M&G Real Estate: Asia Pacific Outlook

December 216 M&G Real Estate: Asia Pacific Outlook Part of the M&G Group

Executive summary Asia-Pacific economic outlook healthy in near-term, but policy uncertainty globally poses risks. Regional property total returns look set to taper as yield compression slows with lower transaction volumes. Development, alternatives, and tactical opportunities could drive next wave of investments. 25% Ratio to GDP of China s non-financial debt 15%+ Expected rise in Sydney effective office rents in 216 6.5% Average annual APAC property returns expected in next 3 years GDP growth (%) 6 5 4 3 2 1 Near-term economic outlook remains healthy The economic outlook for major Asia-Pacific markets remains relatively healthy, with overall regional growth estimates for 217 upgraded slightly to 4.6% in the third quarter. This was led by improved forecasts in Australasia and India, which helped to widen the region s expected outperformance over North America (2.2%) and the euro zone (1.3%). However, with the surprise victory of Donald Trump in the US presidential elections in November, there is now some potential for a stronger US domestic economy at the expense of global trade. Uncertainty over US trade policies could lead to a re-assessment of regional performance but the actual impact could be drawn out, so there are strong grounds to remain optimistic, not least because of growing intraregional trade. Fig 1: APAC still comfortably ahead China looks set to report GDP growth of 6.7% for 216, with a slight increase in commodity demand helping to soothe nagging worries over a possible economic hard landing. Fears of stock market and housing bubbles in China continue to rank among the biggest risks to the Asia-Pacific economy because of the financial system s escalating debt levels. Non-financial debt in China has risen to more than 25% of GDP from 15% in 28 and smaller Chinese banks have extremely high loanto-deposit ratios that put them at risk if non-performing loans increase. Much of China s positive economic outlook, and perhaps the world s, rests on the belief that the Chinese government has the financial strength to support any crisis. In addition to domestic issues, recent political and economic relations between the US and China appear to have worsened and any negative ramifications could potentially affect the global economy. Fears of stock market and housing bubbles in China continue to rank among the biggest risks... In Japan, unprecedented efforts to lift the world s thirdlargest economy out of a 2-year deflationary spiral appear to have hit a wall. Yield Curve Control was unveiled as the central bank s latest policy to boost public confidence and inflation. The policy aims to manage the yield curve by keeping 1-year yields at zero and out of negative territory. US Euro zone APAC 215 216F 217F Source: Consensus Economics. Thus far, the loose monetary regime set by Abenomics has supported investment assets well but, as yet, it has not strengthened the real economy significantly, with private capital investment and consumption spending growth 3

still slow. The Japanese government s 2% inflation goal remains elusive with consumer sentiment and business conditions still weak. Major retailers are also still choosing to hold or even lower prices to draw out consumers wallets. Elsewhere, economic situations across individual markets continue to diverge. In Australia, Sydney and Melbourne are growing strongly on the back of record-low interest rates and a housing boom. Infrastructure construction and residential redevelopment in the Sydney and Melbourne central business districts is driving real output growth, along with related business and professional services such as legal and real estate, etc. Consumer sentiment has received a huge boost from the ongoing surge in residential prices, up over 3% since 213. The near-term economic outlook for the Asia-Pacific region is likely to remain uncertain following this year s surprise UK vote to leave the European Union as well as the unexpected US election result. A Trump administration could potentially be positive for the domestic US economy but global trade now appears to be more at risk as potential changes to trade agreements could hurt Asian exports. More uncertainty lies ahead in 217 with much of mainland Europe going to the polls and Asian geopolitical tensions on the rise. However, we remain optimistic in the long-run and expect the Asia-Pacific region s consumption outlook with the middle classes expanding rapidly in China, India, and Southeast Asia to continue to underpin economic growth for the foreseeable future. Meanwhile in Brisbane, and particularly Perth, economic conditions remain soft, despite improving commodity prices. Even as commodity demand picks up, incremental investment from this sector appears unlikely. With some firms still facing financial difficulties, bad loan risks are still high, so Australian bank and sovereign credit ratings face potential downgrades. South Korea has also seen a gradual pick-up in growth, driven by low interest rates and the government s fiscal efforts, including the latest KRW1trillion (US$8.5 billion) stimulus package. But doubts remain over the Korean recovery s sustainability, given fluctuating industrial and manufacturing output reports over the course of 216. Labour strike issues and the impeachment of the country s president have further clouded Korea s economic outlook. Two of Asia s key global cities Singapore and Hong Kong continue to face strong headwinds as they struggle through their respective structural problems. Singapore s government GDP guidance fell further to the lower end of the 1-2% official estimate after economic data for the third quarter showed some weakness in the manufacturing and industrial sectors. Recent defaults by oil and gas service companies and persistent weakness in the shipping industry have played a part in keeping consumer sentiment muted. 217 growth forecasts also look soft. The government s drive to attract highervalue manufacturing and technology companies to help offset weakness in the ailing financial sector faces strong competition globally. Slower Chinese growth plus growing competition from mainland Chinese hubs Shanghai and Shenzhen are part of the structural shift that Hong Kong faces. Political uncertainty also appears to be rising again, two years after mass pro-democracy protests erupted. Pro-Beijing and pro-democracy camps are raising the stakes ahead of elections in March for the Special Administrative Region s chief executive. The uncertainty over China s reaction has kept some business decisions on the side lines. 1-year government bond yields (%) 8 7 6 5 4 3 2 1-1 Q4 2...we remain optimistic in the long-run and expect the Asia-Pacific region s consumption outlook with the middle classes expanding rapidly in China, India, and Southeast Asia to continue to underpin economic growth for the foreseeable future. Fig 2: Property s relative yield appeal Q4 21 Q4 22 Q4 23 Australia South Korea Source: Bloomberg. Q4 24 Q4 25 Hong Kong US Q4 26 Q4 27 Japan Singapore Divergent markets stock withdrawals and rental rebounds the key drivers Q4 28 By country, the property market outlook remains as divergent as their respective economic stories, with the only common themes being strong Chinese tourism growth and persistently low property yields. In broad terms, the pace of yield compression seems to have tapered off as investors become wary of the demanding valuations and toppish rental cycles. This is perhaps best illustrated by the continued decline in transaction volumes, which have Q4 29 Q4 21 Q4 211 Q4 212 Q4 213 Q4 214 Q4 215 Q3 216 4

