Real Estate in Asia-Pacific: Rethinking Commercial Spaces

Office and retail sectors still offer opportunities for investors targeting the region, but fund managers will need to work harder to reinvent undervalued assets hit by the pandemic 

The pandemic has forced fund managers to quickly come to terms with the changing needs of occupiers. GPs are having to rethink space utilization to stay ahead of secular trends such as the persistence of work-from-home arrangements, the boom in e-commerce, and the decline of physical retail. The resulting changes in consumer behavior are opening new avenues for value creation and offer opportunities for GPs to stand out from peers, amid rising competition for capital and deals in Asia-Pacific. As the region finds its path out from under the economic weight of the pandemic, those with the capacity and expertise to proactively manage portfolio assets could be well positioned to outperform over the long term.

While change is never easy, there are reasons to be optimistic. The industry is showing resilience: Asia-Pacific-focused private real estate assets under management (AUM) hit a record-high $138bn as of September 2020 – a rise of more than 14% in just nine months during the height of the pandemic (Fig. 1). 

Moreover, despite hitting a rough patch last year, during which time just $19bn was raised across 55 funds, fundraising looks to be slowly picking up. Real estate funds focused on Asia-Pacific secured $6.8bn in the first quarter of 2021, registering a 142% increase compared with the same period last year (Fig. 2). While H1 2021 is not quite over, the $8.6bn in aggregate capital raised so far this year has already beaten out fundraising totals in both H1 2017 and H1 2019 – helping the asset class leave 2020 in the rear-view mirror. 

These headline figures tell us there is ample investor demand for real estate in the region. Indeed, a Preqin survey of global institutional investors in November 2020 showed that 81% expected to commit more or the same amount of capital to the asset class in the next 12 months. In addition, 90% said they would maintain (45%) or increase allocations (44%) over the longer term. Globally, concern is rising over the specter of inflation. This combines with serious debate about the potential for inflation to be non-transitory, which could be a tailwind for capital flows into real assets, including real estate. On the back of this, we expect Asia-Pacific to garner growing attention from institutional investors, given the region’s comparatively higher, albeit uneven, growth rates and pent-up demand for undervalued allocation opportunities around the world.

Deal Activity Struggles to Find Footing
Anticipation of robust capital flows and investor interest are one thing, but living up to expectations and proving the long-term validity of traditional property portfolios are quite another. Despite the record level of dry powder ($52bn) earmarked for deployment in the region, real estate deal-makers have been cautious to return to the negotiating table. Private equity real estate (PERE) deals in Asia-Pacific took a beating last year, falling more than 36% to an aggregate value of only $35bn across 251 transactions in 2020 (Fig. 3). 

The first half of 2021 shows limited signs of improvement. Only 109 deals, valued at almost $13bn in aggregate, have reached completion thus far. Lackluster turnout is unsurprising given the size of private real estate transactions, the time needed to structure transactions, and the persistent uncertainty in the fight against COVID-19 and its expanding list of variants.

Indeed, fund managers have their work cut out, but deals are still being done across all property types, and activity should return to trend levels in time. Even sectors such as office and retail, which have been very heavily impacted by the pandemic, are seeing significant transactions. GPs are also adapting their strategic approaches to meet the changing needs of occupiers and the market, as evidenced by a Preqin Expert Voices conversation with fund managers in Asia-Pacific. The regional private real estate industry is well positioned to capitalize on a return to normality – whatever form it may take.

The Office Is Dead…Long Live the Office?
Office deals in Asia-Pacific have consistently made up a majority of transactions by both number and value over the years (Fig. 4). This should not be surprising, given the significance of office-based employment, the rapid growth of the service sector, favorable demographics, and Asia-Pacific’s general gravitational pull on global businesses searching for operational hubs in booming tier 1 cities around the world.

