PREI Asian Quarterly April 2011 Market Perspective Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Tel +1 973.683.1745 Fax +1 973.734.1319 Web www.prei.com Executive Summary Notwithstanding the repercussions from the earthquake in Japan, the leading economic indicators for Asia are generally positive, which translates into robust demand for commercial real estate among investors and tenants. Commercial property values are rising as investors eye the improving rental outlook and greater liquidity. There was a hefty year-over-year increase in property sales in Asia in 1Q11, while some large real estate firms are going public. Demand for office space in markets such as China, Hong Kong and Singapore is pushing rents higher. Acquisition yields are compressing in office markets such as Hong Kong and Singapore. The region is fast becoming a key market for international luxury retailers. China, in particular, is projected by McKinsey to account for 20% of the global sales of luxury goods by 2015, which should help sustain demand for prime retail space in the mainland. Spending by mainland Chinese travelers is becoming a key tourist revenue source for other Asian countries. With lenders upbeat about Asia s economic prospects, the debt markets are stable. The region s banks increased the size of their loan portfolios by 16% in 2010. Concerns remain that rising energy and food prices have the potential to diminish the region s growth in the short term. Heightened inflationary expectations will prompt Asia s central banks to step up interest rate increases or allow further local currency appreciation. Although Japan faces considerable economic uncertainty, actions taken by policymakers immediately after the earthquake including an injection of liquidity by the Bank of Japan (BOJ) and the government s planned reconstruction spending have helped to restore some calm to the market. The Tohoku earthquake in Japan on March 11 will cost the nation as much as US$235 billion, or about 4% of GDP, according to the World Bank. In comparison, the Kobe earthquake in 1995 cost only US$100 billion. To assist the reconstruction, the BOJ will keep interest rates low for a prolonged period. The Greater Tokyo Area suffered relatively limited structural damage, so the real estate market in central Tokyo should be resilient in the long term.
REIT Markets REIT returns were fairly flat in 1Q11, and not surprisingly Japanese REITs posted the worst performance, as investors became cautious after the earthquake (Exhibit 1). The sell-off spread to other REIT markets in the region, although sentiment began to stabilize toward the end of the quarter and prices partially recovered in early April. The 5.8% decline in the J-REIT market led to a 3.4% drop in the market capitalization of Asian REITs in the first quarter (in US dollars), which was in line with the broader stock market. Dividend yields of J-REITs rose as prices softened. Exhibit 1: Total Returns, REITs vs. Property Equities In Asia 1Q11 4Q10 3Q10 2Q10 1Q10 2010 2009 2008 2007 REITs Hong Kong 0.8% 8.6% 17.2% 3.2% 1.6% 33.6% 67.3% -28.9% 10.4% Japan -5.8% 22.2% 8.2% -6.7% 8.6% 34.0% 6.1% -49.0% -2.3% Malaysia -0.4% 5.1% 0.8% 0.4% 7.8% 6.9% 30.7% -14.8% 17.8% Singapore -1.3% -0.9% 16.9% 2.4% -1.2% 17.3% 82.2% -56.1% 2.8% Property Hong Kong -1.4% 2.2% 22.5% -6.2% 0.7% 18.1% 73.2% -53.9% 57.1% Japan -7.4% 16.4% 8.6% -13.7% 5.7% 15.4% 5.6% -46.6% -13.2% Malaysia 7.1% 16.0% 14.2% -1.4% 2.9% 34.4% 37.5% -38.5% 41.3% Singapore -5.8% -2.0% 13.5% -0.8% -3.4% 6.7% 85.9% -57.3% 8.9% Standard & Poor s Index Services (local currency), Bloomberg The risk premium between REIT dividends and long-term government bond yields remained fairly attractive in the first quarter (Exhibit 2), although that will be challenged if interest rates rise as expected. Going forward, with the exception of Japan, the heightened inflationary concerns for the rest of Asia will likely prompt REIT investors to become more yield driven. That puts pressure on REITs to deliver higher dividends, which they can do if net operating income grows at a robust rate. Exhibit 2: Market Capitalization and Dividend Yields of Asian REITs No. of REITs Market Cap (US Bil) Average Dividend Yield Risk-free Rate* Risk Premium (bps) Japan 35 $42.68 4.78% 1.26% 352 Singapore 24 $29.09 6.15% 2.48% 367 Hong Kong 7 $12.54 4.80% 2.68% 212 Malaysia 13 $3.55 6.90% 4.10% 280 Korea 1 $0.05 7.70% 4.48% 322 Total 80 $87.91 5.32% (weighted average based on market cap) * Risk-free rate refers to long-term government bond yields Various Stock Exchanges; CEIC; Prudential Real Estate Investors Research (as of 1Q11) The big news in Hong Kong is the mid-april launch of the first Chinese yuan-denominated REIT, Hui Xian REIT, which is controlled by investor Li Ka-shing. Hui Xian owns Beijing s Oriental Plaza, an 8 millionsquare-foot complex with eight office towers, two luxury serviced apartment blocks, the five-star Grand 2