been slowing since the second quarter of 215. The decline would have been even more pronounced in the absence of major acquisitions by sovereign, national insurance, and pension funds. As highlighted previously, the combination of population growth, monetary stimulus, and foreign investments has led to a surge in residential prices in Sydney and Melbourne. Positive consumer sentiment, along with continued tourism demand, have been supportive of retail sales and rents, while the redevelopment of the CBD has brought about significant stock withdrawals in the office market. These withdrawals are the key driver of strong rental increases given fairly flat net absorption demand levels. Sydney office rents are expected to rise in excess of 15% in 216, particularly in the secondary office market where most of the withdrawals are taking place. While office rental incentives in Sydney are falling sharply, albeit from a high base, in Melbourne they remain sticky due to the potential pipeline of new supply in the Docklands area. We expect prime Australian real estate to be one of the few developed sectors in Asia-Pacific to still see some yield compression over the next five years. At the other end of the spectrum, Brisbane and Perth continue to see limited occupier demand and negative net absorption. With vacancy rates at multi-year highs and the rental gap with Sydney widening, investors are increasingly looking towards these markets, particularly Brisbane, as potential contrarian investments. We expect prime Australian real estate to be one of the few developed sectors in Asia-Pacific to still see some yield compression over the next five years. 12 1 peak of the cycle with the looming supply pipeline likely to enter the market from 218-19. On the retail front, inbound Chinese tourist arrival figures continue to rise at a heady pace, though average tourist spend has declined. With visitors spending less on luxury retail, prime retail rents will continue to benefit from Japan s tourism drive but are unlikely to enjoy the huge increases seen in recent years. Logistics-driven industrial demand remains strong, particularly in Tokyo Bay, where vacancy remains low. Outside of the prime industrial areas there is evidence that the rate of absorption has slowed, although vacancy rates remain low. Relatively stable returns in Japan s industrial and residential sectors are also helping to underpin investment interest. Logistics-driven industrial demand remains strong, particularly in Tokyo Bay, where vacancy remains low. The office sector in Seoul continues to see high incentive levels as the supply pipeline comes on-stream. With domestic demand making up the majority of absorption, the uncertainty in the Korean economic outlook is likely to have an impact on expansion plans and rental growth. Similar to Tokyo, the retail sector in Seoul has been a beneficiary of Chinese tourism. Prime retail in Myeongdong district has seen stable rental increases due to its concentration of more-affordable cosmetics and fashion retail shops, instead of luxury boutiques. Fig 4: Growth of Chinese tourists (YOY, %) 2 18 16 14 12 Fig 3: Residential price index (21=1) 8 6 4 2 1 8 6 4 2 21 22 23 24 25 26 27 28 29 21 211 212 213 214 215 216F Australia Source: PMA. Japan (Tokyo) Hong Kong Singapore Office rental growth remained strong in Tokyo, driven by low vacancy rates and fairly strong leasing activity. While this growth is likely to continue in the next three years, we expect rent increases to slow from here as we approach the -2-4 Singapore Hong Kong Japan Australia Korea 212 213 214 215 YTD216 Source: Various tourism boards. Hong Kong s traditional gateway-to-china role for international firms could potentially be compromised as Tier-1 cities in China continue to develop rapidly. The incremental demand needed to absorb the large supply pipeline in Kowloon East also seems unlikely to come through, as financial firms downsize. Still, office demand in Hong Kong Central remains resilient as firms continue to 5

