Churchouse Letter
October 2009          by Peter Churchouse

Commercial Real Estate Debt; Next Shoe to Drop

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Jackboot or flip-flop! Implications for Asian Assets

Triangulating Loss Estimates in US Commercial Real Estate Lending

You have heard the word. The oracle has spoken. Mr. Bernanke has officially declared the recession is over! Capital markets being the discounting mechanisms that they are, have been telling us that for some time. But although all the technical definitional criteria may have been satisfied to declare victory, even Mr. Bernanke’s verbal body language suggests that he does not seem to be totally convinced.

Commercial Real Estate Lending Hole for US Banks. Real Estate Roundtable Evidence to Congress: Equity gap exceeds US$1 trillion in commercial real estate loans; 3.5 trillion in commercial real estate loans; average prices down 30%, average rentals down 20%. Real financing loans virtually clod. Deutsche Bank Study: 64% CMBS loans (US$401bn) not refinanceable; US$236bn CMBS loans to default in


He is certainly not alone in that, but there is also no shortage of commentators, investors and analysts out there who think economic life is headed back to normalcy in no time at all. Such proponents point to the massive stimulus that governments and central banks have poured into the global economy.

They may cite the notion that the deeper the recession, the more pronounced the recovery. And given the very much more inter-connectedness of economies, the relatively more robust economies of Asia are having at least a mildly positive impact. But many countries in Asia, contrary to popular belief in the west, are also in recession.

While it may be clear that the US economy is technically out of recession, there are still enough indicators out there that suggest that recovery is likely to be slow, or even stall altogether.

  • Unemployment pushing 10% is hardly the stuff of recoveries.
  • Home sales rebounds may have stalled, or reversed.
  • US households are saving more, which translates to consuming less.
  • Bank lending is anemic, with banks seemingly more focused on rebuilding balance sheets rather than lending.
  • What happens when the “cash for clunkers” schemes dissipate?
  • Capacity utilization rate is running at just below 70%, near a record low.
  • Corporate profits seem to have been conjured more out of cost cutting (very laudable – i.e. cutting jobs!), than by major improvements in sales or margins.

So while debate on whether the recovery is real, and what shape it may prove to be, “V”, “W”, “L” OR “U”, focus is nevertheless currently placed on the real economy and now less on the financial economy, and the banking system.

The Banking System is Saved! Glory Be…… Or is it?

The assumption seems to be that the banking system has been saved – Glory be! The sub prime mortgage crisis is winding its way through the system. The Fed has signaled a slowing of its emergency programs:

  • The Fed’s target of buying US$1.45 trillion of mortgage backed securities and debt from the banking system and other institutions is now being slowed to March next year from a target set as the end of this year.
  • The Fed is also reducing the amount of cash available under the Term Auction Facility, a facility where the Fed makes short term money available to banks.
  • The Fed is cutting back programs that allow investment companies to swap risky financial securities for safe Treasury securities.
  • The Fed is winding down a US$300 billion debt buying program that has been trying to reduce interest rates on various forms of consumer debt.

With all of this, one could be forgiven for thinking that the mortgage related financial crisis is over. I think there is good reason to question whether this is really the case and whether the banking system is really moving back into rude health. Yes, the residential mortgage problems may be easing, and although are not entirely over by any means, the quantum is now more understood and being addressed.

Commercial Real Estate Lending the Next big Apple to Drop.

Of big concern next should be the impacts of huge potential defaults in commercial real estate loans and Commercial Mortgage Backed Securities (CMBS). The scale of these potential defaults is also huge, and may send the banking system back into a tailspin. Will it be a case of the Fed/Treasury riding to the rescue yet again?

While this report focuses on Asian real estate and other hard assets, the lessons of the past couple of years lead me to try to figure if and how the impending commercial real estate mess in the US (and indeed the UK) may impact Asian real estate asset and financial markets.

Many parts of Asia are experiencing a significant uptick in real estate markets at present, following sharp declines in 2008. (See Figure 1–2) Could a meltdown in commercial real estate lending markets in the US/UK, lead to another sharp retracement in regional property markets in a way that the sub-prime crisis generated a sharp downward reaction in Asian real estate?

