PART 2: The Capital

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T H E C A P I TA L II

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T H E C A P I TA L II

This report, Part II in Cushman & Wakefield’s Reset 2022 trilogy, brings together the views of a panel of institutional investors as shared during the webinar “Unlocking Strategy in a Changing Environment” on 18th August 2022. The analysis in this report draws upon these views along with live audience polling conducted during the webinar and the results of an investor intention survey conducted over approximately three weeks in August 2022.

UNLOCKING STRATEGY IN A CHANGING ENVIRONMENT

WEBINAR SPEAKERS

LAURENT FISCHLER Head of investment APAC

LOUISE KAVANAGH CIO & Head of Asia Pacific Real Estate

Webinar Summary

HAMISH MACDONALD Managing Director Real Estate

ANTHEA LEE Chief Executive Officer

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INTEREST RATE PRICING fundamentals. Unsurprisingly this is resulting in diverging bid-ask spreads. There is no easy solution out of this impasse, other than to assess the asset within the current climate. Vendors choosing to put their asset on the market

To date, the region has remained remarkably resilient. Not only is the regional GDP outlook better than other regions in 2022, but the region is also forecasting stronger growth in 2023. In this respect Asia Pacific sits alone as the only region to forecast stronger growth in 2023 than 2022. However, global inflationary pressures are causing central banks to lift interest rates both earlier and more aggressively than originally heralded. With this, commercial real estate pricing is coming under pressure and it is likely only a matter of time before capitalisation rates (cap rates) soften. Those markets where interest rate hikes have been earlier and more aggressive are likely to come under pressure first, but at the same time these markets are therefore likely to “reset” first and set the environment for other markets to follow. Arguably, it is no longer tenable for capitalisation rates to remain as tight as current standards when increasing interest rates are pushing up the short end of the yield curve such that property to bond yield spreads are now below longer-term averages. While inverted yield spreads are not new, at the same time they are also not an enduring trend. The upward pressure on property yields is not universal. Not only are central banks lifting interest rates at variable speeds, but there is also a great deal of heterogeneity in property market

need to recognise purchasers’ likely increased cost of debt and the impacts on return metrics. At the same time, purchasers seeking high quality assets, especially in off-market transactions, also need to recognise the premium of these assets and their likely resilience through the temporary downturn. DOWNWARD PRESSURE ON PRICING IS LIKELY TO INCREASE AS INTEREST RATES RISE. POTENTIAL VENDORS NEED TO UNDERSTAND WHY THEY ARE LOOKING TO TRADE AND MEET THE MARKET ACCORDINGLY. Outside of this wider pricing pressure, current conditions may shift investor strategy in other ways. The stronger underlying growth prospects of the Asia Pacific region may cause some investors to divert more capital into the region, especially given the greater inflationary pressures seen elsewhere. At the same time current conditions and “risk-off”

Macro-economic volatility together with rising interest rates have driven a level of

uncertainty in commercial real estate investment. This has resulted in something of a pause as investors adapt their strategy to the changed environment. For those investors with capital to deploy, the region remains attractive for its long-term growth fundamentals. This, together with an increasing urgency to address Environmental, Social and Governance (ESG) requirements expected by both capital partners and corporate occupiers is also expected to drive deal activity as investors look through current conditions and continue averaging-in to the region. Against this macro-economic backdrop, the focus then shifts to identifying appropriate opportunities across sectors within the region.

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SECTORAL DIVERSIFICATION

strategies are likely to keep Asia Pacific investor interest closer to home either within the region or within their domestic market. Avoiding cross-border investment eliminates exposure to currency fluctuation and therefore hedging costs while simultaneously leverages

greater market insight and existing debt and investor relationships. Conversely a wide geographical reach in Asia Pacific can create a natural hedge, and this is acknowledged as being the direction of travel for some platforms and funds.

OFFICE The office sector is arguably the most mature across the region and so understandably is the sector that most investors primarily navigate to. Here, the message is mostly positive. The region continues to experience positive demand – regionally, 175 million square feet more of office space is currently occupied than at the start of the pandemic – although this is tempered by a somewhat anaemic rental outlook. Here we see bifurcation, firstly between the dynamics of supply and demand. Secondly, there is sub-market bifurcation, with high amenity, high-quality buildings experiencing the highest tenant demand. This presents investors with two main options – focus on high-quality assets or seek out under-serviced assets in desirable locations and seek to improve their credentials.

NOW IS NOT THE TIME TO BACK DOWN ON BUILDING UPGRADES. THE “BROWN TAX” ON LOWER CREDENTIALLED ASSETS COULD BE LARGER THAN CURRENT AND SO CAPITAL EXPENDITURE REQUIREMENTS NEED TO BE BALANCED WITH OPPORTUNITY COSTS, I.E. THE COST OF NOT MEETING MARKET REQUIREMENTS FOR BUILDING SPECIFICATION.

