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Investment outlook

Asia Pacific: As a matter of interest

Harry Tan
Head of Research, Real Estate, Asia Pacific
Asia Pacific -as a matter of interest

Monetary policy expectations have shifted since the latter months of 2018. A more muted global growth outlook, unresolved trade conflict between the United States and China, and risk of a no-deal Brexit have altered (somewhat, at least in the near term) the trajectory of forward global interest rate moves. While the Fed’s most recent projections still indicate a number of rate increases this year, the market currently expects a cut late 2019 or early 2020. A reversal in the global monetary policy outlook (and relatedly global financial and liquidity conditions, and consequently, capital flows) will have a direct measurable near-term impact on Asia Pacific real estate markets, noting that most regional economies have a soft peg to, and partially dictated by movements in, the US dollar. Singapore, for instance, employs the S$NEER as a monetary policy tool to manage growth and inflation expectations.

Rate cycle to take a pause

In both Singapore and Hong Kong, which are open economies with high trade and financial services exposure, domestic banking system liquidity has already started to steadily tighten since 2015 in line with the Fed funds rate rises (Fig.1). But in Hong Kong, the stock market rebound aside, a more tepid Fed funds rate outlook recently has almost instantly led to a more upbeat view of the residential market. By virtue of the dollar peg (the Hong Kong dollar is a proxy funding currency for the greenback), housing market sentiment has become more settled, after months of price declines since the second half of 2018 on economic concerns (as reflected in the more than 60bp drop in the 3-month interbank rate in January this year).Similarly, the recent sharp depreciation of the dollar against the Japanese yen from a more sanguine Fed outlook, has unsettled policymakers: the Bank of Japan Governor has indicated that if the yen continues to strengthen, the central bank may consider further additional easing measures to support growth, especially given the high correlation between the yen and Nikkei 225 by way of the outlook for manufacturing and exports (Fig.2). Weak inflationary expectation thus far, following years of still subdued consumer price inflation post Abenomics, also continues to be a major concern.

Post the global financial crisis and the subsequent decade-long global monetary easing, Asia Pacific real estate (and asset) markets have benefitted from very income and price supportive financial conditions, alongside broadly supportive economic and market fundamentals. To be sure, interest rate cycles across the region have either lagged, or diverged, from OECD central banks so far in this current rate tightening cycle. High household debt-to-GDP ratio and weak consumer spending have either pushed back (e.g.Australia) or held back (e.g.South Korea) more meaningful rate increases. In Japan, while quantitative easing has slowed, yield curve management will continue to maintain very loose monetary conditions for more time to come. China has channeled more funds into the banking system through lowering the reserve requirement ratio twice over the past six months, to 11% from 16.5% at the beginning of last year. Only Singapore and Hong Kong have seen rates shift higher in order to adjust to a tighter external liquidity environment (Fig.3). In all, the recent respite in monetary policy tightening is especially welcome amidst heightened risks and slowing global growth this year (see Think Asia Pacific in 2019: watch for risks and opportunities dated January 2019). But this is a mid-cycle pause in an overall tightening monetary policy stance: a normalization of interest rates and/or reduction in quantitative easing after a decade of low-for-long environment is still to be expected in the coming years (Fig.4).

That said, a lower global trend growth outlook post 2008 also means that the peak of the next interest rate cycle is likely to be lower than the previous peak before the global financial crisis. Not forgetting too that global interest rates have been on a structural downtrend over the past few decades. Ongoing strong interests in diversification, and greater allocation into property to supplement other asset classes, also point to quite suppressed cap rates over the long term (versus historical averages), especially in the markets that are developing quickly with rising interests from foreign institutional investors. Global real estate investors should not take this window of interest rate pause as a signal to intensify their investment program. Rather, it is an opportunity to reassess their portfolio, be more tactically focused on markets less impacted by medium-term increases in rates and where the longer-term fundamentals continue to point to income and valuation support. Investing into core assets with bond-like characteristics, such as long WALE and durable income, is key at this point of the economic and interest rate cycle. On this note, there is commonality between real estate and bonds, in that both are impacted by a discount rate effect when interest rates rise. That is, as long-term rates rise, the present value of a given future cash flow diminishes, putting negative pressure on both asset classes. However, unlike bonds, the future cash flows of real estate are not fixed. When rising rates coincide with rising growth expectations, the growth can dominate the discount rate, resulting in low correlations of real estate to interest-rate factors, and pro-cyclical real estate behavior. Markets that can deliver rental uplift or step up growth can thus help to mitigate rising rate risks.

But watch for policy risks

Lower loan-to-value will help to mitigate the downside risks from rising rates on real estate pricing too. Investors will need to, however, watch carefully for signs of stricter regulatory clampdown on bank lending and/or tighter policy measures. Since the global financial crisis and the synchronized global monetary easing, extremely low financing costs have led to strong investment interests and sharp escalation in asset prices across key institutional markets across the region. Onerous stamp duties have been imposed on the Hong Kong and Singapore residential markets for instance. Commercial lending has also been curtailed in Australia to forestall systemic banking risks. The next key market to watch for is Japan, following the super-loose monetary policy environment post Abenomics. Bank lending into property hit a record high in 2018, increasing for the fourth consecutive year. With near-zero interest rate and JGB yields, the easy monetary policy environment has funneled strong money flows into property, driving up property prices by 26% (Fig.6) since the bottom in 2012. While pricing remains far off from the bubble in the late 1980s, an overheating of the real estate market, with multiplier impact on other economic sectors, warrants close monitoring. Real estate lending as a % of GDP rose to 14.18% last year, above the long-term trend. If it persists, long-term financial risk stability may prompt the BOJ to act, particularly considering the structurally-weak demographic trend of an ageing and declining population.

A normalization in the interest rate cycle, in line with improving economic conditions, will help to underpin the regional real estate market for long-term structural growth. A near-term pause in the tightening cycle will also help alleviate potential downside risks from the current more uncertain global and regional economic outlook. All said, however, the best moments for property are over (for now), as medium-term returns are likely to be dragged down by elevated pricing as well as lower income yield. Hence, more than ever, the focus on core investments in resilient markets will help to ‘future-proof’ long-term portfolio returns. The long-term value in regional real estate markets is intact: continue riding the tide of positive structural megatrends underpinning the region.

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