Asia Pacific real estate market update

China’s reopening and the perception that interest rates are near their peak have brightened economic prospects in APAC. Even so, commercial real estate investment in Q1 fell to its lowest quarterly level since 2010. The office sector is still under pressure, partly due to high supply. Retail and hospitality should benefit in 2023 from higher consumption and the return of tourism. Secular growth trends are still driving logistics, but the sector faces oversupply in certain markets. Investors are paying attention to alternative asset types, but these will show uneven volume growth. Property yields are rising, and are starting to approach effective debt costs, but it will take time for market sentiment to recover.

Economic outlook slightly brighter, peak in interest rates may be in sight

Mainland China’s relaxation of its zero-Covid-19 policy and the reopening of its borders have accelerated recovery prospects in APAC’s largest market (about 45% of regional GDP). Led by domestic services, the Chinese economy experienced a strong rebound in Q1 2023, notably in March. Economic data for April were much more mixed, but it still seems reasonable to expect real GDP growth in a range of 5%-7% in 2023; Schroders has just raised its forecast to 6.5%. China should help pull up the rest of APAC, if not to the same extent as after the Global Financial Crisis (GFC) or during the initial “post-Covid 19” rebound of 2021, and no major APAC market is expected to see negative growth in 2023.

Policy interest rates have jumped over the past year in many APAC markets (though not in China and Japan). However, there is growing evidence that global inflationary pressures are moderating. Further, there is now a perception – which  Schroders shares – that US interest rates are nearing their peak as recession risks increase. In combination, these factors should ease the pressure on APAC central banks to hold interest rates high. Interest rates in APAC should therefore also be near their peak, and many economists expect rates to decline over 2024. In China, where inflation is very subdued, interest rates are expected to stay stable or even fall further in 2023. Japan is a possible wild card. The dominant view is that Kazuo Ueda, the new governor of the Bank of Japan, will maintain the country’s zero interest rate policy for some time. There is a minority view that rising inflation in Japan will lead to rapid normalisation of monetary policy.

Higher interest rates have made bank financing harder to obtain. Consequently, commercial real estate investment transactions across APAC fell 50% YOY in Q1, to USD27.1 billion, the lowest quarterly level since 2010. The only markets to show higher volumes were Hong Kong (+15% YOY) and Singapore (+40% YOY). In Hong Kong’s case, the growth was very superficial, being boosted by large distressed asset deals. In Singapore’s case, the increase reflected three large deals in the retail sector. Despite a fall in volumes of over 40% YOY, Japan was the only major market where the deal pipeline grew rather than shrank in Q1.¹

Office sector: most markets favour tenants, important challenges remain

China’s economic recovery should drive a pick-up in office leasing demand across APAC in 2023, but to a lesser extent than after the GFC. Besides Australia, office markets in developed APAC have been less affected by home working than most western markets. However, many cities are experiencing high near-term supply, including Shanghai and Beijing (where vacancy rates stand at about 18%) and Hong Kong (about 15%). Increased supply has also impacted Tokyo, although combined vacancy for Grade A and Grade B offices is much lower at 5%. High vacancy levels have weighed on rent growth, which remains negative in various markets including Hong Kong.

The biggest exception is Seoul, where office vacancy rates in popular districts are in the low single digit per cent range. Net effective rents grew about 17% in Seoul over 2022, and the growth rate accelerated to about 23% YOY or 5% QOQ in Q1. Another market which still favours landlords is Singapore. While new leasing demand has weakened due to pressures on multinational technology and banking occupiers, the outlook for new supply is modest and vacancy should stay low. Average rents ought to rise 1%-2% over the year, and rise at a faster rate in 2024.

Investment transactions in the APAC office sector fell 53% YOY in Q1 2023 to USD10.5 billion. It is hard to point to bright spots in the market. Singapore was APAC’s top city by investment volume in Q1, but office transactions here fell over 80% YOY in Q1; the sale of Robinson Point for SGD400 million was the only sizable deal. Cap rates for prime-grade Singapore office assets stood in a range of 3.2%-3.8% in Q1, little changed from Q4 2022. This range seems too low to attract much buying interest, whereas present owners of office assets continue to demand full prices. Office deals also fell sharply in Seoul, despite APAC’s highest rent growth. In Japan, much evidence suggests that offices are declining in popularity as investment targets, whereas multifamily apartments and hotels are increasing. This trend should persist.

Looking forward, sustainability poses an additional challenge to the office sector. Unlike the EU and the UK, most APAC markets have not set deadlines for buildings to meet energy efficiency targets. That said, large corporate occupiers will increasingly demand green buildings as they adopt sustainability targets themselves, and older or lower-grade offices will face obsolescence risk, notably outside central business districts (CBDs). Occupiers place particular attention on sustainability in Australia, Singapore and South Korea. In Japan, 70% of people work for SMEs, which are less likely to have long-run ESG targets than big multinational groups. However, Japanese cities also have high stock of Grade B and Grade C offices, as well as high average building age. A high proportion of these buildings will require renovation in coming years.