Expect a greater focus on assets in the Asia Pacific region as weakness in some other regions sharpens investor focus on fewer cross-border destinations.

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There are concerns over how quickly pricing in the industrial sector has increased over recent years, especially since the pandemic, though overall the outlook remains positive. Many believe the sector remains undersupplied while the more conservative expect slower, but positive growth and few believe the sector is too hot to invest

which supports investor “averaging in” mentality. Investors targeting industrial development need to have a clear understanding of construction costs. Raw material pricing has increased, as have labour costs. General tightness in the availability of materials and labour have also pushed out construction times, further contributing to an overall increase in project costs. While this is a growth sector, largely underserved in many markets, return metrics still need to meet current input development costs.

INDUSTRIAL Outside of office assets there are two front-of-mind sectors: industrial (including its emerging sub-sectors) and alternatives. The industrial sector has a buoyant future, driven by a bourgeoning middle class that is forecast to increase by 1.5bn people (2020-30), which will drive the need for goods and services. There is clear evidence of China+ manufacturing strategies benefitting markets in South East Asia and India. Here, there is no shortage of demand, though rental growth is highly variable as developers compete to secure landbanks and bring product to market. In mature markets, there has been considerable cap-rate compression which has helped lift property book values. To an extent, this has been supported by prime rental uplift – arguably most visibly in Australia but also in Hong Kong, Japan, Singapore and South Korea. Investors are also increasingly looking for value-added opportunities in industrial sub-sectors such as self-storage and cold storage.

IT IS RARE TO PICK MARKET INFLECTION POINTS PERFECTLY. RATHER IT IS MORE IMPORTANT TO “AVERAGE IN” OVER TIME AND UNDERWRITE CAUTIOUSLY TO BALANCE THE PEAKS AND TROUGHS OF THE MARKET. MAINTAINING A SUPPLY OF DRY-POWDER CAPITAL IS ESSENTIAL AND FOR MANY INVESTORS, SO IS MAINTAINING A CAPABLE DEVELOPMENT OR OPERATIONAL PARTNER TO PERMIT ONGOING INVESTMENT INTO ASSETS.

Expect counter pressures between

increasing construction costs and limited supply of high-quality greenfield industrial land, especially in developed markets. Capital partnering offers a solution to meet desired development return metrics.

FIGURE 1: FOCUSING ON THE LOGISTICS SECTOR, WHAT BEST DESCRIBES YOUR MINDSET?

Growth sector - undersupplied

Rents will match construction costs

Yields will remain tight

Slow growth - but will meet hurdles

Rent growth to o set capital growth decline

Sector is too hot

0% 5% 10% 15% 20% 25% 30% 35% 40%

Source: Cushman & Wakefield

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DATA CENTRES The new, emerging asset class in Asia Pacific, indeed globally, is the alternatives sector. Data centres are now firmly on many investors’ radars, with total investment volume in stabilised assets growing from USD1bn in 2016 to over USD6bn in 2021. But while they may have captured mainstream attention, they remain at less than 10% of office investment volume and a considerable proportion of this is entity

MULTIFAMILY AND “LIVING ASSETS”

level activity. This sector, which used to be hard to get into and hard to get out of, is now even harder to get into, especially as fewer owners are looking to exit. This is not only a function of the sector’s long-term attractiveness but also a wider shift within commercial real estate investing to funds that would typically see underwriting of an extended duration (e.g. Open Ended Funds & REITs). This is illustrated by the open-ended real estate fund sector, as seen in the growth of the ANREV ODCE index, which has grown from 6 funds, 181 properties and a gross asset value of USD12.9bn in Q4 2019 to 8 funds, 355 assets and a gross asset value of USD21.4bn in Q4 2021. This may mean fewer assets available on open-market transactions and more assets trading between related parties. Within the data centre market specifically, investors will need to increasingly focus on partnering with developers and operators to develop their own product.

student visas were granted in Australia – reflecting a strong uptake in visas during the six months after Australia’s international borders reopened to students in December 2021. SAME TIME RECOGNISE THAT WHILE THEY HAVE ATTRACTED MAINSTREAM ATTENTION, THEY ARE STILL A COMPARATIVELY SMALL PROPORTION OF OVERALL INVESTMENT VOLUME. DO LOOK TO INCORPORATE ALTERNATIVES IN YOUR ASSET ALLOCATION, BUT AT THE

The mature Japanese multifamily sector will be sought after for its stable occupier demand. Japan’s aged care sector, which is heavily fragmented, could also garner greater focus given the country’s ageing population. Elsewhere in the region, the Australian build-to-rent market is set to expand rapidly with over 14,000 units currently planned for development. However, given its nascent nature, there are unlikely to be transactional opportunities for stabilised assets in the near term. Running alongside this, the more mature Australian purpose-built student accommodation (PBSA) sector appears to be recovering strongly. In the year to June 2022, almost 230,000

FIGURE 2: MULTIFAMILY OVERTOOK ALL OTHER ASSET CLASSES IN THE U.S. TO BECOME THE LARGEST ASSET CLASS BY TRANSACTION VOLUME. WILL THIS HAPPEN IN ASIA PACIFIC?

