Publications

- March 1, 2018: Vol. 10, Number 3

Debt-related: Debt is an immature asset class in Asia, creating an opportunity for inbound and outbound capital flows, and potential advantages for early adopters

by Alex Frew McMillan

Asia is a secret no more. Both as a source and a destination for capital, it is very much on the institutional-investor map. Up against fierce local competition, cross-border players would do well to identify specialty sectors and immature asset classes to find greater opportunity.

Real estate debt is a case in point. Interest in debt as an asset class has picked up in recent years, notes Alan Dalgleish, CEO of ANREV, the Asian Association for Investors in Non-listed Real Estate Vehicles.

“It is still a relatively-small means of allocation,” explains Dalgleish. That is true when compared with nonlisted funds or club deals in Asia, and “it is also smaller than in other regions,” as a percentage of investors’ allocations.

In outbound terms, ANREV noted a significant pickup in interest last year in US mezzanine debt finance from Korean investors, who identified it as an opportunity to generate attractive yields. Korean institutions are under pressure to invest outside South Korea’s borders because of their massive asset bases and the relatively-small size of the Seoul office market.

Asian investors’ interest in the sector reflects their growing sophistication. With some Asian players still finding their feet with simple strategies such as fund investment or the direct purchase of core real estate, the interest in more-technical disciplines, such as property debt, will come as Asian institutions mature.

ANREV’s European counterpart, INREV, has produced a due-diligence questionnaire for debt vehicles that prospective investors can use. The progressive maturity of nonlisted asset classes requires greater specialisation in the method for selecting fund managers or vehicles. The idea behind the questionnaire is to produce standardised responses an investor can compare in its selection process.

“We assume that there will be a growing desire to deploy capital flexibly across all means of allocation to real estate, including debt, in the coming years,” says Dalgleish. “For sure, it will become a relatively-bigger piece of the pie.”

Still to find its champions

ANREV’s newly-released Investment Intensions Survey 2018 paints the picture. The survey polled 320 participants, representing an aggregate US$2.3 trillion in real estate assets under management, on their plans regarding real estate allocation for the next two years.

The bulk of Asian institutional investors — 72 percent — do not invest in nonlisted debt. The remainder are almost evenly split between those expecting no change in their holdings over the next two years (14.7 percent) and those who plan to increase (13.3 percent).

No Asian investors, however, were looking to reduce their exposure to debt. The same cannot be said of listed products such as REITs, where 10.7 percent of investors expect to unwind positions. That was more than balanced out, though, by the 14.7 percent of investors looking to increase REIT exposure.

So while debt seems to have few detractors, it simply does not have champions among the broad institutional-investor spectrum. Real estate funds, joint ventures and club deals dominate investor share of mind at this stage.

That may be due to the availability of debt in the region. When ANREV asked investors for a list of their concerns, being able to raise debt was at the bottom. At the other extreme, the lack of transparency in Asian property markets and the risk of foreign-currency swings are the issues keeping investors up at night.

Lack of scarcity would explain the reticence among some investors to tap the asset class. Debt has, of course, also been very cheap, thanks to the massive liquidity pumped into the global financial system by central banks — stimulus that is now gradually being withdrawn.

US interest

Ryan Krauch, a principal at Los Angeles–based debt-fund manager Mesa West Capital, says he has seen an increase in interest from Asian investors looking to put money to work in the United States through debt products. That interest has risen over the course of the past couple of years.

The initial interest, explains Krauch, was restricted to mezzanine investments — much like the mezz interest out of South Korea detected by ANREV. But Asian investors have broadened their horizons into other sorts of debt products, such as first mortgages, as well as expanded their geographic scope into Europe and the United States.

Some investors favour even-more conservative lending strategies than mezz debt or preferred equity. Other investors are demonstrating greater interest in open-end vehicles, which traditionally have not attracted any interest from Asian institutions as an investment structure.

Within Asia, opportunities are arising for nontraditional lenders because the banks that have dominated the debt scene are becoming more conservative in their lending. In many cases, it is a change being forced upon them. Taking to heart the lessons learned from the Asian financial crisis and the global financial crisis, regulators have become tougher in their lending restrictions and capital requirements.

So although banks are awash with capital, they are also forced to hold much of that liquidity back from property. The more banks sit back, the greater the opportunity for other debt offerings to gain traction.

