China’s reopening boosts Asia Pacific commercial real estate market sentiment

The reopening of China has boosted sentiment in the Asia Pacific (APAC) commercial real estate sector, despite higher interest rates in many countries which have depressed investment activity. While APAC real estate markets are not all moving in the same direction, a couple of trends stand out. One is that many office markets are under pressure, partly due to high supply, despite a generally smaller impact from home working than in western countries. Another trend is the upturn from a low base in the retail and hospitality segments of the real estate market, which the return of tourist travel in 2023 (especially from China) should support. We expect to see yield expansion in 2023 across most asset types.

Economic outlook slightly brighter, but high interest rates a major challenge

The economic outlook for APAC markets has improved modestly since the start of 2023. Apart from signs of economic resilience and peaking inflation in other regions, the key development has been the reopening of mainland China after the easing of its zero-Covid-19 policy. After signs of turnaround in December 2022, high-frequency data and the January Purchasing Managers' Index (PMI) surveys show that Chinese service sector activity has rebounded strongly, even if improvement in manufacturing has been capped by weak external demand. Overall, activity is normalising, and Schroders believes a recovery led by services will drive real GDP growth of 6.2% in 2023 and 4.5% in 2024.¹

A services-led recovery in mainland China will offer only limited support to the rest of the world, and a renewed investment cycle in Chinese manufacturing which sucks in imports looks unlikely. However, many Asian markets will benefit from the return of Chinese visitors. Travel within mainland China has already recovered very strongly so far in 2023, and outbound travel should pick up rapidly over the rest of the year as remaining restrictions on Chinese tourists are lifted.

In APAC, inflation remains well above central banks’ targets in Australia, South Korea and Singapore. In combination, high inflation and the prospect of high US interest rates for the next few quarters are likely to remove any incentive for central banks in those markets to start loosening monetary policy until late 2023 or 2024. Despite lower inflation, Hong Kong will also be forced to hold interest rates high, because the territory’s US dollar peg effectively ties Hong Kong policy rates to US Fed Funds rates.

In contrast, interest rates have not increased in mainland China and Japan. In mainland China, policy interest rates fell slightly over 2022, and look set to stay flat in 2023. In Japan, the central bank has held short-term interest rates at close to zero, while the long-term-term bond yield has risen but remains the world’s lowest at 0.5%. Japan is one of the very few markets globally with a wide positive spread between government bond yields and prime-grade property yields.

Higher interest rates in much of the region have made bank financing harder to obtain, depressing real estate investment volumes. Total APAC commercial property investment transactions fell by 24% over 2022, to USD171 billion, but by a much steeper 52% year-on-year (y-o-y) in Q4. However, this outcome was actually better than the outcome for the Americas or EMEA, where transactions fell by 60% - 70%, and Japan outperformed nearly all global markets in Q4 with a drop of just 19%.² We expect total APAC investment transactions to fall further in 2023, but Japan should again outperform.

We comment below on key recent developments and prospects for the major developed APAC real estate markets.

Japan: office market turns down modestly, hotel sector picks up

The major Japanese cities have low office vacancy rates in comparison to most other APAC cities: about 4% for Tokyo (Grade A and Grade B combined) and 3% for Osaka at end-2022. This reflects the fact that there has not been a big shift to home or hybrid working among the small and medium-sized companies which employ 70% of working Japanese, although there have been changes of working practices among large occupiers. However, in Tokyo at least, vacancy has risen steadily from a low point of under 1% in 2019 and H1 2020, while rents have fallen: gross Grade A rent per tsubo per month is down 13% - 14% since H1 2020, to about JPY34,700 in Q4, and Grade B rent is down about 10%.

