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The Institutional Real Estate Newsletter - Asia Pacific

When Published, San Ramon

Core Matters

Jan 18, 2012
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Large Institutional Investors Are Focusing Again on Core Real Estate

By Mard Naman

In the run-up to the financial crisis, many large investors concentrated more on the value-added and opportunistic parts of their portfolios. But that has changed. As core real estate reassumes its traditional prominent place among large institutional investors, competition for properties has increased, leading to very high prices and very low cap rates in some major gateway cities. As investors search for safety and value, will the developing Asia Pacific core market soon have a place in more of their portfolios?

The current craving for more safety and less risk certainly makes sense. After licking their wounds in the aftermath of the global financial crisis, and in light of continuing economic uncertainty worldwide, many large institutional investors have been shifting from riskier, opportunistic plays to stable, income-producing core properties. In their search for safety, these investors are getting back to basics and focusing on the fundamentals of real estate investing.

“It’s on point to say the recent trend has been more toward core on the part of the large investors,” says Anthony Frammartino, a partner with consulting firm The Townsend Group.

This includes putting into play some of the lessons learned since the financial crisis began. Niel Thassim, managing director, head of real estate, Asia Pacific, for RREEF, cites three important lessons: First, avoid over-leverage. “If you need to over-lever to make a deal work, it’s not a good deal,” he says. Second, when underwriting deals, don’t only model an upside and base case, but genuinely work through how asset management plans will change under various situations. In other words, plan for worst-case scenarios. And finally, “stable, long-term income streams on good assets with good-quality tenants will always perform better in volatile and uncertain markets.”

Graeme Torre, managing director for Invesco Real Estate Asia, concurs that important lessons include the more judicious use of leverage — both the amount and the type — and that income can be considered an attractive source of returns, especially when coming from a low base in markets with good rental growth potential.

These lessons have led many large investors to increase their focus on core real estate. For example, the United States’ US$146 billion California State Teachers’ Retirement System (CalSTRS) lost 43 percent in the value of its real estate investments in the 2008–2009 fiscal year. CalSTRS has since upped its target percentage for core investments from 30 percent to 50 percent, while reducing opportunistic investments from 50 percent down to 30 percent. In addition, in 2011 the US$223 billion California Public Employees’ Retirement System (CalPERS), the United States’ largest pension fund, announced a five-year “back to basics” strategic plan that stated it would focus its US$16 billion real estate program on income-generating properties, restraints on risk and debt, and separate accounts with partners. The plan calls for investing at least 75 percent of the portfolio in core properties, mainly in U.S. retail, office, industrial and multifamily housing.

In a memo in 2011 to the CalPERS investment committee from Pension Consulting Alliance (PCA), the consulting firm explained the move back to core, stating, “the losses suffered in real estate were primarily driven by: a) vintage-year concentration and b) investment focus on noncore assets with high amounts of leverage.” While acknowledging the cyclical nature of real estate, PCA also believed that “with proper oversight and active risk management, a moderately levered core-oriented portfolio will better insulate CalPERS from such severe losses in the future.”

Of course, the extent to which investors move toward core depends on their mandates and portfolio construction, but RREEF’s Thassim notes that “we are seeing a noticeable ‘barbell effect,’ where there is either a strong preference for genuine core strategies or a preference for opportunistic, distressed strategies. We are seeing much less interest for the value-add and core-plus strategies in-between.”

Regardless of specific strategy, there is a much greater awareness of risk. “In the excitement of the bull market, investors began to pursue returns without properly adjusting for risk,” says Merrit Maddux, managing director, Asia, for Forum Partners in Hong Kong. “Investors’ shift toward core assets is really an attempt to rein in risk.”


When most institutional investors think of core, they think of the United States or Western Europe, and not Asia Pacific, except perhaps Japan and Australia. That is certainly true of CalPERS and CalSTRS, which invest almost exclusively in U.S. core assets. But that thinking may be slowly starting to change. According to a recent report commissioned by the Asia Pacific Real Estate Association (APREA), Asian real estate offers better relative returns than U.S. and European markets.

“Asia is not just about the opportunistic space — there are quality products available,” says Graeme Newell, the report’s author and a professor of property investment at the University of Western Sydney. The APREA report cites the availability of core, value-add and opportunistic funds, as well as the increased use of separate accounts and club deals by larger institutional investors. And according to Newell, both REITs and direct real estate in the Asia Pacific region have important roles in providing exposure to high-quality real estate. There are now REITs in seven Asian countries.