“As these largest lending institutions sit on the sidelines, regional banks and foreign investors are stepping into the void to capitalise on the opportunity,” says Chuck Scully, CIO at MetLife Investment Management.

Developed markets, developed interest

In the Asia Pacific region, Australia and Japan appeal the most to MetLife. Japan still has loose monetary conditions, boosted by supportive fiscal spending from the government of Prime Minister Shinzo Abe. Combine with robust external demand and a tight labour pool, and commercial property looks attractive, believes Scully, with Japan finally emerging from decades of deflation.

It is a sea change to see the Japanese economy tip into sustained economic growth. Although the inflation rate has yet to approach anything close to the 2 percent target set by the Bank of Japan, the government has made a commitment to drive the economy forward.

Japan saw seven consecutive quarters of economic growth through third quarter 2017, the longest run in more than a decade. It has been three years since it experienced two consecutive down quarters — the definition of a recession — which have been a dime a dozen since the bubble of the 1980s burst. In addition, the jobless rate has fallen to a 25-year low.

Japan, therefore, has the twin bonuses of steady growth and predictability. The Japanese economy likely grew at 1.8 percent for 2017 and should sustain 1.7 growth in 2018, according to Oxford Economics. But the Bank of Japan remains committed to suppressing borrowing rates, keeping the mid-term 10-year Japanese government bond interest rate at or close to zero percent.

“A relatively-low-inflation environment may appeal to fixed-rated debt investors concerned about the erosion of real returns that could occur in a higher-inflation economy,” notes Scully.

The cost of borrowing is exceptionally low in Japan, so real estate investment makes eminent sense. That’s doubly true of investors with liabilities denominated in yen, says David Politano, the head of international real estate at MetLife Investment Management.

The commercial real estate market in Japan — basically, Tokyo and, to a lesser extent, Osaka — is large and has shown a pattern of stable capital gains and attractive rental returns in this recent phase of growth. It represents a good diversification opportunity for global investors that do not have much in the way of Asian exposure.

Yields on commercial mortgages in Japan typically provide a spread of 50 basis points to 100 basis points over the local Japanese swap rate, says Politano, “a welcome opportunity for income pickup in a market where sourcing higher yields can be very challenging.”

Turning up opportunity Down Under

Australia’s 2018 GDP growth, which Oxford Economics forecasts at 2.5 percent, is positively turbocharged by comparison, cresting to an estimated 3.1 percent by the turn of the decade. That’s running at a similar pace to the United States and its expected 2.7 percent growth rate for this year. But in Australia, the progress is virtually assured. The country has yet to experience a recession in the past quarter of a century.

Fixed-rate investors should find Australia attractive because the central bank continues to struggle to produce the 2 percent to 3 percent inflation it is targeting. The firm Australian dollar and benign inflation elsewhere in the world further point to the likelihood of steady growth.

The big banks have historically had a stranglehold on real estate lending in Australia. That fostered an inward-looking industry devoted to a domestic private-equity and listed investor base.

The Australian Prudential Regulatory Authority was slower to impose capital-adequacy ratios than its counterparts overseas, notes Wayne Lasky, founding partner and managing director at the Australian real estate debt manager, MaxCap Group. As a result, Australia’s “Big Four” banks increased their market share of the commercial real estate debt market from 60 percent in 2008 to 85 percent in 2017.

The size of the market grew 40 percent over the decade, meaning the big four banks’ aggregate market share rose to A$185 billion (US$147 billion) in exposure to property debt. That is a vast amount considering the entire debt market was only A$160 billion (US$127 billion) in 2008.

Mind the funding gap in Asia

Lasky estimates the “funding gap” between the amount of debt the banking sector can supply and overall demand from asset owners stands at more than A$50 billion (US$40 billion). That is a gap non-bank lenders can fill — something the regulator would like to see happen because it would prefer the banks’ market share to be less than two-thirds.

“Capital availability is often dependent on just four balance sheets,” says Lasky. Regulatory pressure on banks, therefore, has a bigger impact. The lack of securitised debt means there is less liquidity than in other Western core markets and further boosts the attraction of new players. “This has created opportunity for non-bank financiers to lend at a premium.”

The regulatory pinch has also cut off the debt flow of funds out of major banks in markets such as mainland China and Hong Kong, causing a double effect: Regulators are placing restrictions on mortgages and purchasing limits on real estate itself, while also pushing banks to lower their own risk.