The big cities face significant office supply over the three years to 2025. In Tokyo, expected new space could amount to 9-10% of combined Grade A and Grade B stock in the five central wards of about 19.1 million sq metres at end-2022, while for new supply in Osaka may equal about 8% of stock. In Yokohama and Fukuoka, the corresponding proportions could be 12% - 15%. This new supply looks set to depress rents further, with most brokers’ forecasts calling for a 7-8% fall in Grade A net effective rent in Tokyo in 2023. Large high grade offices are the most affected by changes in working style. Conversely, there is less pressure on rents for lower-grade office space (below about JPY18,000-19,000 per tsubo per month), and the market expectation is that market rents for these spaces will stay roughly the same.

In contrast, the hotels market in Japan continues to recover. Prior to Covid-19, stable domestic leisure and business travel made up 80% of hospitality demand, but inbound foreign travel surged over the 2010s to reach 20% of the total. Japan dropped Covid-19 entry restrictions for most visitors in October 2022, and will lift nearly all remaining restrictions for mainland Chinese visitors on 1 March. Inbound tourism has already rebounded sharply: anecdotally, hotel average daily rates (ADRs) in Tokyo in Q4 exceeded ADRs in the peak year of 2019. In the past, there was a close relationship between inbound visitors and the USD/JPY exchange rate, and we expect the current weakness of the yen to support tourism from across Asia. Staff shortages and higher food prices are challenges for hotel operators, but sharp recovery in the sector should persist.

Singapore: office leasing firm despite low investment, retail continues to recover

The Singapore office sector remains well-supported, and average rents for investment-grade office stock grew 8% - 9% last year. While various technology and media groups have laid off staff and surrendered space, the impact on leasing demand should be balanced by expansion by wealth management firms and family offices. Forecasts of new supply have been revised up recently. Even so, expected average annual new supply of office space across the city over 2023-2025 of 1.3 million sq feet should be below the annual average for the past ten years of 1.4 million sq feet. With citywide vacancy of under 6%, rents should grow moderately again in 2023.³

Against the positive background, owners of office assets continue to demand full prices, and cap rate expansion is likely to be moderate even with higher interest rates. However, the Singapore government continues to promote revitalisation of the central business district (CBD) through the CBD Incentive Scheme, which encourages conversion of offices to mixed use. Office upgrades in the central district are likely to be an area of continued investment interest.

Average prime retail rents in Singapore fell about 23% between the peak level of 2014-2015 and a trough in late-2021 before picking up 2-4% in 2022 as the country recovered from Covid-19.⁴ Recent trends suggest that this rebound should continue. Total retail sales in Singapore rose 13% y-o-y in Q3, driven in part by the return of tourists, but sales growth eased to 8% y-o-y in Q4⁵ as domestic consumption moderated. The recovery in tourism and the resumption of MICE events have raised optimism in Singapore’s retail and hospitality sectors, and sales growth in retail prime districts like Orchard Road and Marina Bay Sands should rebound further in 2023. Sales should also be resilient in the neighbourhood malls where the tenant mix is weighted towards necessity retail categories and services. Retail sales growth does not necessarily feed through into expansion in retail rents. Nevertheless, with new supply modest, it seems reasonable to expect 2-3% rental growth per annum in the Singapore retail sector over the next three years.

Mainland China: recent trends in Shanghai dull, but consumption set to pick up

In mainland China, the focus of investment and leasing activity in commercial real estate remains Shanghai. Investment in Shanghai outperformed mainland China as a whole in 2022: the city recorded a drop in transaction volumes of just 12%, to USD14.4 billion. On this basis, Shanghai ranked as APAC’s third largest commercial property investment centre, after Tokyo and Seoul. Certain major deals were reported in Shanghai in Q4, including AIA Life’s acquisition of the SIIC Center and CapitaLand’s purchase of a business park, each for about USD1 billion.⁶ With the national economy now recovering and interest rates set to remain stable, interest in investment assets in Shanghai may well remain firm.