That being said, the core market is really still in its infancy. In fact, according to data collected and tracked by Institutional Real Estate, Inc., of the 256 core and core-plus funds in the global investment marketplace, only 17 are targeting Asia. By contrast, 142 funds are targeting European markets, and 71 are targeting the United States.

Invesco Real Estate’s Torre believes there are three primary reasons investors are starting to change how they think about core in the Asia Pacific region. The first is the sheer amount of institutional-grade property now available. Ten years ago, only a few markets had buildings that would be suitable for occupancy by foreign companies or that even could be considered institutional. “A decade ago, the share of the global institutional investable market for real estate in situated Asia amounted to only about 15 percent,” notes Torre.

Furthermore, getting access to those assets was very difficult because many of the best assets were tightly held by local development and property companies. Until Japanese REITs were introduced in 2001, the most common way for foreign money to enter the market was through development and opportunistic-style investing. “All the risks involved in that style of investing usually added up to relatively high required returns for anyone prepared to invest in this part of the world,” says Torre.

Today, Asia is estimated to be more than 30 percent of the global market of institutional properties, says Torre.. It has essentially doubled. “All of a sudden, you can’t ignore it,” he says. “If you have a global mandate, Asia is now one-third of your investment universe, and with its low correlation to the other regions, there is a clear case for allocating real estate capital to this part of the world. With the region representing such a substantial piece of the global market, it would be unwise to invest solely in the opportunistic category; you’ve got to find something that on a risk-adjusted basis balances the high-risk/high-return approach that has been adopted by most foreign investors to date.”

The second reason for greater interest in Asian core real estate is that the level of expertise available to a foreign investor is now far greater, so the management and execution risk is lower. “One of the reasons Asia used to get a 20 percent required return tag was because of the risk, and in real estate, risks can be measured in both qualitative and quantitative terms,” explains Torre.

There are many things that create the perception of greater risk in real estate: execution risk, government intervention, partner risk, currency risk, availability of data and the distance from one’s home territory. Many investors still consider political and currency risk to be high in Asia Pacific, but that doesn’t make the region unique today.

However, Torre believes that many of the risk factors have changed dramatically for the better during the past 12 years. He points to a whole new set of fund managers throughout Asia Pacific that did not exist before. That’s spurred the growth of the advisory sector — lawyers, accountants and tax advisers — who understand the needs of foreign investors.

And he says there’s a far more receptive banking community now, one that has experience of and confidence in lending to foreigners and funds. A decade ago, they’d prefer to lend to local development companies, and this was reflected in the terms offered. “The whole industry has grown,” says Torre. “There’s a greater ability to manage money, a greater degree of transparency. Foreign investors can place money here and have a choice of managers. And those managers are supplied with good advisers and experienced staff that have been through a cycle or two.”

The third reason investors are looking more toward core in Asia is that “we’ve now been through the advent of the REIT cycle,” says Torre. Many development companies have given up ownership of their properties and put them into REITs, so these assets have been traded and subject to very transparent, open market valuations. (However, some markets, such as China, are still waiting for REITs.)

The Asia Pacific region also has been through a couple of development cycles, so more stock has been built. “A lot of that stock has been bought by funds and is now traded, whereas before it was very rare that you could get a local developer to build a landmark building and sell it,” notes Torre. “They’d just keep it.” There is, in other words, a greater stock of assets that is more widely held by organizations other than traditional Asian property players, and, therefore, there exists a deeper market for trading core assets in the region.

There is also now a greater appreciation of the benefits of investing in real estate for income rather than just capital gain. “Investors now see that the Asian markets have matured sufficiently to provide good-quality income streams,” says Torre. “They really are looking to extract longer-term, more stable returns from Asia, accompanied by lower risk, of course.”

He adds, “The benefits of diversification and access to the growth story of the Asian region are compelling. Core assets offer a lower-risk alternative to the previous convention of investing for opportunistic returns, yet there is still the backdrop of growth. In other words, the region now offers a lower risk approach to the Asian growth story.”


Torre says European investors appear to be ahead of U.S. investors in thinking about Asian core, and that many European investors have a relatively low required return for this style of investing. In the past, the risk premium for coming out to Asia was substantial. But now, many understand the risk because they’ve been investing in Asia for a while. “They can also see there’s a far greater supply of professionals managing money here,” he explains. “And there’s an alignment of the available returns in the various markets and the required returns for these institutions.”

U.S. investors, on the other hand, are still looking primarily domestically for core and to Asia Pacific for opportunistic and value-added investments, says Torre, although this trend appears to be changing.

RREEF’s Thassim adds that U.S. investors are slowly starting to recognize the value of core assets in the Asia Pacific region, given the sustained growth story, improving transparency and lower correlations with their home markets. However, there is still a cautious home bias, and so this trend is moving very slowly.