That has resulted in lower loan-to-value ratios and shorter loan tenors. The amount of capital available for residential development also suffers. “While the cost of funding is relatively low, the cost of risk capital has increased,” indicates Fergal Harris, the head of debt capital in the Asia Pacific region for JLL.

Ample liquidity is present in markets such as Japan, South Korea and Singapore, says Harris. Some of that capital is making its way into international debt, propelling the broader push out of Asia into gateway cities in the West in general.

Playing a new deck of cards

In terms of Asian real estate debt-fund offerings, the appetite is more varied. “I think you are very likely to see a variety of new entrants to the market looking to play in different parts of the capital stack, pursuing different risk profiles,” believes Harris.

Previously, a typical pattern would be for a commercial bank to offer 60 percent loan-to-value on a deal, with perhaps an investment bank taking up a junior-debt position or a private-equity fund extending mezzanine finance. Now, “stretched senior” debt is appearing, as well as junior and mezz offerings from nontraditional sources. Those offerings are then being formalised and institutionalised as Asia Pacific–specific debt funds.

“What I see is a catch-up in certain areas like junior tranches, where a standard inter-creditor agreement is not yet common place amongst the banks,” says Harris. “The trend I see is a move toward Western, more-mature-style lending — I expect to see banks securitise loan books to further reduce risk — especially with clients where the cross-sell penetration isn’t there.”

This corporatisation of the market leads Robert Scholten, head of real estate finance, Asia Pacific, with ING, to say the flavour of debt in Asia is turning “vanilla”. What was once a specialised sector or play is increasingly mainstream, he says.

With the demand for assets crossing borders, “liquidity remains high and markets are highly competitive,” notes Scholten. Operating in new markets can create legal risk in terms of the enforceability of leases or sales deals. “The question is whether country risk is being adequately factored in when investors consider yields,” says Scholten. “Local knowledge does indeed remain key.”

Are the risks rewarded sufficiently?

Markets such as China and India have been little explored by outside players. But as the legal framework evolves and foreign players become more familiar with operating in those nations, investors likely will begin to gather positions in areas such as nonperforming loans.

“This market will evolve, too,” says Harris, particularly once international players begin to better understand the risks and rewards. “As an investor, each market has different levels of market stability and transparency.” Another concern is whether the influx of foreign capital will drive capital values beyond what is justified by property fundamentals.

In Australia, the main opportunities are in senior debt, across the spectrum of strategies and asset classes, in Australia’s first-tier cities. Nonperforming loans are not much of a factor yet in the market.

Lasky feels this early stage of market maturity allows investors to achieve scale rapidly, without compromising underwriting standards. He sees opportunity particularly in opportunistic plays, given big banks’ struggle to find room for them on their balance sheets. The banks resist loan sizes of more than A$100 million (US$79 million), opening the door for new players.

A good play also exists financing value-add and develop-to-core real estate strategies. “There exists a high velocity of activity, with a low capital base currently positioned to fund these strategies,” explains Lasky.

Playing the long game

Much Asian real estate is not particularly liquid. That makes trading in and out of markets outside the most-developed economies difficult.

If they are to enter core and core-plus investment, lenders should consider backing long-term debt in a market such as Australia, to get an edge. The major banks typically only put out three-year money, meaning Australian funds, listed and unlisted alike, have to go offshore to finance borrowings of five years or more.

MetLife has climbed aboard Down Under. Spreads, explains Politano, are attractive compared with developed markets in Asia, running about 150 basis points to 200 basis points over the local Australian swap rate.

“For US and Western European investors, these rates are comparable to, or possibly slightly higher than, what can be achieved in their domestic markets,” says Politano. Swapping into another currency, however, removes some of that advantage, making Aussie investment best suited to investors who can pair their holdings with liabilities denominated in Australian dollars.

Investors may want to exercise caution in second-tier cities, luxury real estate and the hospitality sector, notes Lasky. Those markets are more shallow, and they see higher volatility. “Investors lured by high expected returns may run into trouble when dealing with less-experienced sponsors or more-speculative business plans for which market acceptance remains unproven,” he says.

That still leaves plenty of room for players in the debt space to explore across Asia Pacific — a very large space indeed.

 

Alex Frew McMillan is a freelance writer based in Hong Kong.

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