Last year was a bumper one for Asia's commercial real estate investment market. According to a report published by JLL last week, transaction volumes surged to an all-time high of US$169 billion, a 6 per cent rise year on year, compared with a 4 per cent increase globally and a 5 per cent decline in Europe, where Brexit-related uncertainty weighed on sentiment.
Among the world's 10 most actively traded property markets, four - Seoul, Tokyo, Shanghai and Singapore - were in Asia. The region is also attracting increasing amounts of foreign capital, with Shanghai, Singapore and Sydney among the top 10 recipients of cross-border investment, data from JLL shows.
Over the past decade, the combination of historically low interest rates, institutional investors' higher allocations to real estate and record amounts of capital waiting to be deployed has pushed down rental yields - and thus driven up prices - in the world's office, retail and logistics property markets.
According to data from CBRE, the global all-property yield - a weighted composite of office, retail and logistics prime yields in 50 major cities - fell from 6 per cent in 2011 to just above 4 per cent at the end of last quarter.
However, while prime office yields in London and New York currently stand above their cyclical lows, they have fallen below them in all 10 Asia-Pacific cities tracked by CBRE.
In a sign of the extent to which the wall of money targeting Asian real estate has caused yields to compress, among the 30 global office markets analysed by CBRE, the gap between yields at the end of last quarter and their cyclical lows was the widest in Asian and European cities.
While benchmark borrowing costs have dropped in tandem with property yields over the past several years, spreads, or the risk premium, between real estate yields and their fixed income equivalents are the narrowest in Beijing, Shanghai and Hong Kong, data from CBRE shows.
In all three cities, spreads are significantly below or just under 2 per cent, as opposed to between 2 and 4 per cent in most North American and European cities.
The exceptionally low yields in mainland China's two biggest property markets, and in Hong Kong, is striking given the sharp deterioration in the fundamentals of the three cities' occupier markets.
Leasing activity and rents in Asia's office and retail real estate markets fell in the second half of last year, mainly because of weaker demand and oversupply in Hong Kong and China's Tier 1 cities.
According to CBRE, net absorption of office space in the Asia-Pacific region last quarter fell 18 per cent year on year to a five-year low, mostly due to a sharp decline in demand in "Greater China, particularly Beijing and Shanghai, with net absorption shrinking 44 per cent (year on year)."
In the retail sector, rents in Asia fell 1.5 per cent last quarter, with the "regional average pulled down by Hong Kong, where rents declined 9.7 per cent (quarter on quarter) amid rising vacancy along prime streets in core districts," CBRE notes.
Long before the outbreak of the coronavirus - which has brought China's economy to a near standstill and threatens to severely disrupt supply chains across Asia - investors in Asian property were not being adequately compensated for the increased risks in the region.
The risk-return profile, particularly in mainland China and Hong Kong, now looks even less appealing as concerns about the world's second-largest economy intensify.
The combination of excessively low yields and downward pressure on rents is weighing on capital values. CBRE expects average gross annualised total returns - the sum of income and capital appreciation - for all sectors in Asian commercial property to fall to 3.4 per cent in the next three years, compared with 8.2 per cent between 2017 and 2019. In Hong Kong's office and retail sectors, returns are forecast to be negative.
Still, while the weight of capital seeking exposure to Asian real estate has conspired with weaker occupier fundamentals in mainland China and Hong Kong to diminish the appeal of the region's property markets, investors are not about to turn their backs on the asset class.
First, while yield compression has gone too far in many cities, global financial conditions remain exceptionally loose, with the "lower for longer" interest rate regime likely to persist for the foreseeable future. Real estate will retain its appeal relative to government bonds, which are trading in negative territory in Japan and Europe.
Second, several countries and sectors are still attractively priced. Prime office yields in Australia's main cities currently stand at between 4 and 6.5 per cent, according to CBRE, with the sector benefiting from rental growth. Moreover, the logistics market, which offers investors the highest yields in commercial property, is proving more resilient, underpinned by the rapid growth and sophistication of e-commerce.
Third, prime yields have begun to rise in Hong Kong and Shanghai in a sign that weaker fundamentals are beginning to affect pricing. If this trend continues, this could be the catalyst for a much-needed repricing of risk in Asian real estate.
The wall of money targeting Asian property has pushed yields down to unsustainably low levels. However, stretched valuations should help discipline investors and developers, encouraging a flight to quality.
Nicholas Spiro is a partner at Lauressa Advisory
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