The sharp rise in global interest rates that took hold in the second half of 2022 drove a “great reset” of real estate values, with mixed impact on investors and lenders. However, with interest rates peaking and inflation starting to ease, we are beginning to see the light at the end of the tunnel. The Asia Pacific real estate market is set to begin its recovery in 2024, driven by stabilised capital values and resilient income returns, writes Benett Theseira, head of Asia Pacific, PGIM Real Estate.
The structural growth of demographics, digitalization and decarbonization are driving secular shifts in occupier demand across real estate sectors and geographies. From the cyclical perspective, some markets in Apac are currently offering interesting entry prices and rental growth prospects as the current cycle and price discovery are entering a stabilization stage. Furthermore, the ongoing shift from the more highly-regulated traditional bank-led financing and toward private-market funding is creating new opportunities for debt investors.
Apac emerges as most resilient globally
Apac has been one of the most resilient regions globally thanks to the diversity of its markets. The markets in the region have corrected at a different pace, and this diversity offers exciting opportunities.
Looking ahead, rental growth will be a key driver for the recovery, with the days of capitalization rates compression well behind us. However, the recovery will be uneven with momentum varied across major geographies and sectors. Overall, global real estate values are projected to decline by approximately 30% from peak to trough. Asia (ex-Japan) may see a relatively modest 10-20% decline, while Europe could face falls closer to 40%.
In Apac ex-Japan markets, higher interest rates and expanding cap rates have weighed on asset pricing, particularly in Australia and South Korea. These markets are expected to start stabilizing and improving in the coming 12 months. In contrast, Japan’s persistent low interest rates have supported real estate prices and compressed cap rates in the past two years. The healthy yield spread and market stability continue to make Japan an attractive investment destination. However, the expectation that borrowing costs will rise marginally is putting a dampener on the outlook for asset prices.
Structural opportunities in Apac: The three Ds
As the reset continues and markets remain uncertain, real estate investors need to focus on what they can control – income. Long-term structural trends such as demographics, digitalization and decarbonization are attractive themes that are driving occupier demand and rental growth across various sectors.
Demographics plays a crucial role, particularly in major cities like Sydney, Melbourne, Singapore, and Tokyo where the growing urban population and high cost of home ownership offer attractive prospects in rental housing. Additionally, other living sectors such as student accommodations and senior housing sectors are also benefiting from these population trends. The undersupply of institutional residential rental housing in Australia, Hong Kong and most major cities in the region, and delayed new supply due to higher construction costs support the fundamentals of this sector.
Digitalisation is fueling demand for data centres and logistics. We are in the early stages of a generational structural growth opportunity for data centres. With advancements in generative artificial intelligence accelerating demand for data centers, rental prospects remain robust against the favorable fundamentals of solid demand and limited supply. Hyperscale data centers serving major cloud providers are expected to experience strong rental growth, especially in markets with limited power supply such as Tokyo, Seoul and Singapore, as well as major Australian cities.
While logistics remains a favorable investment theme, investors should focus on selective core submarkets. Prime and centrally located logistics assets in submarkets such as Sydney, Melbourne, Tokyo, Singapore, and Seoul are expected to outperform, driven by automation and increased productivity in the third-party logistics and delivery sectors.
Finally, the decarbonisation trend is driving the need for properties with strong ESG credentials. Investors must therefore carefully select assets with robust green rating credentials and focus on stable income strategies for Grade A properties. However, there are also opportunities with well-located assets at risk of becoming stranded due to weak ESG credentials which could be purchased at depressed pricing for which occupier demand and valuation could be restored and enhanced through thoughtful retrofitting and asset strategies.
While the current entry prices for most Apac markets are starting to look interesting for long-term investors, some cyclical opportunities are also emerging from the downturn. Despite headwinds for the office sector globally, the outlook for office space in Sydney, Seoul, and Singapore appear compelling, while caution is advised for Japan and China. The tourism recovery will be positive for the hospitality sector and high street retail particularly in Tokyo and Osaka.
Real estate debt: Lending into the funding gap
Given market dislocation and the sharp rise in interest rates, over the last 12 to 18 months many institutional investors see this as an attractive entry point to diversify their portfolios with real estate debt.
With the downside protection that it offers, debt typically outperforms during periods of uncertainty, and this especially rings true in the current environment. Tighter banking regulations and low leverage tend to provide attractive entry points, and interest rates and lending spreads have risen boosting returns.
Apac is still well behind the US and Europe in the non-bank lending market, but recent developments to shore up lending standards is accelerating growth. Regulatory restrictions, which increase capital requirements on bank lending, will lead to increasing buffers, suggesting that banks will take an even more cautious approach to commercial real estate lending. This opens the door for non-bank lenders to fund in-demand projects.
In the high yield debt space, Australia presents more compelling opportunities as the banks remain very competitive in most other developed Asian markets. Regulatory pressure on Australian banks to reduce real estate exposures, particularly for riskier assets and projects, and a widening of the capital pool available for real estate lending are assisting this trend. Investors need to be very selective though, particularly in the office sector and for residential developments, targeting higher quality assets and well managed projects that will likely remain attractive to tenants and buyers throughout this cycle.
Portfolio diversification
Private alternatives including real estate and private credit as a broad asset class have been one of the fastest growing among investors in recent years. Traditionally an institutional asset class, it is now growing in favor among private wealth investors as they increasingly turn to alternatives for portfolio diversification and better risk-adjusted return.
This is especially the case for investors who wish to gain access to sectors with enormous growth potential yet higher entry barriers such as data centers. Today, these opportunities can only be accessed via REITs or dedicated private funds managed by experienced active managers.
The “great reset” has certainly caused some short-term pain, but relief looks to be around the corner for long-term investors searching for an attractive entry point. With interest rates hikes in the rear-view mirror, investing in line with the secular trends is a good place for investors to start. In addition, a well-diversified real estate portfolio across equity and debt will no doubt deliver a less volatile and better risk-adjusted outcome as we navigate the on-going market challenges and leverage on the recovery to come.
By Benett Theseira, head of Asia Pacific, PGIM Real Estate.
