Asian real estate represents a series of different stories, each with their own dynamics. There are bubble worries in China, inflation pressures and stalled growth in India, softening markets in Singapore and Hong Kong, and questions about the robustness of REITs across the region. But one question that unites them all is how they will respond to a global downturn or recession.

“Major external shocks from Europe or North America would make it very difficult for Asia to be totally immune,” says Peter Mitchell, CEO of the Asia Pacific Real Estate Association (APREA). “I don’t think Asia is necessarily decoupled from the full effects of what’s going on.”

Paul Guest, a real estate specialist at fund manager LaSalle Investment Management, notes that “the medium term growth story for this region hasn’t changed,” but says the region is unavoidably affected by global malaise: it hits exports, it reduces the hiring of multinational corporations, and most importantly reduces market confidence. The impact, though, varies. “We bucket property markets into several categories,” he says. “At one end, the most affected are the small, open, volatile economies like Hong Kong and Singapore, prone to short sentiment-driven cycles. There is a group where the impact is mainly macro, where a significant share of GDP is driven by exports to more advanced economies: Korea is the biggest example. And the third category is strong internal growth dynamics, including China, India and Australia.” Here, domestic demand shields economies and housing markets from global shocks.

Worries about market declines are reasonably new; until recently, there was a lot of concern about bubbles forming in Asian real estate. “I don’t think there are bubbles in the region except perhaps China,” says Mitchell. Even there, there’s progress. “The government measures to cool the real estate market in the last year or two seem to be paying off and creating a softening; if there as a bubble there, hopefully that means a soft landing.”

‘Soft’ is open to interpretation, though, and some analysts do expect significant declines in China. Patrick Ho, head of equity and credit research at UBS Wealth Management estimates a 10-15% decline in property prices in tier one cities, with lesser declines elsewhere. It’s a question of balancing the influences. “We think there are strong demand factors such as urbanization, demand for an upgrade in living quality, income growth, and strong household balance sheets,” says Ho. “However, affordability is stretched, especially in tier one cities.” With liquidity tight, developers may lower prices to boost sales and generate cashflow, while tightening measures from the state have also depressed demand and land prices have started to fall. “These reasons might contribute to a decline in property prices, but we do not expect a crash,” Ho says.

It’s important to notice how clear a distinction there is in China from one property market to another. “We don’t see a nationwide property bubble in China,” says Raymond Ngai at Bank of America Merrill Lynch. “We see a bubble in certain cities, particularly tier one such as Beijing, Shanghai and Hangzhou. Similarly, property affordability is at a reasonable level nationally: it takes six years of annual income to buy an ordinary-sized apartment in China. But in Beijing or Shanghai, the figure is 10 to 13 times, about the same as Hong Kong.” And while the government has been heavily interventionist, it’s hard to quantify exactly what it wants to see. “The central government’s objective is to see property prices come down to a more reasonable level – but Premier Wen Jiabao didn’t say what is a reasonable level,” says Ngai. “Is it 10, 15, 20% down?”

China’s view on how much moderation is enough – at which point it will presumably stop intervening in the market – will be crucial. In future in China, “we might see some measures not being as rigorously implemented,” says Christopher Gee at JP Morgan. “But at the end of the day, policymakers are unlikely to retract too far from their current stance on the sector: it’s too politically sensitive for them to be making a rapid reversal of policy so soon.”

There are, though, some broader changes on their way to Chinese real estate. Ho says there could be a consolidation of property developers. “Given the current funding constraints, the small developers will be acquired or run out of funding.” That’s better news for bigger, stronger developers who have better access to credit and lower funding costs. For example, as of late November, state-owned developers’ bonds were yielding around 5%, while some smaller developers were over 20%. This clearly has implications for the banks too, though Ho argues that even if property prices decline by 30%, banks will remain profitable.

