In brief

Asia real estate stocks were hammered in 2020, as strict lockdown measures weighed on the sector. 

After a grim 2020, 2021 appears decidedly optimistic for the Asia real estate sector, buttressed by a few factors including:

1. Rebounding economic growth on the back of more effective containment of Covid-19 and the gradual rollout of vaccination campaigns across the Asia ex-Japan region
2. Robust long-term fundamental demand drivers such as rising affluence and urbanisation supporting continued development of the real estate sector
3. Pick up in investment volumes and deal activity to help drive inorganic growth
4. Higher dividend yields stoking investor demand amid the low interest rate environment and voracious appetite for income
5. Low investor expectations and undemanding valuations

While we are positive on the real estate sector in Asia, investors should still be mindful of the risks. The path to normalcy is likely to be uneven and bumpy, and the pace of the economic recovery will largely depend on how fast Covid-19 vaccinations are rolled out globally. We would thus look for real estate players with strong balance sheets and that are well-positioned to ride out this period of uncertainty. 

Investors should also mind potential shifting policy risks on the residential front, as governments may step in with property cooling measures in line with the need to keep housing affordable.

Difficult year for the real estate sector

Asia real estate stocks were hammered in 2020, as strict lockdown measures slashed hotel occupancies and starkly reduced footfalls to retail malls amid a shift to online spending. Meanwhile, companies quickly adopted digital platforms and solutions to allow workers to work remotely, reducing office occupancies as a result. This caused hardship for retail businesses that typically depended on the daily traffic of office workers for their revenue.

In addition, landlords were also on the hook as governments pressured property owners to accept haircuts on rents or forgive them outrightly and encouraged the restructuring of payments for companies suffering under the weight of the economic shutdown. It’s little wonder that the outright restriction of physical movement weighed on the sector far more than others.

Asia real estate underperformed value sectors like financials, energy and consumer discretionary and severely underperformed growth sectors like information technology and health care.

That’s not to say that performance within the sector was homogenous. Intra-sector performance was bifurcated; real estate players with significant exposure to logistics assets such as warehouses, and data centres, outperformed on the back of accelerating work-from-home and e-commerce trends, while hospitality, retail and offices languished. The residential sector also proved surprisingly resilient, buoyed by the low interest rate environment and favourable mortgage rates.

The intra-sector disparity is certainly obvious when one considers the performance of various Real Estate Investment Trusts (REITs) in Singapore. Logistics and data centre REITs like Mapletree Industrial Trust and Keppel DC REIT outshone hospitality and retail REITs like Ascott Hospitality Trust and CapitaLand Integrated Commercial Trust.

The question is: Will this underperformance persist or is there light at the end of the tunnel? After a grim 2020, 2021 appears decidedly optimistic, buttressed by more effective containment of Covid-19, gradual rollout of vaccination campaigns across the region and undemanding valuations.

Growth rebound

The current economic recovery will be determined in large part by the path of the Covid-19 virus. Governments are unlikely to abandon socially restrictive policies until and unless the virus is permanently contained. The good news is that vaccines are finally available. The challenge, however, is to ensure that the drugs are administered widely enough to generate herd immunity. This will not be a smooth process as production, infrastructure and organisational hurdles may complicate the implementation of mass vaccination programmes. Also, the emergence of new Covid-19 variants could potentially diminish the efficacy of existing vaccines, although very little evidence of this has been found. Nevertheless, we should not miss the forest for the trees – yes, there are executional risks, but the broader trend still points towards the return to some degree of normalcy this year.

As it stands, countries in the Asia Pacific region have been fairly successful in containing the spread of the virus relative to their developed market peers in Europe and the US, as evidenced by the low hump in average daily cases. Importantly, the number of Covid-19 cases have not spiralled out of control as was the case in Europe and the US late last year. And this has paid dividends for countries in Asia. China, Taiwan and Vietnam were among the few economies that avoided falling into an outright recession in 2020, in large part due to their effective containment of the virus. Meanwhile, Singapore and Hong Kong saw GDP growth resume quickly in the third quarter, although they are expected to record a contraction on a yearly basis.

We should also recognise that governments in Asia have become a lot more adept at containing the spread of the virus, often implementing targeted measures to prevent the outright disruption of economic activity. Even with the recent tightening of social restrictions in many Asian countries to combat new virus waves, mobility data has not deteriorated to the lows of March. Also, more effective containment measures, alongside improvement in global demand, have contributed to the recovery of business sentiment as evidenced by the region’s manufacturing Purchasing Managers’ Indices (PMIs). PMIs for most Asia ex-Japan economies have risen above the 50-point expansionary threshold, signalling a more positive outlook for businesses. Targeted social restrictions, alongside the rollout of massive vaccine campaigns globally, will help contain the virus and stoke global demand, thereby supporting growth in 2021.