While U.S. investors may not all be looking to Asia Pacific to buy core, there is a trend of Asia Pacific investors looking to the United States and Europe to buy core. “We are seeing a lot of that,” says Torre. “We have managed money for several large Asian institutions into core investments in Europe and the U.S., and into the global REIT market as well.”

Thassim agrees that Asia Pacific investors are definitely looking at and buying core assets in the United States and Europe, given the size, liquidity and transparency of those markets. For example, South Korea’s National Pension Service, the second largest pension fund in Asia, has purchased large core assets in London, Berlin and Paris. And other South Korean institutional investors have purchased core office assets in U.S. markets such as San Francisco.


In Japan, Torre sees mispriced opportunities to buy core because there are a fair number of forced sellers. But in Australia, the institutional-quality assets are widely held by REITs, so finding a mispriced opportunity in Australia is virtually impossible because of its transparency.

Of the product that is available in Australia, Thassim still sees buying opportunities for good-quality core assets with strong rental growth prospects. He says domestic competition for these products is limited, given the current trading position of A-REITs and balance-sheet issues with domestic products. However, he is seeing increasing competition from foreign investors seeking strong yields and good-quality structured leases.

Torre thinks Japan has stabilized, and sees rental growth there. Notwithstanding the tragic human story, Torre calls the rebuilding taking place in the aftermath of the tsunami and nuclear disasters, “Japan’s old-style of pump-priming the economy and creating jobs. We think the prognosis there is positive.”

Thassim also likes Japan. He says there is still some good spreads in Japan, given the low rates of Japanese government bonds and property yield spreads of 3.5 percent to 4.5 percent for core real estate in Tokyo and Osaka. “We expect more recovery activity. Rents appear to be bottoming out, suggesting that a turnaround is not too far away,” he notes.

South Korea has an oversupply of office, but Torre says that is an opportunity to buy. “The cap rates are softening; if you can find vendors who have to sell, it’s a good time to buy Korean office,” he says. “You have to take a relatively long-term view, maybe three to five years to get maximum growth from the market.”

Thassim agrees. “We like Seoul, given the economic growth fundamentals, low volatility and general move into more financial services and service industries, in addition to its traditional manufacturing base,” he says. “The continual expansion of its three city centers will further enhance the liquidity and size of this core opportunity.”

In China, Thassim expects the gateway cities of Beijing and Shanghai, as well as certain second-tier cities, to demonstrate some core traits. “As their respective real estate markets continue to grow and develop along more institutionalized exit strategies, there is a strong likelihood that these markets can become more stable, especially when some of their core industries, including their financial markets, become more open,” he notes.

Torre says one of the appeals of the core investing strategy is “you can today pick up acceptable base yields in markets which have rental growth.” He believes retail and office rental growth in China remains a very strong story, even though expectations for GDP growth in China have recently been downgraded. The retail sector in China is largely driven by the growth of domestic corporations and the growing wealth of the middle class. In fact, Torre says the retail story is strong for the entire region, in no small part, helped by mainland Chinese tourists. “Luxury good taxation is lower everywhere than China,” observes Torre. “So you’ll find hordes of Chinese shoppers in Seoul, Hong Kong, Sing-apore and Tokyo. It has a tangible effect.”

Thassim notes that in recent years some investors have started to view Sing-apore more as a core market, given its very active REIT market, which has improved transparency and liquidity. But Sing-apore’s real estate market still suffers from very short boom/bust cycles, given its very open and exposed economy. However, Thassim believes the government is actively addressing this issue by expanding more industries, including finance, wealth management and the gaming sector, making Sing-apore less dependent on trade.


The search for safety can take many forms beyond traditional core. And the current focus on core is seen by some as part of the cyclical nature of real estate investing. The pendulum has swung to core for now, but it will be swinging back. Townsend’s Frammartino believes it’s a short-term trend.

“Where investors are focusing the weight of their capital is a result of what happened in the recent past, and it’s a bit of an over-reaction,” explains Frammartino. “Most expectations for core have lower growth assumptions priced in. It’s definitely attractive relative to fixed income, and may be uncertain relative to equities, but I think you are looking at a more temporary trend. If you’re a long-term, large investor, you’re never going to abandon core. It’s going to be 50 percent or so of your portfolio. But there’s only so much core, and investors are going to be stretched for yields and returns. So that leads me to believe that the focus on noncore will increase necessarily,” Frammartino adds. v

Mard Naman is a freelance writer based in Santa Cruz, Calif., USA.