Investing in Asia - balancing the opportunity with the risks

At a time when there is a wealth of opportunities available within the vast European market for the typical institutional investor, it is easy to ask the fundamental question: ”Why commit significant resources and time to understanding and ultimately investing in the Asian market, which can seem extremely vast and risky?”

While these two continents are vastly different in history, geography and culture, they share more similarities than one would assume at first glance. For starters, both regions are conglomerates of mature economies and emerging ones, both regions have registered improving economic growth over the past few years. Regional groupings feature prominently and have had a generally positive bearing on economic performance and are used as the basis for inter and intra-region negotiations on the economic, social and political fronts.

The similarities and differences between Europe and Asia have many ramifications in terms of investment potential for investors looking at investing in Asia and this article highlights the immense growth potential and the unique advantages investors have in Asia.

Regional overview of Europe and Asia

The strong growth in real estate
Global real estate investment flows have increased dramatically in recent years. According to analysis by Jones Lang LaSalle, there was approximately US$290 billion in global real estate direct investments completed in the first six months of 2006 – setting a new record. Europe saw an investment volume of US$117bn while only US$43bn was invested into the Asia Pacific region. Within Asia, Japan was the largest market, accounting for 51% of investment volumes.

In terms of funds flow, “Global” Sources of Funds, US, Singaporean and Australian investors were a key origination source of funds for investment in Asia but the surprising statistic was that European investors were largely absent from the Asia Pacific region in the first six months of 2006.

The steady rise of the Asian giants
The strong increase of capital flows into global real estate can be explained partly by the strong global economic growth since 2004, but the headline is that Asia has dominated economic growth and prospects globally. The rise of China and India as well as the re-emergence of Japan after over a decade of stagnation has seen Asia achieving strong growth supported by strong export demand and, more importantly, by rising domestic consumption and intra-regional trade. China and India’s economies grew by more than 8% in 2006, supporting the rest of Asia’s growth momentum. Given their young populations, high savings, and the sheer amount of catching up they still have to do, most economists figure China and India possess the fundamentals to keep growing in the seven to eight percent range for decades. This is an unprecedented opportunity to participate in what may be the most compelling investment story in modern economic history.

The demographic effect
Both population and labour force growth are essential drivers of property markets, along with rising personal and national incomes. This is where the prospects of Asia are immensely positive as the rapid urbanization and growth of consumer base continue to gain pace in China, India and South East Asia. Population projections by the United Nations indicate that the population of Asia’s urban areas will increase by approximately 71% to 2.7 billion by 2050. This marks an increase of more than a billion people and is at least twice the estimated population of all the cities in Europe. The majority of this population growth is skewed towards India, China and South East Asia, while the more developed countries like Japan and South Korea share similar trends with Europe. Simultaneously, demographics in Asian emerging markets continue to support new development which is also likely to continue to give rise to significant real estate investment opportunities in emerging Asia.

Significant market opportunities in Asia driven by strong fundamentals
The Asian real estate markets offer the greatest scale of choices for investors, from opportunistic development in India and China, redevelopment and leasing strategies in developed economies like South Korea and Japan, all the way to core and core-plus opportunities in Singapore and Tokyo.

In the more mature economies of Japan, Korea, Hong Kong, Taiwan and Singapore, there are strong requirements for the upgrading of current stock and also good potential for the development of new real estate types. Investors seeking higher risk, and therefore higher returns, should consider some of the dynamic emerging markets like China and India, with a wide range of opportunities driven by the fast pace of economic and consumer spending growth coupled with a shortage of existing stock and the relative immaturity of domestic real estate markets. The high demand for access to these markets has seen foreign investors already starting to expand their geographic interests within India and China into secondary cities. South East Asia also presents interesting opportunities, especially in Malaysia and Singapore, driven by a maturing economic structure and rising incomes. The emergence of Vietnam and its recent entry into the World Trade Organisation and young demographic profile will also likely drive investment interest in the country.