Indeed, major economies in Asia are expected to rebound significantly this year. Growth will inevitably vary across countries in Asia, while some countries could face headwinds that test the strength and resilience of their recoveries. Nevertheless, versus other regions, Asia is broadly positioned to outperform. According to projections by the Bank of Singapore, China’s economy is expected to expand 8.1% this year, while the rest of Asia is forecasted to grow at an annual pace of 7.9%. This is higher than their global GDP growth forecast of 5.9%.

Better growth prospects should be a boon for the real estate sector. The gradual return to normalcy, aided by widespread distribution of vaccines, should increase footfall and tenant sales in shopping malls while physical occupancies in offices may rise with the gradual relaxation of social restrictions, thereby helping peripheral businesses that depend on office traffic. Meanwhile, logistics and data centres will continue to benefit from the tailwinds of higher e-commerce penetration rates and widespread adoption of technology – secular growth trends that have only accelerated with the pandemic.

The worst is certainly over for the real estate sector. Historically, earnings of cyclical sectors such as real estate have been more sensitive to economic growth. Given the positive reflationary backdrop, we expect earnings of real estate businesses to rebound. The sector is also well-placed to ride out inflation concerns, as it is traditionally seen as a good hedge against inflation.

Given that markets are generally forward looking, near-term equity prices may increasingly reflect such buoyant expectations. As the reach of vaccines improve, Covid-19 cases will recede and growth will return. Of course, prevailing uncertainties naturally mean stock price recovery may not be smooth.

Robust long-term demand drivers

Undemanding sector valuations provide an attractive opportunity for investors who are willing to look through near term turbulence to invest in a sector that has promising long-term potential. Asia real estate should benefit from robust long-term demand drivers that are underpinned by favourable demographics, rising urbanisation rates and a growing middle-class.

According to projections by the United Nations, Asia’s urbanisation rate is estimated to increase from 51.1% in 2020 to 56.7% in 2030 and 66.2% in 2050. Urbanisation rates between 2020 and 2030 is expected to be the strongest in Asia relative to other major regions, with China leading the charge. Movement restrictions to stem the spread of the virus last year was a clear setback for urbanisation. However, this obstacle should be temporary. Demand for real estate in major metropolitan cities will continue to rise as border and migration restrictions ease amid the return of economic normalcy on the back of widespread inoculation.

Notwithstanding the transient effects of Covid-19, megacities in Asia are expected to grow and develop over time, and potentially rank among the most dynamic cities in the world. By one estimate, Jones Lang Lasalle – a real estate consultancy – predicts Asia will be home to nine of the top 15 global income-producing metropolitan cities by 2025. With the region expected to house 64% of the global middle-class population by 2030, the growth and development of the real estate sector is certainly one to watch in the years to come.

A nuanced view of various real estate sub-sectors

Understandably, investors are concerned about the structural implications of Covid-19 on the real estate sector. Perhaps, it is best to analyse its effects on a sub-sector basis.

As mentioned earlier, Covid-19 has mostly accelerated work-from-home and e-commerce trends, impacting the demand for office space and brick-and-mortar retail. On the surface, these trends appear unambiguously negative for these real estate sub-sectors. But there are finer points to consider.

First, on offices, the cacophony of business leaders openly questioning the wisdom, productivity and sustainability of a pure work-from-home model indicates that there is still a future for offices. Essentially, its function is being reimagined in this post pandemic era. Companies will likely retain hybrid working models adopted during the pandemic whilst also rethinking workplace design and configurations to adapt to a changing work environment. This may well reduce demand for office space but will not eliminate it altogether.

While some companies may seek smaller physical spaces, others may choose to expand. After all, the impact of the pandemic was not symmetric across all businesses. For instance, technology, non-bank financial (i.e. asset managers and family offices) and health care sectors emerged largely unscathed from the pandemic. In fact, many of these office-based businesses grew during the crisis and may seek to expand operations in Asia, which could in turn support leasing demand.

Singapore, for example, remains a popular first choice for Chinese tech giants seeking a springboard to expand internationally. Alibaba-backed Ant Group, China’s second-largest brokerage Haitong Securities, Huawei’s cloud division and Tencent-backed digital bank WeBank have all indicated interest in establishing headquarters in Singapore. The entry and future expansion of these Chinese technology giants may serve to alleviate some pressure from the consolidation of office spaces by other companies.

