, retail sales in the first six months of this year are expected to grow by just over 6% to $1.13 trillion. The forecast growth rates vary across countries. Indonesia s retail sales forecast takes the lead and is expected to grow at about 16.9%. The expected rise is due, in part, to a resurgence in consumer sentiment and confidence resulting from the smooth election process last year. China s retail sales are forecast to grow by 12.8% because of its strong economic growth and employment prospects. Other countries expected to post strong retail sales growth include Thailand, Malaysia and Hong Kong, where retail sales may increase close to or in excess of 9% over the six-month period. Not surprisingly, the improved consumer sentiment has already translated into continued resilience and rent growth in key markets. During the first quarter alone, prime retail rents in Hong Kong, Shanghai, Beijing, Bangkok and Manila have risen between 2% and 6%, while rents in Singapore remained firm. Investor activity stayed high during the quarter Fortune REIT (a Singapore-listed REIT with retail centers in Hong Kong) announced it would acquire six additional retail assets in secondary locations for HK$3.4 billion ($4 billion), representing a 5.6% yield. In Malaysia, interest in establishing REITs has revived following the relaxation of REIT guidelines earlier this year. Unconfirmed reports suggest that three retail REITs could be in the cards in 2005, with up to $656 million worth of REITable assets. In Japan, foreign investors continue to purchase malls in secondary cities, such as Sendai and Osaka, as the prime yields within core Tokyo retail districts compress even further. In Singapore, the government continues to take a pro-active and paternalistic role to ensure that the country remains attractive to tourists. The much-awaited decision was finally made to allow two large-scale, integrated resorts (each with a casino, business, entertainment and leisure facilities) to be built on the island, in the hopes of significantly boosting tourist arrivals and spending. Conclusion Despite slower growth projections (compared with historical levels), the outlook for the Asian real estate markets remains positive. Strong fundamentals coupled with still relatively low interest rates have kept domestic demand high. The opportunity for potentially higher values as the REIT market develops and yields compress are the main drivers of investor interest as well as recent speculative activity. 6

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8 The Investment Research Department of Prudential Real Estate Investors publishes reports on a range of topics of interest to institutional real estate investors. Individual reports are available free of charge in hard copy or via the Web at Reports may also be purchased in quantity for use in conferences and classes. To receive our reports, change your contact information or to be removed from our distribution list, please us at prei.reports@prudential.com, or telephone our US office at Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ USA Tel Fax Web prei.reports@prudential.com Copyright 2005, Prudential Real Estate Investors Prudential Real Estate Investors is a business unit of Prudential Investment Management, Inc., a registered Investment Adviser and indirect wholly owned subsidiary of Prudential Financial, Inc., Newark, New Jersey.