That being said, the office sector has not been immune to the effects of the pandemic and the accelerating trends toward flexible working. Slowing leasing activity and deep strategic evaluation of remote working by corporate occupiers in Asia-Pacific drove Grade A net office absorption in 2020 to only 31 million square feet in gross floor area (GFA) – the lowest in more than a decade, according to CBRE. Moreover, The Knight Frank Asia-Pacific Prime Office Rental Index showed a decline of 4.8% for rents in key business cities in 2020, further indicating significant challenges for even the most coveted office locations.

On the deals front, the picture was more dismal still. Office transactions fell 56% by number to 72 deals completed, valued at only $15bn last year – the lowest figures recorded in more than five years, according to Preqin Pro. Almost halfway through 2021 deals are still lagging, with only 32 deals valued at an aggregate $5bn. These investment patterns may concern many stakeholders active in this property sector, and could even encourage some to preach the “death of the office,” but the reality is not so black and white.

Calling offices obsolete in this virtual working age may be a tad premature. Sure, older developments may reach obsolescence faster than expected, requiring redevelopment, upgrading, or redesign to meet rising tenant demands for sustainable, safe, and innovative workspaces that inspire collaborative creativity. What's more, following the pandemic occupiers will likely be more intentional in identifying their true need for space and more targeted in managing CAPEX in this regard. However, office spaces will continue to serve a role in the commerce value chain, and private capital fund managers have massive scope to play a leading role in its reinvention. 

Indeed, JLL estimates that 40% of Asia-Pacific office space is now in need of some form of refurbishment. Minor or major capital value improvements – depending on the asset – could represent $400bn in unrealized value for investors pursuing value-add strategies. Those able to deliver on the changing demands of tenants could even find an opportunity to differentiate and secure outside returns. For example, a majority of Asia-Pacific corporations (70%) are willing to pay a rental premium to lease sustainability-certified buildings in the future.

The key to success will be offering potential occupiers attractive and flexible spaces. A September 2020 CBRE client survey in Asia-Pacific found 81% of respondents expect at least half of their workforce to be “office-based” in the future, but flexible solutions are attracting greater interest. Among participants, 56% are considering more use of flexible office space, as it offers “unprecedented ability to plan for uncertainty,” while 82% indicate flexibility is a desired attribute as they select buildings to lease in the future. To this end, technology solutions such as Internet of Things sensors are increasingly being leveraged in the workplace by asset owners and occupiers to enhance real estate decision-making processes. 

Despite the alternative work arrangements adopted by many occupiers during the pandemic, there is growing consensus that the traditional office will remain, with greater emphasis on collaborative spaces for teams and event-based meetings. Dr Chua Yang Liang, Head of Group Research & Analytics at ARA Asset Management, explained to Preqin that the firm remained positive about the office sector as one of the drivers of the recovery in Asia-Pacific deal activity in 2021. “Offices are likely to remain as core assets providing regular income to investors,” he explained. He highlighted that, while investors are likely to seek safe havens like Singapore to shield themselves from an increasingly uncertain environment, office occupier trends like the rise of “hub-and-spoke models” that cut costs and promote employee safety could drive demand in decentralized office markets such as North Sydney and Greater Hongqiao in Shanghai.

Looking more closely at the office deals reaching completion this year, we find fund managers favoring the same assets as they always have. There had been some expectation that newer Asian technology and life-science-related companies would lead leasing demand for Grade A offices. But the largest deals so far in 2021 still involve more traditional office assets in central prime locations that have existing, stable tenancies. For instance, the largest office deal so far this year was the purchase of SK Tower in Beijing by Chinese insurer Hexie Health Insurance for RMB 9.06bn ($1.4bn) from SK Group. The 35-story office building in Beijing’s central business district (CBD), right next to the bustling Chang’An Avenue, is reportedly occupied by a Bank of China branch, investment bank CICC, and multiple Japanese Government offices.

The second-largest deal involved an AUD 780mn office portfolio of four buildings in Australia, which was purchased by Charter Hall Group from Korean fund manager AIP Assets. Charter Hall Direct’s CEO Steven Bennett said that a key investment criterion for their funds was the security and longevity of government tenancies. Similarly, the third-largest deal involved the acquisition of OUE by Allianz Group and Korea’s National Pension Service for $477mn. The 18-story tower is currently 99.9% occupied and counts Bank of America and international law firm Allen & Overy as its key tenants.