Investors should also bear in mind that the structural shift to high skilled, service-based, tertiary industries in Asia ex-Japan could buoy office demand over the longer term as well. Asia is often regarded as the world’s manufacturing centre, and services typically account for a smaller fraction of the overall GDP pie. Therefore, it follows that there is significant room for the services sector to expand as economies climb the development ladder. This would invariably support demand for office space over the long term.

Second, e-commerce does not necessarily spell doom for brick-and-mortar retail, although it is a clear headwind. For example, neighbourhood or suburban malls which are located close to local residential catchments may still enjoy an edge over e-commerce for their sheer convenience. Human beings are fundamentally social creatures and the relaxation of lockdown and mobility restrictions in the second half of 2020 has proven as much, as we saw throngs of people gather in malls, seeking human interaction.

Nevertheless, a fundamental shift in shopping behaviour is indeed a challenge for physical retailers, and many will have to implement innovative omni-channel strategies to enhance overall consumer experience in order to be relevant. Inevitably, some will win, and others will lose. Staying selective and judicious in this subsector will be key, as the recovery of retail is contingent on the speed in recovery of domestic consumption and the easing of social restrictions.

Real estate sub-sectors such as industrial, data centres and logistical/storage properties have mostly stayed resilient in the face of economic pressures. These sub-sectors are expected to continue to perform relatively well due to structural demand tailwinds such as the accelerated adoption of e-commerce and cloud computing. For instance, the shift to omni-channel retail and the growth of on-demand delivery may stoke demand for storage space that could be turned into urban fulfilment centres near major residential neighbourhoods. In addition, the data centre market, in recognised technology hubs like Singapore, will continue to benefit from healthy demand dynamics as businesses rapidly embrace digital technology and the use of big data.

Supply chain disruptions due to the pandemic have also triggered a review of potential production vulnerabilities. To guard against such disruptions and build up resilience of supply chains, companies are increasingly considering a “China plus one” strategy, in which China remains the main supply source or consumer market, but certain operations are located elsewhere. Spreading operations across several markets ensures producers are less vulnerable to disruptions in any individual market, although doing so may incur higher costs and inefficiencies – a small price to pay to improve overall resilience. Southeast Asia is a likely beneficiary of such investment flows on account of its proximity to China, a burgeoning consumer market and still attractive labour costs. This will likely translate into higher demand for logistics-related real estate.

As stated earlier, residential real estate is another sub-sector in Asia that has remained remarkably resilient to the impact of Covid-19. Closer to home, prices of private residential properties in Singapore rose by 2.2% in 2020 despite the 5.8% contraction in real GDP, according to the Urban Redevelopment Authority. In China, overall residential transaction value jumped 10.8% in 2020 from a year ago to RMB15.5 trillion, driven by both volume and price increases. The surge in transaction value came despite the closure of show flats and delays in construction due to the Covid-19 outbreak in early 2020, signalling that consumer demand for residential real estate stayed healthy, and in fact grew despite the economic shock. Declining mortgage rates in view of the lower for longer interest rate environment generally underpins the growth in demand for residential real estate.

Meanwhile, enlivened investor interest in growth sectors like technology, health sciences and genomics research will generate demand for facilities that support such activities including science or business parks, opening the doors for more investment flows to this side of the world. Indeed, the adjustment to a new normal in the post pandemic phase of the current economic recovery opens up plenty of opportunities for businesses to reinvent, reimagine, reconfigure the use of spaces and physical assets. Such value-added enhancements will drive investment activity in the sector.

Flow of investments and deal activity expected to pick up this year

Unsurprisingly, the pace of investment activity and deal flow in the Asia ex-Japan real estate sector is expected to pick up in 2021. These took a severe hit last year as countries imposed severe lockdown measures to contain the spread of Covid-19. The economic shock further heightened operational uncertainty. While uncertainty still remains, it has certainly ebbed from the peak of last year as vaccines have been discovered. The potential relaxation of border and social restrictions on the back of widespread inoculation, in addition to ample liquidity and buoyant risk sentiment, should provide a constructive backdrop for the return of investment activities and deal flows.

The resumption of sales and acquisitions of properties will help drive inorganic growth in the sector. As it stands, Jones Lang LaSalle expects real estate investment volumes in the Asia-Pacific region to increase between 15 to 20% in 2021, with hotel, retail and office investments expected to pick up in tandem with the economic recovery and adjustment to a new normal.

Undemanding valuations and higher yield

As mentioned earlier, Asia ex-Japan real estate stocks are still trading at undemanding levels. From a 12-month forward price-to-earnings (P/E) perspective, the MSCI Asia ex-Japan Real Estate Index is trading near its trough. In addition, its current 0.8x forward price-to-book (P/B) ratio is one standard deviation below its past 10-year average, which is attractive in our view.