Let’s first try to put some dimension around the potential scale of the US “black hole” of commercial property lending. In this I will refer to a few sources in trying to “triangulate” some estimates of the potential scale of potential defaults, write-offs, write-downs in commercial real estate.

Asian Real Estate Stock Indices Performance circa October 2009

EPRA-NAREIT ASIA Property Index (UGPA:IND) from 2006-Oct 2009

Bloomberg Asia Property Index (BPRREAL:IND) from 2007-October 2009

Triangulating the Data on the Scale of Commercial Real Estate Fallout

Data Reference 1

First let’s refer to the evidence presented by Jeffrey Deboer to the US Congress Joint Economic Committee in July this year on behalf of The Real Estate Round Table.

The Roundtable represents members that collectively hold more than 5 billion sq ft of commercial real estate in developed property valued at more than $1 trillion. As an industry body, the roundtable’s evidence probably clearly presents an insider’s view, reflecting vested interests no doubt.

Commercial real estate includes offices, retail hotels, industrial, apartments and health care. Mr Deboer reports that commercial property transactions have fallen by almost 80% primarily due to non-availability of credit. His report estimates asset values have fallen by about 35% from their peak and that capitalisation rates have risen by about 250 basis points. (See Figure 3)

What this means, for example is that a property that generated say $1000 of annual net operating rental income, valued at say a 6% cap rate a couple of years ago would have been worth $16,666 ($1000/0.06) Assuming rental income today is the same, that property would now be valued on a cap rate of 8.5%, a value of $11,765, representing a decline of about 30%.

But of course, in many instances rentals have also fallen (Deboer quotes an average of 20% depending on property type). So your $1000 annual rental income is now $800. Applying the 8.5% cap rate, the property value is now $9,411, a decline of about 44%.

Moody's/REAL Commercial Property Price Index (CPPI) from 2001-October 2009

Given that a great many commercial property loans have various covenants on them, for example say that the loan to value ratio must rise to higher than say to 70%, declines of this kind of magnitude are putting a great many commercial property loans into loan covenant breaches. This has also become an issue for some real estate loans in Asia, most notably in Japan, and certainly in Australia.

Loan to value is a very central part of the real estate lending process!

Deboer estimates that commercial real estate sector in the US represents value of about $6.7 trillion, supported by about $3.5 trillion of debt, most of which is on loan terms of 10 years or less (unlike the residential mortgage market where 20 – 30 year terms are the norm). (See Figure 4–5)

Worldwide Commercial Mortgage Backed Securities (CMBS) Issuance from 1999-October 2009

US Commercial Mortgage Backed Securities (CMBS) Issuance from 1990-October 2009

Thus, each year, large chunks of commercial real estate debt need to be refinanced. According to the evidence presented the debt is from 4 main sources:

  1. Commercial banks, with about 43%, or about $1.5 trillion
  2. Commercial Mortgage Backed Securities, about $750 billion, or 22%
  3. Life insurance companies, at 9%, around $315 billion
  4. Government sponsored enterprises, at $330 billion.

The total amount of commercial property loans maturing in 2009 is estimated to lie between $300 billion and $500 billion, with about $400 billion on average maturing each year going forward. Credit markets simply do not have the capacity to refinance this debt, even if it is performing perfectly well, Deboer claims.

Add on top of this the obvious problems of loan covenant breaches through falling property values, as well as property that simply is not making payments, and it is clear that there is another very big shoe to drop in the US banking system, this time from commercial real estate loans, not residential mortgages.

In recent years the report quotes that about 83% of new commercial property loans have been funded by banks and the CMBS market. Both are effectively closed today. For example in 2007, the peak of CMBS issuance, about $230 billion was raised via this route. In 2008 that fell to $12 billion (down 95%), and up to July this year there had been no new CMBS issued.