Leaning into Hybridization of Retail Spaces
Bricks-and-mortar retail investment has long been undermined by cyclical and structural challenges, such as surging e-commerce adoption, on a global scale. But the pandemic has accelerated these trends as shoppers were forced online – many for the first time in Asia-Pacific. Prior to 2020, regional PERE deals in the retail sector accounted for around 19% of transactions by number and 14% of aggregate value each year on average since 2015, according to Preqin Pro. Although still significant, the sector has made up a declining proportion of deal activity over the period, falling to a low of 15% and 5% respectively in 2020. Only 37 transactions changed hands, at a total value of $1.7bn, last year.

While the numbers may be disheartening, activity in the sector is picking up in 2021. Coming up to the end of June, there have already been 23 deals completed, for an aggregate value of $1.2bn. If retail spaces are no longer relevant, why are deals happening in this sector? It is likely that, since deals are closing, deal-makers have plans to repurpose and redesign these assets to position them for recovery. In part, the pick-up could be opportunistically driven, with fund managers pouncing on battered properties that have struggled to weather a protracted decline in footfall. However, it is also likely that undervalued retail assets with attractive catchment areas have potential for upgrading and placemaking.

As restrictions across Asia-Pacific ease, demand for prime CBD retail spaces will likely recover as employees and traffic return to these areas. In addition, consumer support for neighborhood and community retailing is expected to benefit from rising interest in shopping locally – a boon to malls with significant residential catchments. Beyond a general return to normality, retail properties have become much more than just shopping destinations in recent years, and asset owners are increasingly motivated to offer memorable experiences complete with multi-purpose environments. Other value-add opportunities include embracing technology to seamlessly integrate offline and online shopping (omnichannel) experiences, and pursuing a mixed-use strategy to convert pure retail assets into a mix of retail, office, and last-mile logistics uses.

Many of the deals this year show that these value levers are being pulled by acquirers. For instance, Elanor Investors Group acquired Clifford Gardens Shopping Centre from Blackstone for AUD 145mn through the Clifford Gardens Fund, which is set up in partnership with Savills Investment Management. While the deal was transacted at a “relatively soft” 7.9% yield, plans are already lined up to improve the Toowoomba mall with “plenty of upside and scope for further investment.” The co-head of real estate for Elanor, Michael Baliva, shared with the Australian Financial Review that the firm will be taking advantage of infrastructure development in the region, the site’s prominent central location, and a potential opportunity to introduce a health, medical, and essential services precinct to the mall. “Additional opportunities exist to unlock value from the underutilized land on the extensive nine-hectare site. Our strategy is focused on enhancing both the income and capital value of the property for our capital partners,” said Baliva. Clifford Gardens was previously bought by Blackstone in 2016 for AUD 188.5mn.

Indeed, many active fund managers are supportive of the retail property sector, but they recognize proactivity and adaptation are key. Speaking on the real estate market in Asia-Pacific, Mike Pyke, Head of Institutional Capital at Moelis Australia, told Preqin in May that there are many opportunities still available on the retail front, not only on a relative basis, but also from a value-add perspective, as these spaces adapt to new needs. “For example, we have witnessed tenants invest further in ’click & collect’ initiatives in our centers. This omnichannel approach will be an important feature of retailers in the future, allowing store footprints to be utilized as quasi-distribution centers for online sales,” he explained.

Asia-Pacific Real Estate Here to Stay
While the real estate market in Asia-Pacific has experienced significant headwinds in the wake of the pandemic, fund managers are adapting and reimagining the spaces of tomorrow. Amid such challenges, those that can remain patient and actively steer their portfolio assets through the transition will be best able to stand out from their peers. Many opportunities remain for both GPs and LPs to capitalize on market dislocations and, in some cases, even access attractive asset valuations across the region. This will be especially true as government support programs and bank forbearance policies end. In short, the real estate market is here to stay in Asia-Pacific, and even the property types suffering the most could be hiding unseen potential.