PREI Hyatt Beijing and a shopping center. Hui Xian was selling 11.16 billion yuan (US$1.7 billion) of shares to a mix of institutional and retail investors. The initial indication was that foreign institutions that want to invest in the Chinese currency were snapping up shares, while demand from retail investors was weaker. The firm is projecting a dividend of roughly 4%. Singapore s second-quarter calendar also includes a new listing, Mapletree Commercial Trust, which is selling about S$627 million (US$503 million) of shares. The firm owns a S$2.8 billion (US$2.3 billion) portfolio that is comprised of the largest shopping mall in Singapore and two office properties. Capital Markets Credit spreads in Asia remained stable in the first quarter, despite the worries caused by the natural disasters in Japan (Exhibit 3). Not much is expected to change, as lenders have confidence based on the region s growth and the potential expansion of domestic consumption markets. Total bank loans in the region rose by 16% in 2010 to US$17.3 trillion, compared to about 14% growth in the previous year, according to the Economist Intelligence Unit. Corporate bond investors are being selective in light of the aggressive new-issue pipeline, geopolitical risks and higher energy prices. Exhibit 3: Credit Spreads In Asia Remained Stable In 1Q11 J.P. Morgan Asian Credit Index 900 800 700 600 500 400 300 200 100 0 Sep-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 J.P. Morgan Asian stock markets raised US$26.3 billion through initial public offerings (IPOs) in the first quarter, accounting for 65% of global activity, according to Ernst & Young. Mainland China with 105 IPOs that raised US$18.3 billion remained the hot spot. China s robust fundraising activities will likely spur growth among investment banks and other ancillary professional service companies, which translates to higher demand for office space going forward. Investment Markets Property sales in Asia totaled US$62.7 billion in 2010, accounting for about 23% of global sales, according to Real Capital Analytics (Exhibit 4). Asia s transaction activity was almost 42% higher than the same period last year, with solid increases posted in most countries other than Japan. Investment activity could slow down a little in coming months due to the worries about the economic impact from Japan, monetary 3
tightening across the region resulting from inflationary pressure and the potential impact of interest rate increases on property values. Exhibit 4: Transaction Activity In Asia Rose In 2010 Asia Property Sales Volume (l), % of Global Property Sales (r) $40 $35 $30 $25 $20 $15 $10 $5 $0 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 40% 35% 30% 25% 20% 15% 10% 5% 0% Asia (ex-japan) Japan Australia-NZ Asia-Pac Global Share (r) Real Capital Analytics Given the impressive class-a office rental increases in 2010 (Exhibit 5), we would expect the sector to remain the darling of institutional investors in 2011. Indeed, the strong upward momentum continued in the first quarter, particularly in Hong Kong and Singapore. Rents grew in all major cities except the class-a office market in Tokyo, which was impacted by the slowdown in the overall economy and the Tohoku earthquake. Given the enormous structural damages, corporations in Tokyo are likely to hold back on expansion plans until there is a clear picture of the economic prospects. That said, the enormous scale of reconstruction could possibly serve as a stimulus to the economy. Exhibit 5: Except For Tokyo, Office Rents Grew In Asia In 1Q11 Class-A Office Rents in Asia (q-o-q change) 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% Tokyo Seoul Hong Kong (Central) Singapore (Raffles Place) Beijing (CBD) Shanghai (Pudong) 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 Jones Lang LaSalle, Prudential Real Estate Investors Research 4