Yes - 2 years

Yes - 5 years

Yes - 10 years, Japan largest

Yes - 10 years, China largest

Yes - 10 years, India largest

Never / Not within 10 years

0%

10%

20%

30%

40%

Source: Cushman & Wakefield

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ALTERNATIVE ASSET CLASSES IN CHINA

GEOGRAPHICAL DIVERSIFICATION The region’s emerging markets offer attractive growth opportunities. Among these, India and Vietnam are currently leading investor interest, with the former more focussed on the office sector and the latter on the industrial sector. However, given the expansionary nature of these markets, as well as others in South East Asia, we have seen and will

continue to see strong growth in all sectors. As a corollary to this, Singapore plays an important role and is likely to receive an indirect boost given its geographical position and central connectivity to this sub-region. For some investors, especially those lower on the risk curve, Singapore offers a proxy for investing in Asia’s emerging markets growth story.

Mainland China offers an attractive opportunity across a range of emerging sectors. Investors are now becoming increasingly granular in their approach to identify future growth. With this, while mainstream sectors will continue to attract interest, diligent investors are beginning to prioritise alternative sectors to get ahead of the curve. Within the industrial sector, cold chain logistics has been identified as an area that needs significant development to meet future needs of the population. Similarly, life sciences is an emerging sector that has been targeted for ongoing government support through such policies as “Healthy China 2030” and the commensurate increase in access to healthcare insurance. The living sector in Greater China is also gaining traction with increasing international investor participation in serviced apartments or hotel conversions. With the current restructuring of China’s property market, more people are becoming increasingly willing to rent, boosting demand in the rental housing market

FIGURE 3: IN WHAT ORDER DO YOU PRIORITISE INVESTMENT IN THE FOLLOWING EMERGING MARKETS?

1st

2nd

3rd

4th

5th

6th

India

Vietnam

Indonesia

Thailand

Malaysia

Philippines

0%

20%

40%

60%

80%

100%

% of respondents

Source: Cushman & Wakefield

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RISK – RETURN

It is a difficult time for investors. At one end of the spectrum, core assets remain in very high demand and continue to command a price premium. Capital growth prospects are muted and income growth prospects are mixed. This means that in a lower growth environment, total returns may come under pressure in the near term. At the other end of the spectrum, opportunistic investments may well now be “risk off”. Rather the middle ground is in mature markets and playing the middle field of “value add”. This could be improving asset ESG credentials and/ or taking some leasing risk. Indeed,

green accreditation of buildings in some markets, such as Hong Kong, is an opportunity to increase asset value. Analysis of wider return to office metrics has highlighted that high quality buildings in high-amenity locations are bouncing back faster and enjoying higher levels of occupancy. The overall “greening” of the industrial sector is another growth story to play out over the longer term. Also in that longer-term growth mindset, albeit higher up the risk curve, emerging markets in India and South East Asia continue to offer strong potential.

Asia Pacific is a diverse region and opportunities for investment exist between sectors and along the risk curve. Growth markets and growth assets remain available

FIGURE 4: WHERE IS THE BEST RISK / RETURN TODAY? (TOP 3 RESPONSES)

53%

16%

9%

within the current macro-economic environment.

Value-add Tier 1

Emerging economies

Development - developed markets

Source: Cushman & Wakefield

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As many markets adjust to higher interest rates and a generally more volatile environment, the fundamentals of investment remain as important as ever. This is not the first time that interest rates have risen or that the economic outlook has become more clouded – downside risks are not a new phenomenon. Asia Pacific remains expansionary and is highly diverse both by geography and by sector and therefore offers a variety of return profiles. Real estate continues to play a crucial role, which is why institutional investor target allocation to the region is the highest in the world – 11.4% in 2021 compared to 10.7% globally. Actual deployment remains somewhat lower at 8.5% in Asia Pacific compared to 9.3% globally (according to HodesWeill & Associates), highlighting the mismatch between investor demand and capital placement. To be successful, especially in the current climate, investors will likely need to become more nimble and think more laterally in their view to identify growth assets in growth sectors and markets. CONCLUSION

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CONTACTS DR. DOMINIC BROWN Head of Insight & Analysis, APAC dominic.brown@cushwake.com

GORDON MARSDEN Regional Director, APAC Capital Markets gordon.marsden@cushwake.com

About Cushman & Wakefield Cushman & Wakefield (NYSE: CWK) is a leading global real estate services firm that delivers exceptional value for real estate occupiers and owners. Cushman & Wakefield is among the largest real estate services firms with approximately 50,000 employees in over 400 offices and approximately 60 countries. In 2021, the firm had revenue of $9.4 billion across core services of property, facilities and project management, leasing, capital markets, and valuation and other services. To learn more, visit www.cushmanwakefield. com or follow @CushWake on Twitter.