It’s also worth remembering that China’s whole property market will evolve from its residential dominance. “The development of commercial real estate in China is still in its infancy, and we think there will be a greater flow of funds away from basic home building, from a build and sell business model to a real build and own business model,” says Gee. He notes that home builders account for about $120 billion of enterprise value in China, compared to $40-50 billion in the USA.

While they wait, though, investors have been voting with their feet. “International investors have already been reducing exposure and taking out active short positions in this space,” Gee says. “A number of high profile hedge fund managers have taken that view.”

China grabs the most attention, but property is also a mainstay of local conversation (and international investor interest) in the established hubs of Singapore and Hong Kong. Both have enjoyed considerable increases in property prices, particularly in residential; both are experiencing softening now. In Singapore’s case, so far it’s more a slowing of growth rather than a decline – growth momentum has slowed for eight consecutive quarters in private residential property, according to the URA price index – but there is a growing feeling that a decline is on the way. “Our forecast is that we could see 5-15% declines in Singapore private residential real estate prices over the next 12 months,” says Tan Chin Keong, Singapore equity analyst at UBS Wealth Management.

There’s more to Singapore than housing: it has sophisticated listed sectors, including REITs, in office, retail and logistics besides residential. Office is especially vulnerable, and Tan says he sees “potential cyclical weakness” since office space demand is particularly sensitive to the economy and macro uncertainties. That said, it won’t fall 60% as it did in 2008-9, largely because it has never regained that ground; today rentals are still 40% below the previous peak in 2007 and the supply of new office space on its way is expected to be below average in the next few years, Tan says. Industrial, on the other hand, is generally more resilient. “While Singapore industrial production activity is slowing, we could potentially see some office tenants downgrading to business park and hi-tech space in order to save on rental costs,” Tan says. Retail, too, holds up well in downturns, especially retail property rentals that cater for consumer staples.

“We see a plateauing of real estate values in Singapore, particularly residential, but there is unlikely to be a collapse,” says Gee. “There is still significant demand in the mass market space, the result of pent-up demand that built up when Singapore had a significant pro-immigration policy.”

Hong Kong is slightly different, in particular because Hong Kong has much less control over its own currency (which is pegged to the US dollar) and therefore monetary policy. “I think that the cause of overheating in the real estate market in the early 1990s, and in the last two years, was that our currency was linked to the US dollar but our economy is tied more to the Chinese economy,” says Ngai. “Unlike Singapore we don’t have any opportunity for currency revaluation, which makes the situation more difficult.”

Gee agrees. “In Singapore the strain is taken by the currency; in Hong Kong it obviously has not adjusted because of the peg,” he says. “Hot money flows from China and elsewhere have been a hugely powerful driver of the real estate market in Hong Kong.”

This is one reason the Hong Kong market tends to turn very sharply, and at the moment most people think the likely direction is downwards – indeed, in residential, it’s already falling. “We expect the Hong Kong housing market to continue to correct, for two main reasons,” says Ngai. “First, we are starting to see more land supply coming onstream.” The Hong Kong government has pledged to supply land upon which 20,000 units of housing can be built, each year, compared to a recent average rate of about 15,000 in terms of annual takeup. Additionally, new clauses in land sale documents require developers to build more small-size units, which will likely lead to an oversupply within three or four years. “The other is demand. Next year we expect the economy in Hong Kong to slow down, unemployment to move up, and the mortgage rate to rise. When you add these supply and demand effects, we are looking for a 10 to 20% drop in housing prices.” In the fund management community, Guest at LaSalle says he has seen predictions everywhere from no change to a 30% decline. While he is not that bearish, he notes: “When Hong Kong declines, it’s never single digits.”

As Gee puts it: “It’s a hugely volatile space: as soon as people think the next move in prices is down, it compounds on itself, and the inflexion point is very sharp. You go from extreme optimism to extreme pessimism in a heartbeat.”

