What’s ahead in APAC real estate?

In nearly every sector, one can trace the grim progress of the COVID-19 pandemic from continent to continent, starting with its origin in China. Real estate is no exception. Real Capital Analytics reports that for the first 13 weeks of 2020, the volume of Asia Pacific deals valued at $10 million or more was down 56% compared with the same period in 2019. EMEA and the Americas, meanwhile, were down 18% and just 1%, respectively, though doubtless with worse to come.

But being further down the road also means that APAC’s real estate markets may also offer a glimpse of what’s ahead for the sector. In our recent webcast, Windows on real estate, John Saunders, Head of BlackRock Asia-Pacific Real Estate, joined speakers from across our real estate platform to share his views. Following are excerpts from his conversation with Mark Everitt, Head of Investment Research and Strategy at BlackRock Alternative investors.

The global real estate market has changed enormously since Q4 2019, and the changes began in APAC. Where did things stand on the eve of the crisis?

Dialling the clock back to December 2019, we had a clear sense that markets were late in the cycle, yields were tight, there was too much capital chasing too few assets and there was evidently a lot of style drift in the market.

In this region, the market cycle looked especially mature to us. The trade conflict had taken its toll on the economy in China. Hong Kong had pretty much stalled with slower trade and local protests. While conditions were strong in Japan, Australia and Singapore, assets were absolutely priced to perfection.

With all this in mind, we approached the late-cycle real estate markets with the right degree of caution. We were far less inclined to bank on further cap rate compression. We were working harder to realise rental growth from reversion and asset improvement. We continued to seek out the untapped pockets of yield and income growth.

So, coming into this coronavirus outbreak, we were already cautious on pricing. We stressed the need for disciplined investment, both in terms of a defined strategy and a keen awareness of fundamental pricing.

How have things progressed in APAC since then?

Surveying the landscape today, it is quite dramatic to see the abrupt changes in the market in the space of just the last three months.

Obviously, what comes next will critically depend on this coronavirus. So far, we are seeing a little bit of good news on the outbreak in parts of Asia, with more signs of viral containment and fading momentum in infections in both March and April.

The recovery in China has been long enough and strong enough to close down all the temporary hospitals and quarantine shelters; and to reopen factories, office buildings and train lines. Traffic jams are back in Shanghai. We are starting to see tenant inspections in our buildings again. Schools are being progressively reopened across China now and into May. Luxury retail stores are having some of their biggest trading days as buyers head out of quarantine and engage into some so-called ‘revenge spending’. Overall, there is a broader sense of a gradual return out of lockdown and back towards normality.

This lays the groundwork for real estate transactions to return. However, I think the correction in asset prices will take several more months to realise.

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I think the correction in asset prices will take several more months to realise.

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Where an owner is over-levered or poorly structured; or an asset is sitting in a fund with a long redemption queue, some of these assets will eventually come to market, with price discounts to match their sense of urgency.

In that context, the strategy for us in 2020 is pretty clear.

For existing investments, we are working very hard to maintain occupancy (above prevailing market levels) and ensure debt funding terms and covenants that are in excess of our expected needs, so that banks do not drive our hold / sell decisions – and on this measure our portfolio is sitting comfortably.

How does this crisis compare with prior ones?

Certainly, every market cycle is different, but there are some important and instructive points to draw out, by looking at these prior cycles.

For us in Asia, not only have we seen the Global Financial Crisis and the dot com bust, but we have also seen the Asian Financial Crisis and the first-hand impacts of previous coronavirus outbreaks with SARS in 2003 and MERS in 2015.

While those previous viral outbreaks were not as damaging or disruptive as this one, the mechanisms for market dislocation are exacting the same. With SARS, MERS and COVID-19, it is the travel, hospitality and related sectors that are the hardest hit.

The effective shutdown of travel and tourism – then and now – did massive damage to the hotel and associated retail sectors. This time, the disruption is much wider in scope and potentially longer in duration.

These tourism shocks do spill clearly into the retail market as well. This time around, the added impacts of social distancing and stay-at-home measures are driving a much more challenging retail cycle

Where there is exposure to the food and beverage sector, there are some material impacts on turnover and rent collections as well, given diminished foot traffic and mostly smaller ‘mom-and-pop’ operations.

While there is undoubtedly some drag on the office market, the impact has been relatively milder. In this region, larger tenants are not missing a beat with their work-from-home contingency plans. It is the smaller tenants who face more risk from the economic disruption and diminished revenues.

For now, we see less direct cyclical parallels with the Global Financial Crisis and the credit crunch of 2008-09. Indeed, we are not seeing the same ticking timebombs such as the US sub-prime mortgages or leveraged buyouts. Bank balance sheets are not under the same degree of jeopardy, an assessment that is supported by equity prices and CDO spreads. The GFC drove a dip in asset prices that was sharp and long. Over the SARS experience, the price correction was milder and shorter. However, in both these cases, we saw that it took at least two to four quarters before capital markets found their true bottom and began correcting back toward pre-crisis levels.  Assuming history repeats itself, we will see pricing corrections beginning to appear across the region during the latter part of this year.

What are some of the developing opportunities to put capital to work in APAC?

In the middle of a concerted pricing reset, I am quite confident that there will be no shortage of opportunities in the APAC region.

We can see clearly the signs of mounting distress in some asset owners, whether that is coming from sharply reduced occupancy, binding debt servicing covenants or longer redemption queues.

While the economic indicators are starting to come back in China, that is not the case everywhere. I think there is still a lot of time to find the right opportunity and the right entry price.

And just because the most acute distress is coming through in hospitality and retail, it doesn’t necessarily follow that these are the best opportunities for new investment.

Indeed, I think that the risk premia for hotels need a sizeable reset before they become competitive with other sectors, especially given the inequality built into the owner-operator contract model. Meanwhile, I think the strategies that have worked well in the past will continue to work well in the future.

Specifically, assets with good, stable, recurring incomes reduce a lot of vacancy risks, especially during periods of weaker demand as we are seeing now. This notion has carried us well in core and even in value-add strategies.

Moreover, we like markets with a positive spread – a dependable yield in excess of funding costs. That positive carry means that time is working in our favour and we are less reliant on pure capital gains or yield compression. In this context, markets like offices in Australia and Japan and industrial in Singapore continue to deliver the most pipeline potential.

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In this context, markets like offices in Australia and Japan and industrial in Singapore continue to deliver the most pipeline potential.

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In Japan in particular, we have recently been engaged by numerous vendors where their public sales processes have fallen over due to the impacts of COVID-19. Our track record of off-market deals in the most liquid markets of Tokyo and Osaka and history of working with domestic owners of distressed assets to develop creative take out solutions is attractive in a market like Japan.  Through our relationships with local Japanese banks, we have previously been recommended as a solution provider to vendors who may be concerned about near term lease expiries or loan covenant hurdles which require the hands-on, active asset management our teams can provide

Ultimately, we have the on-the-ground capacity to operate across multiple markets and all the sectors across the APAC region. In an unfolding market correction and improving value, what we do will greatly depend on price (and the prospects for rent reversion and therefore also price reversion).

While we have clear preferences to find recurring income, fixable impairments and positive carry, we have considerable scope to achieve our goals through a number of strategies, particularly as we move through the bottom of the market cycle.

Stephan Caron
Head of European Middle Market Debt
Mark Everitt, CFA
Head of Investment Research and Strategy, BlackRock Alternative Investors
Making sense of market turmoil
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Making sense of market turmoil