Office vacancy rates (% stock) 25 2 15 1 5 value being in Hong Kong s premier office location, despite the significantly lower asking rents across the water in the new business district. The decline in mainland Chinese luxury spending continues to impact retail sales and the sharp correction in prime retail rents, once the highest in the world, is expected to be protracted. In Singapore, pre-leasing for upcoming major office completions has picked up at the expense of asking rents. Older stock within the business district is likely to be impacted the most as landlords continue to see flightto-quality as tenants take advantage of the soft rental market, which could see declines extend into 217. The outlook for prime retail in Singapore remains similarly uninspiring, suffering from lower average tourist spend and competition from convenient, high-quality suburban malls. We expect property yields to see some expansion in both Singapore and Hong Kong over the next five years. Top 3 for rental growth 217 219 22 221 Sydney office Sydney secondary office Melbourne office Source: M&G Real Estate. Perth office Singapore office Hong Kong retail Asia-Pacific real estate is on track to deliver some of the highest total returns globally, averaging almost 11% in 216, supported by continued monetary stimulus and stronger economic expansion. Returns in recent years have been driven by very sharp yield compression, which we believe will now slow. With investors becoming more cautious, we expect returns to taper to more sustainable Fig 2: Mixed picture levels of 8% in 217 and to average 6.5% p.a. over the next three years. With interest rates in the region expected to remain low over this period, these returns will still provide a comfortable spread over bond yields. With investors becoming more cautious, we expect returns to taper to more sustainable levels of 8% in 217 and to average 6.5% p.a. over the next three years. A closer look at some regional markets reveals that high office returns often mask significant incentives, particularly in Australia and Korea. In comparison, we expect the retail sector to provide stronger and less volatile effective returns, ranging from 5 to 2 basis points above office sector returns. Weak near-term fundamentals in the Singapore and Hong Kong office sectors, coupled with stubbornly high pricing, are key reasons why M&G Real Estate has selectively focused on other sectors elsewhere in the region such as retail property in Australia and Korea, which offers higher returns, and Japan s residential and logistics sectors, where the returns are less volatile. As some of these structural trading opportunities become increasingly crowded and the low-hanging fruit largely gets picked, we believe that new tactical opportunities in currently-weak markets could drive the next wave of transactions. With global capital still on the lookout for diversified real estate returns, low interest rates and pockets of fundamental property strength are likely to keep both prime and secondary property yields in Asia down in the near-term. Faced with declining prospective returns and limited availability of assets, investors are increasingly looking outside of traditional core sectors. By carefully balancing the risks and potential returns, we believe there is scope for investors to continue to be rewarded in the region. Development projects, for example, could provide investors with exposure to closely-held sectors that are historically difficult to access. Sourcing for deals in secondtier cities with stable domestic fundamentals could be another avenue for rewarding risk-adjusted returns. Q2 21 Q2 22 Q2 23 Q2 24 Q2 25 Q2 26 Q2 27 Q2 28 Q2 29 Q2 21 Q2 211 Sydney Melbourne Brisbane Perth Tokyo Osaka Singapore Seoul Source: PMA. Q2 212 Q2 213 Q2 214 Q2 215 Hong Kong Q2 216 Sourcing for deals in second-tier cities with stable domestic fundamentals could be another avenue for rewarding risk-adjusted returns. 6

For more information Yip Kai Research Analyst +65 6349 9 kai.yip@mandg.sg Richard Gwilliam Head of Property Research +44 ()2 7548 6863 richard.gwilliam@mandg.com Lucy Williams Director, Institutional Business UK and Europe, Real Estate +44 ()2 7548 6585 lucy.williams@mandg.com Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland +31 ()2 799 768 stefan.cornelissen@mandg.co.uk Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate www.mandg.com/realestate +65 6436 5331 chris.j.andrews@mandg.com IMPORTANT INFORMATION: Not for further distribution. The value of investments can fall as well as rise. This article reflects M&G Real Estate s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of Professional Client as defined in the Handbook published by the UK Financial Conduct Authority. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G Real Estate does not accept liability for the accuracy of the contents. Notice to recipients in Australia: M&G Investment Management Limited does not hold an Australian financial services licence and is exempt from the requirement to hold one for the financial services it provides. M&G Investment Management Limited is regulated by the Financial Conduct Authority under the laws of the UK which differ from Australian laws. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Notice to recipients in Singapore: This document has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this document and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of shares may not be circulated or distributed, nor may shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 34 of the Securities and Futures Act, Chapter 289 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. M&G Investments and M&G Real Estate are business names of M&G Investment Management Limited and are used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under numbers 936683 with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number 3852763 with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Investment Management Limited and M&G Real Estate Limited are indirect subsidiaries of Prudential plc of the United Kingdom. Prudential plc and its affiliated companies constitute one of the world s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. DEC 16 / 17481