The other national market worth taking a close look at is India. Again, the outlook depends on the sector. “We are more bullish on the commercial side than the residential side,” says Jyoti Jaipuria, [TITLE BEING CHECKED] at Bank of America Merrill Lynch in Mumbai.  “In commercial, the demand is still fairly decent and supply overhand will ease off.” That’s in contrast to residential (retail, in India, being a small and niche market so far). “On residential in general, we are quite negative. We think there will be a lot more supply coming up, and demand has been fairly weak.”

India has spent recent years battling inflation pressures, a key priority of the Reserve Bank of India. “When the boom was taking place, the Reserve Bank did caution banks against lending to real estate companies,” notes Jaipuria. “For example they don’t allow lending for land, just for real estate. That semi-cautious stance may not change in a hurry, because the central bank thinks this is a relatively risky segment.”

Investors are positioning themselves for a decline, at which point opportunity might arise. “The crux is we are seeing a slowdown in demand, but nobody is cutting prices,” Jaipuria says. “From a strategy perspective, the decision the developers have to make is: do they roll back their plans, not develop and not reduce prices; or do they go ahead with new projects and reduce prices? Then you have a chance of volumes coming back, but the margins may be lower. The builders have to decide what to do.”

From a regional perspective, one market to watch closely is real estate investment trusts (REITs). These are supposed to be stable, steady generators of yield, yet in the global financial crisis the REIT market in Singapore – the biggest in Asia outside Japan – underperformed the broader market, exactly what it’s not meant to do. However, many feel that it is in far better shape today. “Going into the heart of the GFC at the end of 2007 there were a number of REITs that had levered up on the expectation that cheap credit was here to stay forever,” says Gee. Others had committed to large acquisitions that needed to be funded, had bullet repayment loans due, and a concentrated debt maturity profile at a time when the debt capital markets closed. “Today the situation is rather different. The number of outstanding and unfunded acquisitions was far fewer, REITs have recapitalised post financial crisis, and in general they are in a far healthier state than in the previous cycle.”

Any market downturn will hit REITs, and they generally do need access to capital markets to sustain them, since they need distribute their taxable income and need new capital to expand. “But Asia’s banking system has proven to be quite resilient, having reformed itself as a result of the Asian crisis, so access to debt didn’t totally dry up here like it did in the US in 2008-9,” Mitchell says.

“The Asian REIT market has been impressively resilient,” he adds. “It has some positive features post-crisis that are not shared in North America and Europe.” For a start, its market cap today is higher than before the crisis, and it has sustained capital raisings, including new IPOs. Mitchell adds that regulators in Singapore, Japan and Malaysia in particular have been supportive of REIT markets and intervened swiftly where necessary; they also insist on openness. “There are a lot of REIT regulations here which make them very transparent,” Mitchell says.

“People used to say they were boring products before the crisis: they are restricted as to what they can invest in, the gearing is limited and there are other investor protection rules that don’t apply to operating companies. That has held them in good stead.”

Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

We’re all property investors one way or another. If we have a mortgage, we’re invested in real estate. But beyond our own home, there are several other ways of investing in property as part of a portfolio.

This article will focus on listed property – stocks that can be bought and sold like any other share, but which give exposure to real estate. There are two types of stock that do this: shares of companies that are engaged in property, and so-called A-REITs – Australian real estate investment trusts – which are a special type of investment vehicle that hold properties within them and pay out regular dividends based on the income that comes from those properties.

A-REITs have had a tough time in recent years. The financial crisis badly hit products like these, partly because of some bad habits that had crept into their management during the preceding good years: high gearing, ambitious dividend programmes, and a sense of being a bit too clever for their own good. Many A-REITs badly underperformed the Australian market through this period, and several got into real trouble.