Although the Deboer report does not specifically identify the amount of commercial real estate loans that will default, or need to be written off, the report does suggest that “preliminary conservative estimates reveal an equity gap exceeding $1 trillion over the next several years”. Some of that “equity gap” may get filled – listed real estate vehicle in the US have raised more than $16 billion in public equity markets – but it is clear, that without further major programs, several hundred billion dollars of loans may end up going south.

Commercial Real Estate:
“Property fundamentals are sliding due to weakness in the overall economy. Default and foreclosures are expected to increase due to the paralyzed credit markets. Together, the resulting value declines and debt dislocations threaten to undermine any nascent economic stabilization some believe is underway”
– Jeffrey Deboer evidence to Congress

We are left to draw our own conclusions as to the impact of these defaults on the hundreds of banks, institutions and insurance companies that own these loans in various shapes and forms.

Clearly a new and potentially huge round of financial institution failures is likely.

Data Reference 2

Let’s now turn to work undertaken at Deutsche Bank by Richard Parkus and Jing An which focuses particularly on the US CMBS market.

The two parts of their study aim to determine what proportion of CMBS loans will default at maturity, and what may default prior to maturity. Their analysis considers a severe recession scenario and a moderate recession scenario. According to this work, the relevant CMBS market is approximately $625 billion in some 54,000 loans.

Their study concludes that, under the “moderate” stress scenario, and based on forecast declines in property Net Operating Income, assumed cap rates:

  • Some 64% of CMBS loans ($401 billion) would not be re-financeable at maturity under the NOI/cap rate assumptions, without equity injections.
  • About 37% of loans – some $228 billion – would be non refinanceable at maturity and would also suffer losses.
  • About $56 billion of losses would occur in loans that default at maturity.

The big issue here is that about 64% of total CMBS loans would not be refinanceable at maturity under these conditions. That means that the value of the properties behind these loans would not support the Loan to Value (LTV) conditions of the original loan.

In simple terms, if a borrower took a 70% loan on a $10 million property, with a covenant that the LTV should not exceed say 80%, and if the property falls in value, by say 20% to $8 million, the LTV is 87.5%, and the borrower is in breach. Even if the borrower is making all the required payments. In this situation, the borrower is required to stump up with another $750,000 of equity in order to avoid breaching the loan covenant.

So what happens in such circumstances? In the current market, the CMBS market is effectively dead, so that any CMBS coming to maturity right now will not be financeable by further issuance of CMBS. There is no rollover capability. Banks are certainly not picking up the slack.


All in all the Deutsche study suggests that under a moderate stress scenario, about $236 billion of CMBS loans to commercial real estate will go into default and that total losses on these loans could be around $66 billion. For the severe stress scenario the numbers are $291 billion and $88 billion respectively.

That is the CMBS Story – What About Banks’ Exposure to Commercial Real Estate?

We need to bear in mind that this study refers only to the CMBS loans. Banks have almost 3 times as much in commercial real estate loans, about $1.7 trillion. On average commercial real estate loans amount to about 25% of total bank assets, but such loans for smaller banks account for a much higher proportion of total assets at around 39%.

Of the total bank commercial property loan book, about $550 billion is to construction and land development financings, definitely somewhat more risky than loans to completed properties. Loss severities on defaulting construction loans in the current environment are likely to be very high, as much as 75%.


Delinquencies for construction loans in bank portfolios have risen from well below 1% in 2005/06 to around 15% on average. This is certainly an extremely high number but probably way understates the true level of delinquencies in this part of the commercial loan books of banks.

Losses on land and construction loans is likely to exceed 25%, suggesting losses of around $130 billion for banks, a great deal of this in mid size and smaller regional banks.

There are good reasons to suppose that bank loans to core, completed commercial properties are more risky than loans in the CMBS programs.

  1. The rapid rise of the CMBS markets captured a great deal of the better quality loans to completed real estate, using competitive rates, forcing smaller banks in particular to take on riskier types of commercial loans.
  2. Bank loans tend to be shorter term, with the result that a great portion of loans are likely to mature in the depths of the recession.
  3. Delinquency rates on CMBS loans have been consistently lower than for core commercial real estate loans in bank portfolios.
  4. Even assuming a similar rate of loan loss for banks as for CMBS loans, would imply losses of roughly $115 – $150 billion, and yet it is likely that bank loans are ven more risky than CMBS loans.