PREI Sub-Regional Markets Japan: Investment sales of commercial real estate in Japan in 1Q11 totaled 684 billion yen, up 146% from 4Q10, albeit down by about 14% year-over-year, according to DTZ. The quarterly surge was attributed to efforts by local companies to dispose of assets before the fiscal year ended in March. Offices accounted for the bulk of transactions (64%) in the quarter, followed by retail (16%). Transaction volume in Japan will likely level off in the second quarter, but rents, property values and acquisition yields should be stable as supply and demand remains largely unchanged. Office vacancies in central Tokyo rose in the first quarter, as newly completed buildings struggled to find tenants. Buildings less than 12 months old saw vacancy rates rise to 21.7% at the end of March, up from 13.6% at year-end 2010, according to Miki Shoji. The average vacancy rate of older buildings rose by 14 bps to 9%, Miki Shoji said. Effective rents in Class-A buildings fell by 1.5% in the first quarter from 4Q10, according to JLL. Asia Tigers: Consumer prices in the Hong Kong SAR rose in the first quarter due to increases in housing rents, utilities and food prices. Escalating energy and commodity prices will maintain inflationary pressure in the months ahead. Even so, retail sales in Hong Kong in the first two months of 2011 rose by 19% yearover-year, according to the Census and Statistics Department (CSD). Part of the increase comes from spending by visitors from mainland China, who are buying more goods during their stays. Nearly 74% of tourist spending by mainland Chinese visitors was on goods as opposed to hotel accommodation, dining and entertainment, up from about 60% in 2002, according to the CSD. With robust demand from banking and financial sector tenants, Class-A effective rents rose 9.2% in 1Q11 in Hong Kong s Central office submarket, according to JLL. The increase is the largest since 2Q10, and it puts rental levels just 4.4% lower than the previous peak in 4Q08. Most new supply in Central this year will come from government buildings, which are occupied by the owner. As the remaining supply is primarily limited to a handful of small buildings, rents have room to increase. Strong investor demand for properties has prompted compression in acquisition yields. With the Singapore economy expanding, inflation has crept up above 5% so far this year, according to Singapore Statistics. Meanwhile, the strong economic growth helped fuel a 15.6% year-over-year increase in retail sales (excluding motor vehicles) in January. Tourist arrivals in January and February reached record highs, and the country s two integrated resorts are attracting more overseas visitors. Class-A office rents in Singapore continued to surge in the first quarter, although the level has moderated compared to the previous two quarters. In the Raffles Place submarket, effective class-a office rents increased 7.9% quarter-over-quarter, compared to 10.9% in 3Q10 and 8.6% in 4Q10, according to JLL. We believe the upward momentum is sustainable, since current rents are still about 50% lower than the peak in 3Q08, and leasing activity is supported by financial institutions relocating from the fringe into the central business district (CBD). New supply in Raffles Place will peak in 2011, which means that the landlords will gain more leverage in future years. 5
Consumer prices in Korea rose to a 29-month high in March, prompting the Bank of Korea (BOK) to raise interest rates twice by a total of 50 bps, to 3%. Higher oil and food prices will likely prompt the central bank to tighten monetary policy further this year. In the Seoul CBD, demand for new prime office buildings has been slower than expected, leading some landlords to become more realistic in their rental expectations. In Yoido, a large batch of new supply this year and next will restrain any rental growth going forward. No new supply is expected in Gangnam this year, but some existing tenants may be tempted to relocate to new modern buildings in the CBD, which moderates the rental prospects in Seoul this year. Private residential prices in Singapore rose 2.1% in the first quarter, the lowest increase since 3Q09. Developer sales volume fell in the first quarter, an indication that buyers have become more selective in view of government actions in January to keep the market from getting overheated. The government has taken action to reduce housing inflation four times since September 2009. Housing prices rose by 17.6% in 2010, which is arguably justified in light of the 14.5% expansion in GDP. However, GDP growth in 2011 is expected to be significantly less than 2010, which should limit increases in residential prices. Indeed, a mild correction could be in the cards if transaction volume continues to dwindle. Australia: Commercial property sales in Australia are off to a good start in 2011, with A$5.2 billion sales in 1Q11, up from A$4.4 billion in 4Q10, according to DTZ. The jump was mainly due to the sale of an A$2.5 billion industrial portfolio. Office property sales totaled A$1.7 billion in the first quarter. Purchases by foreign investors totaled about