For the first time in years, though, fund managers are talking with much greater confidence about the sector. “A-REITs are probably in the best financial shape they’ve been in for at least five, if not closer to 10 years,” says Stephen Hiscock of SG Hiscock & Co, a Melbourne-based specialist property fund manager. “If you go through all of the issues with the sector in recent years, they’ve been dealt with. Gearing is back to 2002 levels: it was far too high in the mid-2000s, well over 40% in many cases, but that’s been fixed. Banking covenants, in hindsight, were lax, but the vast majority of those have been renegotiated. Dividends had always been a concern to us: for many years, the average payout ratio was more than 100% of free cashflow.” That is, paying out more than they were getting in. “Now REITs are, for the first time in a long time, on a sustainable model, paying out on average about 77% of earnings. It’s a huge positive.”

And the general raison d’etre of REITs has returned to what it used to be: a stable, even boring model of paying out reliable and decent yield from incoming rents. “If you look at the management practices, there was a focus on non-rental income and poor quality earnings. Now there’s a renewed focus on going back to basics for the majority of REITs.”

Andrew McGrath, director of Reliance Investment Management, which is the manager behind a new property fund from Charter Hall, agrees. “We see the lessons learned in the GFC: back to basics,” he says. “They’ve got rid of non-core overseas property exposures, reduced their debt, and regained some of the safe haven benefits of property exposure. That’s reflected in their share price volatility, which is back to historical averages.”

And, on top of that, where once the sector was expensive, now it’s cheap. “Pre-GFC, the sector was trading probably more than 30% above fair value,” Hiscock says. “Now, on our numbers, it’s trading below fair value: in a technical sense, it’s a good time to get in.” The same applies to the valuation of the underlying properties, which have also fallen.

It all adds up to a positive outlook. “We are quite confident the sector will return more than 10% per annum:  a yield of 6%, with earnings growth of 2 to 4% over the next few years,” Hiscock says. McGrath adds: “The discounts to the net asset backing make it quite appealing. Normally we’d expect property returns to be in the 8 to 12% range. But since we see stocks trading back towards NTA [net tangible assets – that is, the value of the thing the REIT holds] in the long term, A-REITs should return to the higher end of that range, if not slightly above.”

Where should listed property fit into a portfolio? “I think listed property, ideally, should provide you with an inflation hedge with an attractive yield,” says Hiscock. “Over the long term, it will be connected to the direction of the commercial property market.” For this reason, comparing listed property exposure with investment properties is counterintuitive. “Residential has a very low yield on a net basis; if you deduct capital expenditure then net yield is very unattractive compared to REITs. In the REIT sector the net yield is 6.2%.”

And McGrath argues that listed property adds diversification. “Having your own exposure to residential property is one asset class; we believe commercial property is another.”

One of the oddities about listed property is that it tends to be very focused towards a few names, although not as severely as it once was. At one stage Westfield accounted for 53% of the listed property market in Australia; today it’s 27%, with Westfield Retail Trust adding a further 11% to bring Westfield’s overall stake in the market to 38%. This is a big issue for active managers, because if they significantly underweight Westfield they run the risk of looking foolish if they get it wrong (or smart if they get it right). Reliance, for example, has a total of 11% in the Westfield stocks. “We are index unaware,” McGrath says.”We believe in investing in stocks where there is true value, and we can find better opportunities relative to Westfield.”

Property trusts cover a range of different property sectors, from offices to warehouses, shopping malls to hotels. Fund managers tend to have different views on these sectors at different times. “We are more happy to be exposed to those sectors we call corporate, or commercial/industrial, than retail or residential,” McGrath says. He sees retail and residential as more consumer related sectors of real estate, “and we think the consumer is under a lot more pressure, whereas corporate Australia is basically benefiting from the flow down into ancillary services from the mining sector.”