    Putting it all together, the losses on construction and core commercial real estate loans in the banks could total up to $300 billion. Charge offs by the banks to date come nowhere near these amounts.

    So, for the CMBS loans and bank loans, total losses to lenders is likely to be in the range of $250 billion to $400 billion.

    Data Reference 3

    The Third Leg of this Triangulation of Likely Bank Losses from Commercial Real Estate.

    Now for the final leg in this assessment, if you have not totally fallen asleep yet.

    For this we refer to some work by Institutional Risk Analytics that looks at the problems looming at the Federal Deposit Insurance Corporation (FDIC). The FDIC at present has about 400 US banks on its “watch” list. IRA allocates an “F” rating, the lowest on their scale, to 2,256 banks, and project that more than 1,000 banks will either fold or be taken over in the coming cycle. (see John Maudlin, “The Hole in the FDIC”, 19 September 2009)

    About 94 banks have folded so far in 2009 – 900 or so to go??

    How much moolah is involved here?

    Well, the banks rated “F” by IRA have insured assets of about US$4.46 trillion. They also note that for banks that have failed so far in this cycle, losses are running at around 25% of assets, way higher than the 11% losses shown in previous down cycles. (See Figure 6)

    IRA Bank Assets Stress Distributions from 2006-October 2009


    “Our firm’s long-held view of the likely loss rate peak for the US banks in this credit cycle is 2X 1990 loss rates or, as noted by the IMF, around 4% of total loans. Since total loans and leases held by all FDIC- insured banks was some $7.7trillion as of Q2 2009, the IMF estimate implies a cumulative loss of over $300 billion”

    IRA’s estimates of losses are framed as follows:

    “If you start with the internal assumptions used by our firm that roughly half of the banks currently rated “F” or some 1,000 banks will fail and/or be merged with another institution and that the loss to the FDIC bank insurance will be approximately 20 – 25% of total assets, then the cost of these resolutions to the FDIC through the full credit downturn could be in excess of $400 – $500 billion.”

    This analysis includes only the “F” rated banks. Some banks rated better than “F” may also fail.

    IRA note “our overall “worst case” or maximum possible loss (“MPL”) for large US banks above $10 billion in assets is $800 billion through the current credit cycle.”

    The FDIC simply does not have sufficient reserves to cover these potential losses, and will need massive new funding from somewhere – the US taxpayer? Higher charges to banks? Additional borrowing? Probably all of the above.

    All Roads Point to $300 billion of Bank Losses to Come. Possibly $800bn. 1,000 banks to fold.

    No matter how we slice and dice the data, it seems that the likely losses to be taken by the banking system in the US from commercial real estate lending is going to run to some $300 billion, at the low end of the scale, to as much as $800 billion. These numbers are multiples of the losses experienced in the Savings and Loan crisis of the early 1990’s.

    But Looking on the Bright Side…… the Fed, Treasury and the Administration generally now has gained considerable experience in such huge bail-out numbers, and may well take this in their stride. But however it pans out, it points to the probability of further state orchestrated bailouts of real estate loans, this time commercial (and therefore perhaps politically rather less contentious) than residential mortgage loans.

    So What? Should Asia be Impervious to this US Banking Problem?

    There is much thinking in Asia that these problems should not impact Asian financial markets, lending, and real estate markets. It is easy to fall into that thinking given that the major economies of the ICI group (India, China and Indonesia) have all avoided recession, and find asset markets rebounding solidly over the past 6 months or so, real estate included. (See Figure 7–9) But most other Asian countries have sagged into recessions of their own. (See Figure 10–18)

    I continue to believe that it is somewhat dangerous to get sucked into that line of thought. Many did in the early stages of this financial crisis, and were caught off guard when credit withdrawal turned out to be a global phenomenon, and not just limited to the epicenter of the financial hurricane. Asia experienced its own credit withdrawal, perhaps not as acutely as in western markets but problems nonetheless – ask just about any Japanese or Australian property company, not to mention Chinese and Indian property companies.