A$500 million, 23.5% higher than the preceding quarter. The outlook for the Australian economy is somewhat clouded by the severe flooding in Queensland and Victoria in late 2010 and early 2011, which the government estimates will reduce GDP growth by 50 bps this year. More flooding could inflate food prices, which might prompt the Reserve Bank of Australia to hold interest rates steady. China: China's economy expanded by a steady 9.7% year-over-year in the first quarter from a year earlier, according to the National Bureau of Statistics. The purchasing managers index fell in the first two months of 2011 but rebounded in March as a result of an improvement in industrial production and new orders. Consumer prices rose at a rate of about 5% year-over-year in February and March. The People s Bank of China (PBOC) in March raised the required reserve ratio (RRR) by 50 bps, the third hike his year and the ninth hike since January 2010. In early April, the PBOC raised the benchmark interest rate by 25 bps, the fourth increase since October. More rate hikes are likely if consumer prices remain stubbornly high, which may moderate consumer and corporate loan growth. The class-a office markets in Beijing and Shanghai continued to grow in the first quarter, as China s increasing influence in the global economy attracts more international companies to set up offices in the mainland. In Beijing, strong demand for office space from both multi-national and domestic companies drove up effective rents by 6.9%, compared to 9% in 4Q10 and 3.8% in 1Q10. In Shanghai in 1Q11, Puxi (8.8%) continued to outperform Pudong (2.9%) in rental growth. Demand for class-a space in Shanghai is driven by the expansion of financial sector tenants. China s dominance of the global IPO market is inducing demand for office space in Shanghai, which is seen as a key activity center for new listings of Chinese companies. The construction of a new Disneyland in Shanghai will also attract investment capital into the 6
PREI city and possibly boost demand for office space, especially from ancillary services companies associated with the theme park. The central government has introduced a series of measures to slow down residential housing inflation, including purchase restrictions, higher borrowing rates and price caps. The State Council has sent eight inspection teams to monitor property markets in 16 provinces/municipalities. The teams will monitor local efforts to build public housing and increase land supply, and also assess the effectiveness of restrictions on property markets. The central government is likely to review the findings before considering whether further cooling measures are warranted. With the residential market slowly beginning to favor buyers, developers will have to be more realistic in price expectations going forward. Closing Thoughts Asia s economies trended up in the first quarter of 2011, thanks to the spillover effect from the rebound in the previous year. This year, the region s growth is likely to normalize to a relatively lower but more sustainable level. The labor market is tightening, creating upward pressure on wages. Demand for skilled labor in China is so strong that the country had to raise the minimum wage. While it is good news that household income in Asia is improving, escalating energy and food prices raise concerns about inflation, prompting central banks in South Korea and China to raise interest rates as a counter measure. Japan s economic outlook has obviously weakened, considering the aftermath of the Tohoku earthquake and the softening sentiment among large manufacturers that is reflected in the BOJ s Tankan survey. Japan will probably struggle over the short term, but the economy is likely to be ignited in the medium- to long-term when reconstruction efforts are fully underway. Asian real estate may warrant more weight going forward for a number of reasons. The region s strong growth has produced a cyclical upturn in demand for commercial real estate. Bank lending in the region remains conducive for borrowers. Meanwhile, property values are rising steadily, reflecting the growth in rental income and transaction activity. Acquisition yields of class-a office properties in Australia, Hong Kong and Singapore are gradually compressing. Property values are rising faster than rents at the moment, but rental increases will eventually catch up. China s growth story remains intact, and there are signs that residential prices are moderating in response to government measures. Such stability is a positive development for the market in the long term. 7
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