Listed property is not the only way to go. Many mutual funds offer exposure to unlisted property – direct stakes in the bricks and mortar – or offer a combination of some listed and some unlisted property. The argument for unlisted property is that it represents much more of a diversifier than listed property, because when the stock market is moving around, listed property will tend to move in tandem with it, to an extent. The argument against it is that it is illiquid, and this became particularly important during the financial crisis. “For some investors liquidity is not a concern. They might have a long timeframe, and for them a modest amount in unlisted property is fine,” Hiscock says. “For other investors, for whom liquidity is important, REITs are the preferred entity in my view. But it depends on the investor.”

McGrath adds: “In the GFC we had a number of funds that were hybrid with exposure to listed and unlisted real estate, and when the tough times came, those funds had to close up redemptions and you couldn’t get your money out. Liquidity, for retail investors, is an important difference.”

And for those who do want listed property, there is an alternative to active managers: you can also get your exposure passively, through an index mutual fund or, increasingly, an exchanged-traded fund (ETF) which can be bought and sold like any other share. Vanguard, for example, has both a passive property fund and an ETF; State Street offers a property ETF.

“If investors decide they want access to property securities, they are really thinking about their overall asset allocation and about achieving diversification through holding a range of sectors in the portfolio,” says Robyn Laidlaw at Vanguard. “With a property securities index, they are getting diversified exposure to a range of Australian-listed property securities companies. You get retail, offices, industrial – all the different sectors of the property market.”

There are numerous other ways of getting property exposure: international property funds; in the near future, likely an international property ETF; and of course just buying a house as an investment property. But what’s striking at the moment is that after five years of bad news about listed property, there’s an uncommon sense of stability and optimism.

How to judge the real estate investment trust (REIT) market in Asia Pacific? One one hand, it had a stellar 2010, with the overall market increasing in market cap by 22.8% over the course of the year to US$158.6 billion, according to the Asia Pacific Real Estate Association (APREA). On the other hand, that’s still 20% less than its size October 2007.

So the overall story is one of revival rather than success. But in truth, it depends where you’re looking.

Once again based on APREA statistics, Australian (43.6%) and Japanese (26.3%) REITs account for by far the largest part of the regional REIT market. But when many investors think of the Asia Pacific market, they’re looking for the emerging market growth story that tends to exclude Australia and Japan, which are more likely to be handled in other portfolios. Looking at the ex-Australia REIT market, that market cap is at an all-time high: US$93.1 billion at the end of December, with Singapore very much the driver. There, the market grew has grown from US$7.8 billion in March 2009 to US$28.9 billion at the end of 2010 – it has more than trebled in size.

And this, really, is the story for real estate fund managers looking for Asian growth exposure. If one sees Japan and Australia as separate, then Singapore has succeeded in making itself the hub for regional REITs. It has done so through a number of measures, some about infrastructure, some market behaviour.

On the infrastructure side, the Monetary Authority of Singapore was very quick to see the opportunity in a regional REIT market and swiftly put in place the tax environment to allow it to flourish. Singapore Exchange, which has always had an eye for a new market opportunity, also made life easier for issuers and has been very supportive of its development.

On top of that, Singapore has been blessed with key issuers – chiefly Capitaland, but also Mapletree, for example – who have understood how to launch REITs that not only work for the company by generating regular cash from their assets, but also keep investors happy. A CapitaLand REIT – and there are now four of them in Singapore, plus two in Malaysia – puts its best assets into the vehicle, and gets its best people to run them. That’s in stark contrast to Hong Kong, whose own REIT market has stumbled and been unpopular, thanks largely to the habits of some early issuers who filled their structures with elaborate financial engineering that made them difficult to understand and often poor performers too.

When one looks at the Singapore REIT market today, it is usefully diversified. Analysts tend not to cover it as a single bloc anymore but a serious of separate sectors within the REIT universe, which is a clear sign of diversification: Nomura, for example, covers office REITs, retail REITs, industrial REITs and non-Singapore landlords in separate categories (and has notably different views for each, currently seeing office as the best opportunity). That last category, non-Singapore landlords, is particularly significant: vehicles such as Global Logistic Properties (not strictly a REIT but nevertheless a powerful real estate play) and CapitaMalls Asia have all of their assets outside of Singapore, increasing the sense of the country as a regional rather than a local hub.