    Credit markets in most parts of Asia have eased, as monetary and fiscal stimulus programs have kicked in but certainly not back to pre-crisis levels. The very important CMBS market, however, is dead. That had been an important ingredient in Japan’s rebounding property market up until late 2007. Even in Singapore, approximately 25% -30% of lending there had been via foreign banks, most of whom have left the stage.

    So while credit markets are slowly beginning to loosen in the west as fallout from the residential mortgage mess is unwinding, the concern I have is that another round of real estate related bank failures is about to be unleashed on the world financial markets, leading to another round of credit concerns.

    World thinks Asia is doing fine, but much of Asia is in recession.

    India and China's GDP growth rate circa October 2009

    Indonesia and Singapore's GDP growth rate circa October 2009

    Hong Kong and Japan's GDP growth rate circa October 2009

    Australia and Malaysia's GDP growth rate circa October 2009

    Philippine's and Thaland's GDP growth rate circa October 2009

    Taiwan and South Korea's GDP growth rate circa October 2009

    How might this all affect Asian asset markets, and real estate in particular?

    Let’s take the downside risks first.

    • While credit markets have eased in most parts of Asia, foreign banks and financial institutions are a much weaker force in lending to real estate than they have been in recent years.
    • This means that real estate lending has fallen to the local players, who in some cases have their own lending and balance sheet issues to address. So credit is still not as freely available to commercial real estate borrowers as previously.
    • Further fallout in the US commercial property markets, and a new round of bank failures will likely delay the return of foreign banks to Asian commercial real estate lending for some time. Resurrection of the CMBS markets in markets such as Japan will likely be delayed, perhaps for some years.
    • Lenders to Asian commercial real estate became much more risk averse following the onset sub-prime crisis, with most borrowers in Asia paying higher spreads for commercial real estate borrowing. This has eased back a little in recent months in some markets, but a new round of bank failures may raise risk aversion again, and a new round of higher rates for commercial real estate borrowing.
    • Risk aversion may manifest in higher capitalization rates, as is very much the case in most western markets, and as was the case in many Asian markets in the early stages of this credit cycle. Cap rates have come down again in some commercial property markets in recent months –i.e. prices have started to rise again.
    • Commercial property vacancy rates have risen in most Asian property markets as economies have softened and financial services companies in particular have cut headcount.
    • A number of governments and central banks around the region have warned of the danger of asset bubbles forming in property markets. Bearing in mind that it was excess property lending that got the world into the current mess, it is understandable that central banks and governments everywhere may be leery about allowing such asset bubbles to form again. They may be much quicker to tighten liquidity than has been the case in the past.

    And now the positive side of the story.

    • Banks in most parts of Asia are well capitalized – perhaps they never had enough time to get themselves into too much trouble after repairing damaged balance after the Asian financial crisis of the late 1990’s. Japanese banks are possibly less well positioned in this regard.
    • Loan to deposit ratios are generally low in Asia.
    • Both of these factors suggest that there should be no shortage of ability to lend in absolute terms. Willingness to lend, and at what price may be another story.
    • Commercial property prices have rebounded sharply in the past few months in some Asian markets reflecting easier credit availability, views that Asian economies are likely to rebound, and renewed investor enthusiasm for the asset class.
    • Commercial property rentals in major financial centres appear to be bottoming, in Hong Kong and Singapore, down 40% to 50% from 2008 highs.
    • Hiring intentions in financial service industries are picking up again, leading to a view that vacancies have peaked out and rental growth is just around the corner, leading to further upside in capital values.
    • Financial markets have rallied strongly, and capital raising, IPO’s M&A have all rebounded, boosting jobs, investment and demand for commercial space.
    • Singapore, Hong Kong (not to mention Geneva and Zurich) will likely prove beneficiaries of policy moves to raise taxes in the US and UK and to place ceilings on pay. Remember how all those bright young French derivative traders migrated across to London, HK and elsewhere when the French government legislated the maximum 35 hour work week! Again incremental demand for commercial space, high end housing in these jurisdictions.