Retail sector: rebounding consumption and return of tourism provide support

Retail real estate yields have reached high levels after years of pressure on the sector. However, the sector as a whole has almost certainly passed the bottom. Rebounding consumption and returning tourism drove retail sales growth of 5%-8% YOY in most markets over Q1. Hong Kong posted far higher growth, of 24% YOY in Q1 and 41% YOY in March. March retail sales in Hong Kong were still down 16% versus March 2019, but the trend is moving in the right direction. Higher retail sales will not automatically feed through into higher rents for retail real estate. Even so, it is reasonable to expect retail rents to pick up in Hong Kong and Singapore in particular over 2023 after years of weakness.

Another city likely to see a recovery in prime retail this year is Shanghai. Leasing demand from food and beverages and fashion occupiers was firm in Q1, and the expected delivery of about 235,000 sq metres of new supply should revitalise the commercial appeal of non-prime areas including Qiantan and Suzhou Riverside. The citywide vacancy rate will therefore probably be little changed from the current 8% by the year-end, while rents may rise 1%-2%. Conversely, prime/CBD retail is less likely to recover in Australia. While there should be some boost from recovering tourism in Sydney and Melbourne, retail sales growth of about 6% in Q1 was close to zero in real terms (i.e., after adjusting for high inflation), and domestic consumption growth is weaker than in many other APAC markets.

Although prime retail will bounce back faster in the near term in most APAC markets, from an investment perspective neighbourhood retail generally still looks more attractive. Often anchored by a supermarket, neighbourhood malls usually have high exposure to necessity retail, notably food, for which demand is stable and inelastic; they also have rising exposure to semi-retail services such as doctors’ surgeries, beauty clinics and education providers. In Australia, these defensive features have ensured that neighbourhood shopping malls still trade on tight yields, but cap rate expansion looks likely for larger regional and sub-regional malls with higher exposure to discretionary retail categories.

By transaction volume, the retail sector outperformed most others in APAC in Q1 with a more modest fall of 29% YOY, to USD7.1 billion. Singapore was the most active city with four large deals. Link REIT bought Jurong Point and Thomson Plaza from Mercatus for SGD2.2 billion in total, while Frasers Property and Frasers Centrepoint Trust acquired a 50% stake in NEX for SGD653 million and an additional 10% stake in Waterway Point from Sekisui House. All four malls were traded at yields of 4.5%-5.5%.² Institutional investment in the Hong Kong retail sector also improved over Q1, and excluding distressed asset deals it was the most active sector. Notable shopping centre transactions included the sale of Concord Square in Tsuen Wan for HKD1.0 billion and of West 9 Zone Kids Mall in Tai Kok Tsui for HKD0.75 billion.

Hospitality sector: similar trends to retail, and maybe rebounding faster

The generally positive trends in APAC retail real estate were mirrored in the hospitality sector. Inbound tourism looks set to resurge in APAC over 2023, but the best-placed markets from an investment perspective also enjoy firm domestic travel demand. This applies especially to Japan, but also to South Korea and Australia. Indications from across APAC suggest that, in aggregate, hotel occupancy, ADRs (average room rates) and RevPAR (revenue per available room) in March 2023 were roughly equal to the level of March 2019. A strong recovery in hospitality has therefore already taken place. So far, a sharp rebound in Mainland Chinese inbound tourists has not been evident except in Hong Kong (where there was a very strong influx of tourists over the Golden Week holidays in early May). However, we expect to see such a rebound over the remainder of 2023. Prior to Covid-19, Chinese tourists made up the largest segment of inbound visitors in most important APAC markets.

Total investment volume in hotels fell 56% YOY in Q1, to USD2.5 billion. However, one market which has remained active is Japan. Foreign fund managers invested JPY232 billion (USD1.7 billion) in the Japanese hospitality sector over the 12 months ending in Q1 2023, although domestic investors were less enthusiastic. Large reported deals involving foreign capital in Q1 included the purchase of the Righa Royal Hotel Osaka for at least JPY50 billion (USD366 million) and the purchase of the 746-room luxury Hyatt Regency hotel in Tokyo’s Shinjuku Ward for an undisclosed sum.³

Industrial and logistics: still benefiting from secular growth trends, but risks rising

Key drivers of growth in the logistics sector remain growth in e-commerce and diversification of industrial production and supply chains outside China. In several markets, e-commerce has fallen as a proportion of total retail sales from the high levels seen during Covid-19, but only because physical retail has rebounded from abnormally depressed levels; e-commerce has not stopped growing. The shift in industrial activity beyond China is likewise a long-term trend. The market which has benefited the most so far is probably Vietnam. However, there is increasing evidence of advanced manufacturing operations shifting to India, or shifting back to East Asian locations like Taiwan and Japan.

Among the major APAC markets, Japan in particular is undersupplied with modern logistics warehouses. This is most true in the regional cities; in contrast, there are pockets of oversupply in Greater Tokyo. In South Korea, Greater Seoul has a severe oversupply problem, notably in the cold storage segment and in submarkets on the west side, where vacancy can reach 20%. It could take four to five years for this excess supply to be absorbed. Australia has seen the strongest demand for prime logistics space: Sydney and Melbourne warehouses achieved rent growth of 30%-40% in 2022, and growth was still running at 15%-20% in Q1. We expect rent growth in these cities to moderate from now on.