In one significant new deal in 2010, Singapore welcomed an Islamic REIT, the Sabana Shariah Compliant Industrial REIT. While Malaysia had previously launched Islamic compliant REITs (and based on some interesting underlyings, like hospitals and plantations), Sabana was by far the biggest and was notable for attracting non-Islamic money from anchors such as Fidelity, as well as heavy Middle Eastern participation. Other new deals included Mapletree Industrial Trust, cementing Singapore’s position as a hub for logistics and industrial property.

Another encouraging thing about the Asian REIT market is that the number of centres within it is gradually increasing. This has been talked about for years but has always been undermined by either a lack of suitable infrastructure (such as tax rules in Thailand), political delay in getting legislation through (such as the Philippines), or a general lack of enthusiasm for the market’s development (Taiwan, Korea and until recently Malaysia).

APREA says Malaysia’s REIT market cap grew 122.7% in 2010, thanks largely to two new listings, Sunway REIT and CapitaMalls Malaysia Trust (another CapitaLand REIT). Market cap grew by 52.7% in Korea and 37% in Thailand during the same period, albeit from low bases. These markets are sufficiently small to be heavily changed by new listings: Golden Narae Real Estate Development Investment Trust and KOCREF 15 in Korea, Thai Commercial Investment Fund in Thailand. Another interesting trend speaking of regional growth and integration is a dual listing for a REIT: Fortune REIT, from Singapore, started this in 2010 when it received a second listing in Hong Kong.

Set against these promising themes are the uncertainties of the macro environment. Asia, in contrast to most of the world, is replete with liquidity, which has led to a number of Asian regulators seeking to curb speculation in their real estate markets, and to cool down their economies generally in growing fear of inflation. China, in particular, has intervened hard in its real estate market, and these trends are likely to have knock-on effects on REIT performance.

What does all this mean for fund managers looking at real estate in Asia Pacific? For a start, increasingly, there is a properly diversified range of opportunities for a fund manager to consider, and correspondingly increasing numbers of international fund managers are moving investment professionals into Singapore for real estate portfolio management on the ground. If a fund manager wants an Asian office trust, there are now plenty to choose from; likewise retail or industrial. If they want a REIT based on serviced apartments, or palm oil plantations, that can be done. If they want Islamic paper, or something based on Chinese shopping malls, that can be accessed too.

At the same time, the dust is settling on the financial crisis, leaving REITs with prudent risk management and steady income intact, and those with questionable levels of gearing or financial engineering in less good shape, if they have survived at all. That is making it easier to build a portfolio of more traditional, income-generating securities.

Fund researcher Morningstar’s Hong Kong database now lists 25 funds in the “Asia property indirect” category, including products from Aberdeen, First State, Henderson, Invesco, Prudential, Schroders and JF (run by JP Morgan) as well as local names such as Hang Seng and Bank of China Hong Kong.

The next step will be growing maturity of Asian REIT markets outside of Singapore and Hong Kong (not that Hong Kong’s has shown much sophistication as yet). Malaysia is now taking the opportunities of a REIT market seriously; sooner or later China will allow for the development of one there too.

A postscript: at the time of writing Singapore’s largest ever IPO was being launched – for a foreign company, HPH Trust, part of Hong Kong’s vast Hutchison Whampoa empire. Apart from being significant as a large Hong Kong company that has opted for a Singapore listing, HPH Trust stands out because it uses a structure called business trust. This was devised a few years ago in Singapore as a sort of cross between a corporate listing and a REIT; the company’s assets are held in trust structures and pay out a regular yield like a REIT. The business trust structure has not thrived in Singapore since its initial launches, but when the country’s largest ever listing takes that form, it suggests there’s much more to come, and they may well turn up on the radar of REIT asset managers too.