    So where does this leave us?

    If I had to put money on this, (and I do!), here is what I think the likely scenario for Asian commercial real estate will unfold.

    1. The current surge in capital values of commercial property in Hong Kong and parts of China will be tempered by a modest slowdown in the pace of lending to real estate buyers generally, but no reversal seems likely. The pace of capital value appreciation that we have seen in recent months will slow, but again, no reversal, just a flattening.
    2. A new round of property lending fallout in the US will serve as a reminder to lenders, and raise risk aversion somewhat, also egged on by central bankers.
    3. Banks may raise spreads a little from what has been normal recently, and will likely favour larger, blue chip buyers.
    4. Prices have run ahead of rentals in commercial real estate, in anticipation of a recovery of the economy, space demand, lower vacancies going forward.
    5. By major market, Hong Kong commercial property will probably lead other markets in recovery. Vacancy rates are low, and new supply is modest. Rentals are showing clearer signs of a bottom than other markets, and will probably start coming off the bottom in H1 2010.
    6. Singapore commercial property will likely lag Hong Kong’s recovery simply due to the significant increase in new office supply that is due to come on stream in the coming one to two years. But again, much of the new space is already spoken for and vacancies are not going to rise disastrously. Expect a bottoming of commercial rentals in H1 2010, some recovery perhaps late 2010.
    7. Tokyo office market will likely recover slowly but vacancy rates are probably close to a peak right now, and at around 7% are hardly disastrous for the industry. Rentals in Japan tend to be sticky on the upside and the downside due to institutional factors. There is likely to be more “stressed” or “distressed” property in Japan than some other markets, and that might delay the recovery. There are companies, even now, finding it difficult to rollover credit lines or refinance existing credit positions, leading to forced sales which in turn put pressure on prices. In Japan, it is all about size and connections – the big blue chip companies are not experiencing such difficulties at all.
    8. China is where there really is some risk of significant oversupply in commercial real estate. Importantly too we find a worrying mismatch in price and rental trends in some of China’s markets. For example we see rental trends for property running flat to downward sloping curves, while capital value curves have been trending upwards. That means falling rentals yields. Rentals, in principle, reflect the REAL demand/supply balance for space from end-users. Prices sometimes reflect availability of liquidity and credit more than underlying supply/demand forces. That is the situation in China today in my view. (See Figure 19–20)
    9. Beijing Office Index from 1991-October 2009

      Shanghai Office Index circa October 2009

    10. The diverging rental/capital value curves are unsustainable – something has to give. Either rentals need to start trending upwards, something that is hard to see given the huge amounts of new space coming on stream in markets like Beijing or prices need to come down. I suspect it will be the latter.
    11. Easy credit has been abundant in China this year since the central authorities instructed the main lending banks to go out and lend aggressively at the beginning of this year, as the financial world appeared on the cusp of total meltdown in the wake of the Lehman demise. This they did with a vengeance, making some US$1.1 trillion of new loans in the first 6 months of the year, approximately twice the original target set for the whole year. The past 3 months has seen the rate of lending slow down considerably as officials and bankers have become worried about the possibility of asset bubbles and the longer term impact of much of this new lending being invested inefficiently ….. or worse!
    12. I was recently sitting on a panel of property chaps at a conference. One of the panelists runs a property fund in China. On questioning him about the lending situation in China he indicated that his bank in China had virtually foisted $250 million of lending on to him. His banking manager had a quota to fill, and essentially told my panel colleague that he had to take this new credit line, even though he had not sought out any new funding.

      Is that a quality problem, I asked myself?

      Commercial property focused stocks have been more out of favour than residential players.

      As for stocks to capture the improving prospects in the commercial real estate space, there is a good mix of both REITs and Investment property companies/developers to access the space. While pretty much all property stocks have rallied strongly in most parts of the region, there is probably still more juice left in the sector over the coming 12 – 18 months if my scenario as described above plays out. Net asset values of many companies in this space should rise, and there should be some prospect of an earnings recovery further down the track – bear in mind that 3 year leases makes for slow moving turns in rental incomes both on the upside and the downside. Some of the companies, particularly REITs have raised additional capital this year and are now unlikely to face problems with loan covenants etc that we saw above plaguing the US markets.