These opportunities in Asia are widely available across the different sectors of the property market. In the office sector, there is an opportunity to take advantage of the shortage of modern stocks under strong demand. In the retail sector, there are many opportunities to develop modern shopping centers to take advantage of rising incomes and lifestyle demands. A global study of retail markets by AT Kearney in their 2006 Global Retail Development Index identified India, Vietnam and China as among the top five markets globally, with the rest of Asia also dominating rankings within the Index. Rising urbanisation and household incomes are driving strong demand for residential developments. While the logistics and warehousing sector remains a relatively immature market in Asia, but it is growing rapidly. With global production expanding steadily in Asia, there will be continuing demand for distribution facilities. The hospitality sector is being driven by strong intra-Asia tourism, providing opportunities to develop new properties and to reposition older assets.

Structural changes leading to increased transparency
The development and continued strong growth of REIT-style markets in Europe and Asia is likely to contribute to increased liquidity and transparency through disclosure requirements for listed real estate. REITs will also play a significant role as a source of new capital for real estate markets. This development of REIT-style markets is however expanding at a much faster pace in Asia, and REIT structures have already been introduced in Japan, Singapore, South Korea, Taiwan, Malaysia, and Thailand, with an estimated overall market capitalisation of over US$63 billion towards the end of 2006. Given the relatively small scale of the Asian REIT markets in absolute terms and relative to GDP, this strong pace of growth is likely to continue.

Challenges of playing in a different market
Despite the attraction of Asian real estate for European investors, there are significant challenges to be faced being a foreign investor in a relatively new market, not the least of which is managing a real estate investment strategy within the context of different cultures, languages and regulatory frameworks.

A local business
The first and most obvious difficulty lies in the complexity of navigating in markets dominated by domestic players and cosy relationships between local operators forged over a long period of time. There is no substitute for a strong local presence in the Asian countries. A lot of real estate is held within the wealthy Asian families, and these opportunities are sometimes only available through word of mouth or strong connections with industry players. Concepts like confidentiality and 45 days exclusivity to conduct due diligence are not taken very seriously at times. Asia is now a seller’s market, and while good opportunities still exists, the need to move fast and confidently becomes a severe constraint for European-based institutional investors.

Fundamental importance of research
Detailed real estate market analysis in the underwriting of potential investments can prove to be a very challenging process in Asia and investors have to source a greater amount of data in order to gain an equivalent level of understanding. The most effective way of achieving this level of understanding is to have an on-the-ground presence in the market, to carefully select local sources of information and to have it interpreted by local people who understand your specific needs. Deriving a consistent set of benchmarks for a Pan-Asian investment strategy is also a very difficult process, and real estate conventions differ widely across Asia.

Investment risks
The investment risks associated with emerging markets and established mature markets in Asia are very different. A lack of transparency, difficulty and expense in sourcing reliable market data, government bureaucracy and confusion over new regulations are just some elements of the problem. Other risks include corruption, immature financial markets and the volatility of capital flows, and political instability. Regional risks applicable to all Asian markets include the highly speculative mentality of local players, complicated strata-title ownerships in high rise buildings, and short lease terms.

Beware of tax issues and changes in regulatory structures
Manoeuvring the different tax codes in the different cities in Asia can prove to be a daunting challenge. Typically, investors will have to consider and factor in many different levels of taxation structures, which will include property tax, corporate tax, acquisition taxes for real estate investments and taxes upon exit in the form of capital gains. In addition, changes in regulatory structures can lead to sudden and unexpected changes.

Currency risk
In Europe, currency risk has decreased with the introduction of the Euro, hedging costs associated with pan-European investment. In Asia, currency risks need to be weighed, and hedging and other related costs all contribute to higher costs of investment.

Time factor
There is no doubt that Asia is now, and will be in the years to come, an exciting and rewarding place to invest.  However, the operating environment is significantly different and, unlike investing in Europe, there are more differences than similarities to be found from country to country. Nothing beats a strong local presence and experience in order to navigate around the cultural and regulatory environment. Investors wishing to invest in the region should make sure that the partners they select can provide the benefits of local market presence while also being able to meet their needs in terms of support and reporting.