Capital Markets

REBALANCING STRUCTURAL AND CYCLICAL INVESTMENTS

INVESTMENT ACTIVITY EXPECTED TO REBOUND IN H2 2020

Supported by more active cross-border capital and stronger purchasing by owner-occupiers, domestic real estate investment turnover amounted to RMB 263.3 billion in 2019. This represented a decline of just 0.9% y-o-y on 2018 and came despite weak economic and leasing market fundamentals.

Investment activity in China may fluctuate in 2020 due to the uncertainty of the duration and scale of the coronavirus outbreak. The deal process may lengthen amid the decline in business, especially in Q1 2020. However, CBRE expects investment activity to rebound once the outbreak is contained, supported by more accommodative lending policies, lower interest rates and improving leasing market sentiment.

ATTRACTIVE YIELD SPREAD SET TO SUPPORT REAL ESTATE INVESTMENT

On January 1, 2020, the People’s Bank of China announced a further 50 bps cut to the Reserve Required Ratio (RRR). However, China’s current policy rate remains higher than those in major mature markets. The need to mitigate the impact of the coronavirus outbreak will create ample room for further cuts to the RRR and Loan Prime Rate (LPR) in 2020.

The yield spread between Shanghai Grade A offices and 10-year government bonds is likely to widen to 130-150 bps, making prime commercial real estate pricing more attractive for investors.

DOMESTIC INSURANCE FIRMS LIKELY TO TURN MORE ACTIVE

The continued low interest rate environment will encourage institutional investors to allocate more investment to alternatives such as real estate to enhance overall portfolio returns. China Pacific Insurance Company (CPIC) data show that annualised total investment returns of China’s insurance industry declined from 7.6% in 2015 to 5.6% in H1 2019 due to lower returns from fixed income instruments. In contrast, real estate can generate stable returns as much as 350 bps higher.

With the total asset value of China’s insurance industry exceeding RMB 20 trillion as of the end of November 2019, a one percentage point increase in allocations to real estate would translate to an additional RMB 200 billion spending on domestic real estate.

Foreign real estate funds will remain an active source of capital in 2020. CBRE’s analysis has found that Asia Pacific-focused close-ended real estate funds have approximately US$ 51 billion of dry powder to be deployed over the next five years, of which 20% will be targeted at China.

As demonstrated by Figure 31, although offices remain the preferred asset class (accounting for 42% of allocations), foreign property funds are expected to diversify into other sectors. With the government planning to boost infrastructure investment to stabilise economic growth during and after the coronavirus outbreak, logistics assets will remain keenly sought after, while equity investment in platforms will also continue.

US$ 10 billion will be deployed to China by Asia Pacific focused close ended real estate funds in the next five years. More diversified allocation across property types is expected.

FURTHER OPPORTUNITIES TO ENGAGE IN REAL ESTATE DEBT

This diversification into a broader range of sectors could be viewed as a strategic rebalancing by investors seeking to lower their weighting on cyclical investments and increase their allocations to structural investments amid rising late cycle uncertainty.

REAL ESTATE DEBT OPPORTUNITIES

Other cyclical opportunities can be found in real estate debt. Between 2020 and 2022, domestic developers must refinance RMB 9-10 trillion of debt, a scenario that will provide investors with opportunities to provide development loans and mezzanine debt. In addition, an expected drop in residential sales in H1 2020 due to the coronavirus outbreak is set to increase developers’ thirst for liquidity, forcing them to put more quality assets up for sale in 2020. Net disposals by Chinese developers reached RMB 97.1 billion in 2019, the highest annual figure on record. CBRE expects this trend to continue.

GROWING INTEREST IN OFFICES IN TECH DISTRICTS

Leasing risk is a major concern for investors considering purchasing offices at the late stage of the upward market cycle. However, CBRE believes investors may consider offices in tech districts and business parks in tech cities as a counter-cyclical option. These properties benefit not only from the clustering of fast-growing TMT companies, supported by government incentives and economic transformation, but are also attracting decentralisation demand from occupiers seeking to reduce real estate costs amid economic uncertainty.