The Shanghai office leasing market had a dull year in 2022, with net absorption of 0.5 million sq metres equal to only 60% of new supply of 0.8 million sq metres. The shortfall in demand pushed up the vacancy rate to 18%, and average rents fell about 1% over the year. In 2023, net absorption should rebound strongly as economic growth picks up, with one agency predicting nearly 1.0mn sq metres. New supply, however, could almost double to 1.5 million sq metres. Much of the new stock consists of high-specification buildings which may stimulate demand. Even so, vacancy should rise to 19-20%, and rents are likely to be flat over 2023 and 2024.⁷ In general, prospects for new leasing demand still look firmer in the business park market than the office market, given strong policy support from the authorities for life sciences and smaller technology occupiers to locate themselves in specific business parks in Shanghai and Beijing.

In contrast to the mixed outlook for offices, firmer consumption should support retail real estate in Shanghai in 2023. The market suffered in 2022 from the impact of the lockdown in Q2: citywide take-up of retail space was about –0.5 million sq metres, with surrendered space concentrated in decentralised areas. At the year-end, the vacancy rate stood at 11% for the prime areas and 13% for the decentralised areas, while rents fell 7-8% from 2021. However, the 2023 retail sales are set to benefit from increased travel and the gradual return of tourists, which should underpin resilient demand for luxury goods. At the same time, new mall openings may improve the commercial appeal of non-prime areas including North Bund and Qiantan. Forecast new supply remains substantial, but net absorption ought to bounce back strongly, so vacancy will probably be little changed by year-end. The new supply may limit rent growth to about 1% in 2023, but growth of 2% - 3% per annum looks reasonable for 2024-2026.

Hong Kong SAR: offices still under pressure, retail has passed the bottom

Commercial real estate investment transactions in Hong Kong fell 41% in 2022, to USD6.7 billion. On this basis, Hong Kong ranked in sixth place among APAC markets by deal volume, falling behind Singapore for the first time. Activity was subdued across all market segments. Financing costs for property investors in Hong Kong are usually determined with reference to HIBOR rates, which typically lag changes in policy rates by 6-12 months. This means debt costs for investors may rise further over the rest of 2023. A rapid recovery in deal activity therefore looks unlikely.

The Hong Kong office market saw the fourth consecutive year of falling rents in 2022. Average rents slipped about 4% across the city, bringing the cumulative drop since the peak in Q1 2019 to over 28%. The vacancy rate stood at 12% at end-Q4. Despite the prospect of a pick-up in leasing demand from the reopening of the border with the Mainland, the outlook remains difficult, given continuing high supply of office space. After about 5.0 million sq feet of new supply (equal to 5% of total stock) in 2022, there should be nearly 3.2 million sq feet of new supply in 2023, concentrated in decentralised areas where rents are lower. On this basis, another rent drop of 4-5% looks plausible.⁸

Average prime retail rents in Hong Kong were broadly stable between 2013 and 2016, but by Q4 2022 had fallen about 40% (with a higher drop of 75% for high street retail). Capital values likewise fell about 40% between the peak in mid-2019 and Q4 2022. However, there are signs that the market has now passed the bottom. Aggregate retail sales rose 1% y-o-y in December 2022 after a 4% fall in November, and should rise further as Mainland Chinese visitors return and general consumer sentiment improves from 2022’s low base. The prime shopping centre vacancy rate rose over 2022 from about 4.0% to 6.5%, but even so rents were more or less stable from Q2 to Q4.⁹

Looking ahead, while new leasing demand is generally expected to pick up in 2023, prime new shopping centre supply should reach 4.5 million sq feet, or roughly 10% of stock. Such heavy supply would normally push average rents down, but the fact that about 80% of the new supply comes from developments in decentralised areas (notably Kai Tak and the airport at Chek Lap Kok) means the pressure may well be significantly less. Most brokers thus forecast modest rental growth in 2023 and 2024. High street rents may conceivably rebound faster in the near term than shopping centre rents if tourist demand recovers quickly.

South Korea: office market strong, logistics starts to slow

Seoul was developed APAC’s strongest office leasing market in 2022: net effective rent rose 10-11%, driven by firm demand and almost total lack of new supply. The citywide vacancy rate in Seoul is about 3%, and it is closer to 1% in the Gangnam Business District and the Pangyo satellite area popular with technology groups. Leasing demand may well moderate in 2023 as the global semiconductor cycle turns down and South Korean exports slow, putting pressure on technology occupiers. Even so, with new supply limited, we anticipate competition for available space, and so rents ought to rise further. Growth of 4-5% seems plausible for 2023 and perhaps 2024.

