APAC real estate: Opportunities to rise as borrowing costs bite

February 23, 2023 06:00
Photo: Bloomberg

With major central banks outside of Japan tightening their monetary policies to counter rising inflation in recent months, borrowing costs have increased sharply in most developed Asian markets. Banks are also becoming more selective, restricting their lending conditions amid strong global economic headwinds. Higher borrowing costs and tighter credit market conditions have resulted in a significant slowdown of investment activities, with total transaction volumes in 2022 down by nearly 27% in comparison to the previous year. The widening spread between buyer's and seller's pricing expectations was among the major factors leading to lower transaction volumes.

However, as pressures from the increase in financing costs continue to build up, there are reasons to believe that sellers may become more willing to adjust prices to meet buyers' expectations of discounts. In almost all markets outside of Japan, the cost of borrowing is now higher than the asset's income yields. In other words, asset owners are facing the risks of "negative carry", particularly in highly leveraged investments.

Low loan-to-value helps but interest coverage ratio is eroding fast

Estimates of the interest coverage ratio (ICR) for real estate debts – excluding Japan – show that the regional average of ICR has fallen sharply in recent months toward 2.0, a level considered as a standard threshold for a loan's healthy interest coverage. The relatively low use of leverage since the global financial crisis (GFC) helps soften some pressures on ICR as interest rates rise. However, with interest rates likely rising further in the coming months, there will be an increasing number of assets breaching ICR requirements.

Owners of assets wanting to refinance their debts in the current environment, particularly for those using high leverage, will likely be required to inject more capital to lower the leverage ratio to comply with the standard ICR requirements. Some may choose to sell their assets instead and are more likely to accept necessary discounts. While a large number of distressed sales across markets is unlikely, rising pressures from higher financing costs on debt covenants could force more willing sellers to the markets in the coming quarters.

Annualized APAC returns have outperformed global average since 2005

Data from the Global Real Estate Fund Index (GREFI) shows that annualized real estate returns in the APAC region have outperformed the global average since 2005, noting the delivery of return premium as expected. The dynamism of market conditions in Asia also offers investors the benefits of intra-regional diversification, helping pan-regional portfolios avoid a synchronized decline during market downturns. Evidence from previous down cycles shows that Asia Pacific, as a region, has weathered both regional and global headwinds relatively well.

In regional episodes of market moderations, such as the eurozone debt crisis in 2011 and the taper tantrum in the United States in 2013, Asian markets held up well. At the peak of its own regional event, such as SARs in 2002/03, nearly 50% of markets in Asia still reported capital value growth. During global downturns, such as the GFC in 2008/09, the impacts spread much wider, with nearly 90% of markets reporting capital value declines. However, capital value declines were in a moderate range of 10% p.a. at its trough.

The current global market environment might give a sense of a synchronized downturn coming. Rising inflation and higher interest rates seem to be the top concerns for most major economies across the world. Within Asia Pacific, global headwinds are particularly acute in the export-dependent economies of Hong Kong, Singapore and South Korea. Australia too has been faced with similar pressures in recent quarters.

However, the dynamism of the region is well demonstrated again with China and Japan – the two largest economies in the region, and the second and third largest economies in the world, respectively – continuing to counter this global trend. Japan continues to maintain its highly accommodative monetary policy, while China is actively easing its policy to provide a boost to the weakened domestic economy. Both countries report moderate to low inflation pressures.

Despite global headwinds, pockets of cyclical resiliency remain

With the US and major European economies on the edge of falling into recession, Asian economies are certainly feeling the chilly headwinds of slower global demand. Growth momentum is expected to slow down in the coming quarters, and higher interest rates will build pressures on cap rates and capital values in a number of markets. Nevertheless, pockets of cyclical resiliency remain. Japan can still benefit from the recent border reopening in October, and the Chinese economy could regain some strength after the government started relaxing its strict zero-Covid policy, which has hindered its economy over the past two years.

Looking forward, cap rates are expected to expand in a number of markets, most notably in Australia and South Korea. Among major sectors, office and logistics are facing more intense upward pressures on cap rates, leading to capital values decline in some markets. However, at the same time, a number of markets, particularly in Japan and Singapore, will likely hold their values relatively well. Reflecting these intra-regional dynamics, capital values are expected to mildly decline at the regional average level but have a wide range of outcomes among individual markets.

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Head of Asia Pacific Investment Research, PGIM Real Estate