In 2019, the TMT sector accounted for 25% of total office leasing volume in China, and rental performance in major tech districts across different cities eclipsed the national average.

CORE OFFICE ASSETS REMAIN ATTRACTIVE INVESTMENTS

GENERATING DEFENSIVE INCOME FROM CORE OFFICES

Investors with deeper pockets and longer holding power may consider acquiring stabilised prime office buildings in core locations of gateway cities. Such properties can generate steady defensive income plus long-term capital value gains.

Taking Shanghai as an example, during 2020 and 2022, its core CBD is forecasted to see a vacancy rate slightly above 10% and largely stable rents. This contrasts with the overall market forecast of an average vacancy rate of 20% and falling rents. Competition from new supply in core CBD areas will be relatively mild, with just 3.9% or just under 133,900 sq. m. of new supply due to be completed in core CBD markets during 2020 and 2022

THE RETURN OF RETAIL

Transaction volume for retail properties surged by 52% y-o-y in 2019¹². Although the retail sector will be significantly impacted by the coronavirus outbreak, especially in the first few months of 2020, well-managed regional and community malls remain attractive structural investments in the long run as they continue to benefit from the decentralisation of urban populations, the lack of modern shopping venues in various catchments and the growth of omnichannel retailing.

Rapidly growing spending power and consumption upgrading by China’s middle class is spurring interest in outlet malls. The four outlet malls owned by Sasseur REIT registered y-o-y sales growth of 20.9% in the first three quarters of 2019. McKinsey & Co. data show that the number of upper middle class households (possessing an annual disposable income of between US$16,000-34,000) will exceed 190 million by 2022.¹³

12. Exclude retail projects that will be transformed to other asset classes after purchase

13. Mapping China’s middle class, Mckinsey , June

GROWING DEMAND FOR NICHE ASSETS

THE LOGISTICS STORY CONTINUES

The logistics sector will continue to provide structural opportunities for investors in 2020, with the penetration of modern logistics facilities still below 10%. Solid investment turnover will be fuelled by aggressive fundraising, with more than US$ 6.7 billion raised by China-focused logistics close-ended funds in 2019.

Although leasing fundamentals will remain upbeat for the next three years, investors are advised to adjust their return targets to a more realistic range and familiarise themselves with the short-term oversupply and weaker demand situation in Central and Western cities, especially those affected by the coronavirus outbreak.

MEGATRENDS SPUR DEMAND FOR NICHE SECTORS

Niche sectors such as data centres and cold storage continue to enjoy strong demand in China on the back of long-term structural shifts including digitalisation, urbanisation and consumption upgrading.

However, the coronavirus outbreak has highlighted the lack of such facilities in some urban clusters. Investing in those sectors could therefore benefit from the government’s policy of developing high-tech and infrastructure-related industries.

As these particular alternative assets usually require considerable operational expertise (in the case of multifamily) and significant barriers to entry (in the case of data centres), CBRE recommends investors engage in platform deals with experienced operators.

Recent examples of this trend include Gaw Capital’s formation of a joint-venture with Centrin Data to tap into China’s booming data centre sector, and Bain Capital’s purchase of a local platform with a portfolio of nine data centres.

INCREASING IMPORTANCE OF ASSET MANAGEMENT

Abundant liquidity and lower interest rates are expected to ensure real estate yields remain tight in 2020, offsetting the negative impact of greater economic uncertainty and soft leasing demand in most markets.

However, office yields in few tier II markets could expand slightly to 6.5% due to weaker leasing demand resulting from the coronavirus outbreak, along with high vacancy rates. Logistics yields are projected to remain flat, but asset pricing is no longer cheap, especially for assets in coastal areas with robust leasing fundamentals.

Limited room for capital value appreciation and sustained leasing risk will ensure asset management takes on a more prominent role in enhancing rental income as well as unlocking hidden value.

Investors and landlords are advised to cater to tenants’ rising needs for flexibility, experience and efficiency. Potential strategies may include adding coworking or turnkey space and fitness and catering amenities to an office building; optimising the usage of outdoor space and pop-up stores in shopping malls; and implementing automation to enhance efficiency in logistics facilities.