In contrast, the previously high-flying logistics market should start to slow after recording rent growth of 5-6% in greater Seoul in 2022. With demand still strong and a vacancy rate of only 3% at year-end, there may be further modest rent growth in 2023. However, cold storage warehouses in particular already have seen high vacancy, and heavy new supply originally planned for 2022 has been partly pushed into 2023. According to one broker’s forecast, the vacancy rate could jump to about 20% within two years. If so, rent growth will probably slow sharply from 2024, and may turn negative. This prospect helps explain why investment transactions for South Korean logistics assets fell 89% y-o-y in Q4 and why cap rates in the sector have widened over the past six to nine months to the 4.0-5.8% range.

Australia: office recovery uneven, logistics very strong, retail stable

In some respects, Australian office markets resemble those in the West rather than Asian cities. Australian occupiers have consistently preferred prime-grade property and pay high attention to sustainability. At the same time, Melbourne and Sydney have experienced a greater adverse impact on office occupancy from home working than other APAC gateway cities. This has resulted in an uneven recovery from Covid-19. In 2022, gross leasing recovered quite strongly in the Sydney CDB, but net absorption was negative in H2 as larger occupiers consolidated their space into a smaller footprint. Net effective rent grew 6-7% over the year, but the vacancy rate rose from about 10% to 12%. Melbourne lagged Sydney with weaker gross leasing, negative net absorption in H2 2022, rent growth of about 3% over the year, and an end-Q4 vacancy rate of about 15%. For 2023, vacancy should be fairly stable in both cities, while rent growth of 2% - 3% looks plausible. However, the direction of the market beyond 2023 is hard to gauge.

In marked contrast, the Australian logistics sector recorded the strongest rental growth in APAC in 2022. Total gross leasing reached 4.9 million sq metres nationally, with particular strength in Sydney and Brisbane; the national vacancy rate fell to under 0.5%; and prime rent growth across the country reached 20% - 30%. Average land values grew 25-40% depending on the lot size. Such market strength is unlikely to continue, and for the two big cities we expect rent growth to slow to the 7-12% range in 2023 (higher for Sydney, lower for Melbourne). Given rising interest rates and funding costs, prime capital values have fallen on average by over 6% nationally since the peak in pricing early 2022, pushing up yields to the high 4% range.

After rising for 11 straight months, Australian retail sales fell month-on-month in December 2022, impacted by high interest rates and inflation. Private consumption looks set to slow sharply in 2023, and Australia will not benefit to the same extent as most other Asian markets from the return of Chinese tourists. Regional and sub-regional shopping centre rents appear to have been flat or only mildly positive in Q4 2022. However, Australian shopping centres are recognised to be stable and generally efficient. While near-term prospects for rent growth are very modest, some investors will be attracted by yields in a range of 5-7%.

[1] Source: Schroders, Economic and Strategy Viewpoint Q1 2023 (24 February, 2023)

[2] Source: MSCI, Asia Pacific Capital Trends Q4 2022 presentation (9 February, 2022)

[3] Sources: CBRE, Figures | Singapore Office | Q4 2022; JLL REIS database (February 2022).

[4] Source: JLL REIS database (February 2023)

[5] Source: Department of Statistics, Singapore

[6] Source: MSCI, Capital Trends Asia Pacific 2022 (1 February, 2023)

[7] Sources; JLL REIS database (February 2023); Secondary source: CBRE, Figures | Shanghai | Q4 2022.

[8] Sources: JLL REIS database (Jan. 2023); CBRE, Figures | Hong Kong Office | Q4 2022; Savills, HK Office Leasing (Jan. 2023)

[9] Sources: JLL REIS database (January 2023); CBRE, Figures | Hong Kong Retail | Q4 2022