Valuations suggest that investor expectations are low as earnings have been downgraded for the most part in 2020 to account for the adverse impact of the Covid-19 shock. This sets a pretty low bar for earnings expectations in 2021 and leaves plenty of room for potential positive surprises, which could buoy stock prices.

In addition, the rotation from growth to value stocks may benefit the sector as investors grow increasingly uneasy about unreasonably steep valuations in certain sectors of the equity markets, including technology and health care, and continue to search for value plays that ride on the economic recovery or reflation theme.

At the same time, Asia ex-Japan real estate stocks offer higher dividend yields relative to peers in the US and Europe, and relative to the broader MSCI Asia ex-Japan Index. The forward dividend yield spread between the MSCI Asia ex-Japan Real Estate Index and MSCI Asia ex-Japan Index has widened to about 315 basis points, which is significantly above the past 10-year average of 81 basis points.

The potential to earn higher yield in the Asia ex-Japan real estate sector is certainly attractive when one considers the alternative. Even with the recent spike in the yield of the 10-year US Treasury benchmark, real yields – inflation-adjusted yields – remain negative. At the same time, the stock of negative yielding bonds has exploded during this pandemic-driven crisis.

Indeed, in the era of lower for longer interest rates, asset classes that are able to provide attractive income are few and far between. With interest rates expected to remain wedged at near crisis lows, the hunt for yield will remain a strong structural driver for markets. In view of the sector’s attractive dividend yield, Asia ex-Japan real estate equities are poised to benefit from this hunt.

Nevertheless, investors should still note that dividends are not sacrosanct. A bottom-up stock picking strategy that evaluates the longer-term sustainability of dividend payments should be a key consideration when investing in real estate stocks.

Beware the policy headwinds but focus on the long game

While we are broadly positive on the real estate sector in Asia, there are key risks to consider. First, the path to normalcy is likely to be uneven and bumpy, and the pace of the economic recovery largely hinges on how fast Covid-19 vaccinations are administered globally. Covid-19 variants that have emerged in different parts of the world may complicate inoculation efforts. To mitigate such risks, we would look for real estate players with strong balance sheets and that are well-positioned to ride out this period of uncertainty.

Second, investors should also be mindful of shifting policy risks on the residential front, as governments may step in with property cooling measures in line with the need to keep housing affordable. In Singapore, macroprudential policies have been in place for several years to ensure that the appreciation in home prices is kept in line with economic fundamentals.

Of recent concern is the “three red lines” financing rule announced by the Chinese government in August last year, in addition to other restrictions on real estate related loans including mortgages. This is in line with the government’s recent warning that “housing is for living in, and not for speculation”.

On the surface, it has obvious adverse implications on property developers, essentially preventing them from piling on excessive debt. For now, the scheme affects a select number property developers. If implemented broadly, it will likely trigger a wave of credit re-rating among Chinese property developers and stoke concerns of potential defaults of companies that are restricted from growing debt.

Understandably, near-term sentiment has been gravely impacted. But we must consider the long-term benefits of such a forced deleveraging exercise. Placing controls on the degree of leverage to prevent the potential build-up of financial imbalances – or bubbles – in a systemically important sector such as real estate will invariably cause some near-term pain in exchange for long-term stability. The housing bubble in the US that precipitated the Global Financial Crisis in 2008-2009 is a cautionary tale about the dangers of allowing financial imbalances build until it becomes too late. Where leverage is concerned, prevention certainly is much less painful and costly than a cure. Over the long-term, this will provide a more stable foundation for growth in the sector.

While such perceived “bad news” has received an inordinate amount of attention, other good news has mostly fallen by the wayside. In particular, China’s Ministry of Housing and Urban-Rural Development had recently announced key initiatives to assist in the growth of property management businesses, including encouraging mergers and acquisitions within this market segment, strengthening adoption of smart property management services and enhancing property management fee pricing mechanisms, such as fees being indexed to inflation or service quality. These broad policy strokes should support the property management segment over the longer term.

It also underscores the fact that the Chinese government favours a more targeted approach when dealing with the real estate sector, as opposed to blanket measures. Investing in property management companies is another way to gain exposure to the long-term growth story of the Chinese real estate sector. This segment of the market also tends to be more resilient versus property developers, given that the former is relatively more recession proof and asset light. To be clear, the real estate sector is broad and property developers are just one aspect of the market. There are plenty of opportunities to consider, from REITs to property management companies. It’s akin to a house with many doors – there are many ways to get in.