Asset owners face rising foreign real estate risks

Asian institutions look set to continue their love affair with overseas property, but the coming year may test their resolve in light of lofty valuations and growing uncertainty.
Asset owners face rising foreign real estate risks

Donald Trump won the US presidential election partly on declarations he would take jobs back from China. Yet the property tycoon has been silent over another incursion from the Asian giant: the hunger of its asset owners for prime US real estate.

In May, China Investment Corporation acquired a 49% stake in the 1 New York Plaza office tower from Brookfield Property Partners for $700 million. In the same month, China Life Insurance partnered developer RXR Realty to buy a tower on Manhattan's Sixth Avenue for $1.65 billion. Anbang Insurance then acquired a portfolio of 16 US hotels from private equity firm Blackstone for $6.5 billion in September. And China Life was back in October, snapping up a stake in a US portfolio of hotels from Starwood Capital Group for $2 billion.

Increasingly, companies operating in globally renowned cities are finding their ultimate landlords to be an Asian pension fund, insurance company or sovereign wealth investor.

The appeal of bricks and mortar is clear. While developed-market bond and equity funds have struggled to consistently make net returns above 3% or 4% in recent years, property and real estate private equity funds can often supply internal rates of return in the high single or low double digits.

Property appeal broadening

Larger Asian asset owners have been taking advantage for years, but experts say smaller regional investors are looking to property as a panacea to poor returns on mainstream assets.

“Australian and Singapore investors have been investing into private equity and real estate for a while, but the levels of return have encouraged other Asian asset owners too,” said Aisling Keane, head of alternative investment solutions for Asia Pacific at State Street. “More are entering joint-ventures with asset managers and GPs [general partners] in the private equity and real estate spaces.”

Asia-Pacific asset owners allocated 6.6% of their assets into real estate on average, as of October, estimated research provider Preqin. 

China’s asset owners have been particularly aggressive, as they have quickly accumulated capital that they need to invest, said Frank Marriott, Asia-Pacific director of investment advisory at proeprty services firm Savills. “Over the last few years China has accounted for about 45% of Asia’s overseas direct investment [into real estate].”

Direct investment from China into existing US commercial and residential property could top $218 billion from 2016 to 2020, according to a report published in May by the Asia Society and Rosen Consulting Group. Institutional and retail buyers from the country are estimated to have bought $47 billion in US commercial and residential real estate in 2014 and 2015.

Koreans getting involved

Korean investors are also becoming more assertive, particularly after the Ministry of Strategy and Finance in July allowed state pension funds to increase their overseas and alternatives exposure by two to three percentage points a year.

“They have no choice but to look into the overseas market, as there are not enough alternatives opportunities in [the] domestic market,” said Manuelita Contreras, associate director at research house Cerulli Associates.

This makes sense. Pension funds and insurance companies, are long-term investors by nature, and real estate markets tend to perform well over long periods – provided investors are patient enough to sit through economic cycles.

While real estate is a hot space for asset owners, their interest depends on the rates of return offered relative to stocks and bonds. If the difference declines, the appeal of property is also likely to dip.

Risks rising

The risks of this happening are creeping upwards.

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One factor is demand and supply. While asset owners make more funds available to invest into New York, London, Hong Kong, Sydney and Tokyo, these cities only possess finite amounts of quality office buildings or apartment complexes.

The rush of money to invest is causing valuations to hit lofty heights, particularly in the US. The Green Street US Commercial Property Price Index hit 126.7 points in October, a record high. And in September the S&P CoreLogic Case-Shiller National Home Price Index, which tracks average home prices, rose 0.1% above its previous record in 2006.  

“Across almost all markets we’ve seen capital rate compression, but cap rates remain comfortably above bond yields,” noted Lau Cheng-Soon, managing director for Asia Pacific at Invesco Real Estate. “Property investments in Sydney and Melbourne once yielded 6% or to 7%, but now are closer to 5%. In Tokyo the yield is around 3.5%.”

Moreover, it’s possible that Trump's spending proposals, particularly to invest in infrastructure, will cause inflation and commensurate interest rate hikes. That could well prove painful for real estate, a market largely based on borrowing. Higher costs might hurt rental revenues and property valuations, and push up default rates.

There are already signs of rising delinquencies. Morningstar Credit Ratings predicted that 40% of commercial mortgage-backed securities maturing next year may fail to refinance, versus 20% to 25% this year.

Despite such risks and uncertainties, Asian asset owners look set to keep buying more office buildings, malls, warehouses and apartment complexes, in light of the need to make returns on their fast-growing pools of capital. But they may need a strong stomach in the year to come.

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