      My major immediate concern is less to do with the prospects of the companies themselves and the underlying real estate fundamentals in our markets, but more the effects of a general pullback in equity markets in the region given the very powerful rally that we have enjoyed since February/March.

      If one has these concerns, a smattering of higher yielding commercial property focused REITs should provide at least a little protection in the event of a broad based market pullback. However, in the debacle of equity markets last year, existence of high dividend yields was not a guarantee of share price protection at all.

      In Hong Kong, probably the purest play in commercial property is Hongkong Land (HKL:SP) (listed in Singapore). (See Figure 21) It has the largest portfolio of Grade A office in Hong Kong’s financial district, is lowly geared, very well managed, and typically pays a hefty dividend of more than 50% of net operating profit to shareholders. It also has significant exposure to Singapore’s office market and increasingly involved in China’s property markets.

      HongKongLand stock price vs Hong Kong Office Index from 1984- October 2009


      On the REIT front, Champion REIT (2778:HK) offers good exposure to good quality office and retail space, and should now face reduced risk of any needs for capital injections. Dividend yield for 2009 should be north of 7%, despite the slowdown in rentals since the onset of the financial crisis.

      In Singapore my focus is on REITs at this stage. Singapore based REITs have been at the forefront of capital raising amongst regional REITs this year, and although some dilution has been painful, these companies are now in a position to capitalize on any new accretive acquisitions over the coming year or so as property markets recover. CapitaCommercial Trust (CCT:SP) is the Singapore office focused REIT sponsored by Capitaland, Southeast Asia’s largest listed property company, a company essentially controlled by the Singapore government. Dividend yield is at the higher end of the range for Singapore at around 7.5%. Investors have marked down office focused stocks given the perceptions of significant new supply and the very well signaled fall in office rentals that has taken place in the past year or so. (See Figure 22)

      Singapore Property Index vs Singapore Office Index from 1980-October 2009


      Sister company, Capitamall Trust (CT:SP) is focused on the retail property space in Singapore, and currently sports a lower yield of around 5.6%. Investors have been comfortable that retail property values and rentals would hold up reasonably well, and hence the more expensive valuation. Singapore’s new casino industry is likely to bring in substantially more visitors, bringing potential benefits to the retail property scene.

      Similarly CapitaRetail China Trust (CRCT:SP) is focused on retail malls in China. The view is that China’s domestic consumption is going to drive through the global recession and sustain the Chinese economy. At 15% growth, it is managing to achieve just that. Again, the stock reflects a positive view of the retail/consumer space in China, trading at a yield of around 6.6% or so.

      For Japan, a simple barbell strategy for REITs could be appropriate in which holding of one or two of the very safest, but more expensive J-REITs together with one or two cheaper, higher beta names that should benefit from a gradual easing of credit conditions and the slow recovery of commercial real estate markets could provide a good risk adjusted return over the course of the coming year. (See Figure 23)

      Topix REIT Market Index from 2003-October 2009

      Two low risk candidates are Nippon Building Fund (8951:JP) and Japan Real Estate (8952:JP), sponsored by two of the titans of Japanese real estate – Mitusi Fudosan and Mitsubishi Estates. NBF performed relatively well during the 2008 downturn, largely due to its perceived lower risk, but has been a poor performer so far this year relative to the sector as higher beta names have rebounded in the slightly easier credit environment. Both will produce a dividend yield of about 4.6% to 5% this year.

      For the other side of the barbell, stocks with cheaper valuations might include Astro Japan (AJA:AU), a REIT investing in Japanese commercial properties listed in Australia that has just been divested from the Babcock and Brown stable and now taken over by its management. Shares are trading at approximately 55% discount to their net asset value (NAV) and should produce a high teens dividend yield. Kenedix Realty (8972:JP), with a portfolio of office and residential properties currently trades at a discount of more than 40% to NAV and should produce a dividend yield of about 5.5% this year.