Total investment volume in the industrial and logistics sector fell 61% YOY in Q1 to USD4.9 billion. Certain markets saw significant declines, including Australia where after a decade of compression yields are now rising as funding costs increase. In South Korea, investment seems to have ground to a halt. Anecdotally, it is virtually impossible to obtain financing for development, and some developers may go into default. Yields have expanded 40-70 basis points (bps) from their low point, and high-quality stabilised logistics assets in this market now offer entry yields of 5% or higher. In contrast, Japan has continued to see quite robust investment activity, and yields here have stayed broadly stable.

Alternative assets: interest increases, but volume growth likely to be uneven

The biggest alternative real estate sector in APAC in 2022 was R&D assets (largely life sciences), which saw investment deals of USD4.3 billion (up 61% YOY). We do not have a precise figure for volumes in Q1 2023. The life sciences sector is dominated by China, where Shanghai is home to APAC’s top life sciences cluster. The second-ranked alternative sector was senior housing, where investment deals rose 43% over 2022, to USD2.6 billion. Deals then fell 28% YOY in Q1, but this was below the aggregate APAC fall of 50%. For now, APAC’s senior housing market is concentrated in Japan, where REITs are key institutional owners of retirement and nursing homes. Investment in another large alternative sector, data centres, fell 64% in 2022 after several years of growth. We have not seen clear evidence of a pick-up so far in 2023.

We expect investors to continue to pay attention to alternative assets, including smaller segments such as self-storage and student housing. Certain segments offer attractive yields: for example, Japanese senior housing assets yield about 5.2% on average, roughly equal to hotels on 5.4% as the highest-yielding real estate asset type in Japan.⁴ However, an issue common to many alternative asset types is that they have specialised and intensive operating requirements, which not all fund managers can handle. Investment volumes in alternative assets should pick up over time, but progress is likely to be uneven.

Real estate yields rise towards debt costs, but sentiment will take time to recover

Over the six months to April 2023, according to the most recent survey by one leading real estate consultancy⁵, cap rates for investment-grade office, retail and logistics assets across nearly all APAC markets expanded by 0-125 bps. The only exception was Japan, where cap rates contracted by 0-50 bps. Looking ahead over the next six months, cap rates are expected either to stay stable or expand across all markets.

Based on the same survey, cap rates for Grade A offices in APAC gateway cities range between 2.00%-3.25% for Tokyo at the low end and 5.00%-6.50% for Sydney at the high end. Cap rates for prime shopping malls range between 2.60%-4.00% for Tokyo at the low end and 5.25%-7.25% for Sydney and Melbourne at the high end. Cap rates for high-grade logistics assets range between 2.80%-3.80% for Tokyo at the low end and 5.75%-7.50% for Singapore at the high end; cap rates for traditional logistics assets are higher. Cap rates are also generally higher for hotels and data centres.

Effective borrowing costs for real estate fund managers are usually based on a benchmark lending rate, such as three-month HIBOR in Hong Kong or the five-year loan prime rate in Mainland China, plus a typical margin. In most APAC developed markets, we estimate that effective borrowing rates currently stand in a range of about 5.2%-7.0%. The key exception is Japan, where effective borrowing rates are much lower because the policy lending rate is still close to zero. This is why Japan is the only market in Asia to offer positive carry for all real estate asset types (even though Tokyo stands at the bottom of the cap rate range among APAC gateway cities).

However, cap rates for some asset types in markets other than Japan are now starting to approach effective borrowing costs. We expect capital values to fall and yields to rise further in the office sector in particular over the remainder of 2023. That said, value may be starting to emerge in certain segments of the APAC real estate market, e.g., hospitality, neighbourhood retail, and logistics (notably in Australia and Japan). Regardless of effective borrowing costs, banks in various markets are still reluctant to lend for real estate investment projects. Against this background, real estate market sentiment and investment activity will probably take time to rebound.

Hong Kong: proposal for land leases to be extended with no premium is positive

As a post-script, we should mention some good news from Hong Kong. On 23 May, the Lands Department issued a legislative proposal under which expiring land leases would automatically be extended for 50 years without payment of additional premiums (although an annual rent equivalent to 3% cent of the rateable value of the property would be charged). A bill to enact this proposal is due to be introduced to the Legislative Council in H2 2023.⁶ This news should have limited effect on real estate asset values because local market participants have long assumed it would happen.

^{[1] Primary source: MSCI, Capital Trends Asia Pacific Q1 2023 (May 2023)}

^{[2] Primary source: MSCI, Capital Trends Asia Pacific Q1 2023 (May 2023)}

^{[3] Sources: Mingtiandi (26 January 2023) and Business Wire (27 March, 2023), respectively}

^{[4] Source: MSCI (March 2023), based on data for Q4 2022}

^{[5] CBRE Q1 2023 Asia Pacific Cap Rate Survey (May 2023)}

^{[6] Source: Lands Department of the Government of the Hong Kong SAR (23 May 2023)}