      We cannot expect any real earnings growth in Japanese REITs in the short term as rentals for many forms of property have softened and financing costs for most have gone up, albeit very modestly for some of the larger companies.

      Company Prices, circa October 2009: Hongkong Land Holdings, CHampion REIT, CapitaCommerical Trust, CapitaMall Trust, CapitaRetail China Trust, Nippon Building Fund Inc, Japan Real Estate Investment Corp, Astro Japan Property Trust, Kenedix Realty Investment Corp.

      Property Always Goes Up! You’ve Heard That all Before…..

      I don’t know about you but I have frequently been regaled by (usually) young enthusiastic financial advisors swaning into my office trying to flog me some real estate product with the line that goes something like this “You never loose money in real estate. It always goes up” or “Real estate is the secret to wealth generation”, or “Property is the greatest hedge against inflation or just about any other disaster that might befall you”.

      Recently I had a chap was sitting there extolling the virtues of buying up streets full of new houses under construction in Perth, Western Australia – “The commodity boom tells you that this market is headed for the moon, and you need to be on the rocket ship”. “And by the way, I can set you up with Yen based financing, much lower rates you know”. The answer to the obvious question of, well what currency is any rental income in, or any future sales proceeds, was “The Aussie dollar is soaring against all other major currencies due to the commodity cycle, so you are going to GAIN on currency – not lose!” Funny that – in 2008 the Yen surged more than 40% against the A$ and any gains from lower interest rates would have been more than swamped by the loss in the currency trade. (See Figure 24–25)

      Japanese Yen vs US Dollar and Japanese Yen vs Aussie Dollar graphs, from 1998-October 2009

      This chap was still probably in diapers the last time the Aussie developers lost everything including their shirts in the late 1980’s early 1990’s on similar “carry trade” funding. Then the carry was much greater than it has been recently – then borrowing costs in Australia were approaching 18% and even higher, against say Swiss borrowing costs of around 2% – 3%. That huge spread clearly proved tempting, but even that spread mattered not a jot when the A$ collapsed against the Swiss Franc (and most other majors as well), and Aussie property markets tumbled.

      The 15% or more interest rate cushion certainly did not protect those investors and developers who were sold that particular financing story.

      My young visitor was not even vaguely aware of this history.

      Clearly property has made a lot of people very wealthy, and has provided millions of people with that retirement nest egg, that comforting cash flow. But a one way street to riches and financial nirvana it certainly ain’t!

      Even more so in Asia, where cycles have proven to be fast and furious, and extremely volatile. Timing of market entry and exit is even more important in this part of the world than has been the case historically in the west.

      The accompanying charts demonstrate this for residential and office property in Hong Kong and Singapore, markets where we have very good long term data. (See Figure 26–29)

      Hong Kong Nominal & Real Residential Index from 1984-October 2009

      Hong Kong Nominal & Real Office Index from 1984-October 2009

      Singapore Nominal & Real Residential Index from 1985-October 2009

      Singapore Nominal & Real Office Index from 1985-October 2009


      As an aside, the property markets in Hong Kong are probably the most transparent in the world. Every single property transaction is recorded almost immediately in the Government’s data bases and that information is immediately available to anyone that cares to look at it. Price discovery is excellent!

      Our data here adjusts property price indices using the Consumer Price Index. Clearly investment in real estate has proven to be a good long term investment, but only if the timing is right. For example, investment in Hong Kong residential property in 1984 close to the bottom of that particular cycle would have given the buyer about 12 times his/her money in nominal terms up to today, or about 4 times money in real terms. Add in say 70% gearing and the Return on Equity is a mouthwatering 4000% in nominal terms. That is an average for “mass” housing. Other forms of more high end housing have provided much higher returns.

      But the buyer in 1997 is still under water in nominal terms 12 years later and significantly so in real terms. It is not a nice feeling being trapped in negative equity, a condition that afflicts millions of property owners in the US right now.

      We in Asia are much more used to this kind of volatility. It must be very much more painful for people in the west who have been brought up on the wisdom that “Property always goes up”.

      A rude awakening indeed!

      Return to the Archives

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