Short Talk: Michael Tanujaya, Lend Lease

In many careers there comes a point when it’s time to take a risk. For Michael Tanujaya, that point came several years into a successful career at Lend Lease, Australia’s largest integrated property development group. He was working in head office in Sydney, rising through the ranks and doing well. And then an opportunity came up in Singapore.

“Australia is a fortunate country: it missed the global financial crisis, it’s booming, and I was very comfortable there in head office,” says Tanujaya. “But I noticed that in headquarters, you don’t get into the details too often. You’ll be managing a certain stream of work but you don’t see the actual negotiations that are happening within it. You don’t go in at the deep end.”

Going to a foreign office, he decided, would get him into the heart of negotiations, speaking with agents, tenants, investors and banks. “Asia’s going to be the next world market, no doubt,” he says, so there was voluminous opportunity to get involved. He took the plunge and, one year on, has not looked back. “Coming to Asia I deal with the head of Bovis [Lend Lease’s construction arm], with the head of retail development, with the banks to negotiate the debt. I lead the investment side of tenders, oversee financing models, get commitments on pricing and design. It’s not an opportunity you get sitting in head office.”

Lend Lease is associated with some big projects in Asia – it was the project manager on Malaysia’s landmark Petronas Towers, and in Singapore recently completed 313 Somerset, one of the city’s most exclusive retail developments. But it’s also a foreign competitor against some local heavyweights such as CapitaLand, which are not only world-class developers but are part-owned by the Singapore state. But the sense of being an underdog seems to appeal: he was instrumental in the team that recently won the bid to develop Jurong Gateway, another retail development in Singapore’s west, a hotly contested bid that CapitaLand had very much expected to win. “It’s a tough market,” he says. “But it is very transparent: you know what’s coming up, you put in a price and you find out the same day if you win the bid.”

His role in Singapore covers investment and product development, which includes seeking new institutional investors and finding the right projects to invest in. He covers both Singapore and a newly-established team in Shanghai, China. Both locations are going to be instrumental for Lend Lease’s future growth.

“I think my CPA background has helped a lot in Asia,” he adds. “It’s given me a broader skill set – I know my accounting and tax but also do a lot of business strategy work, and for that I still go back to my CPA folders.”

Box

When Michael Tanujaya left Melbourne University, he thought he wanted a career in banking, not property, and joined the commercial arm of General Electric. After almost three years in Melbourne he was transferred to GE’s head office in Connecticut for two years.

While the opportunity was great, Tanujaya was keen to return to Australia, and had decided that rather than banking, his calling was in property. In Sydney, he found Lend Lease was hiring. “They said: ‘what do you know about property?’” he recalls. “I said, at the end of the day, you build something and people will come.” His approach won over the interviewers and he was hired.

It was a baptism of fire. Immediately placed in the project finance division, he was involved in Lend Lease’s pitch for the iconic Darling Walk site in Sydney’s Darling Harbour development. “There I was,” he says. “I didn’t really know anything about real estate, and they asked me to build a financial model and figure out what the land price was worth. On my first day, I stayed back until 12 a.m. But it was a good learning curve; the best way to learn is to go through the pain yourself.”

After six months he moved within Lend Lease to a new role in the investment management team, which has private equity characteristics and was better suited to his financial experience. The opportunity in Singapore then came along; he has held the role for about a year.

Should you be worried about Australian house prices?

1. Are you planning on moving? Yes/No

If you’re not, and you don’t own an investment property or plan to do so, then the value of Australian housing doesn’t really matter a jot. So what if your house is overvalued? It’s still the same house. To an extent, even if you are looking at moving house, it doesn’t really matter so much, since the whole market is rising – so a new house would cost you more, but your old one would be worth more too.

2. Are you planning on buying an investment property? Yes/No

This is where house prices do become more relevant. Australian house prices have risen vigorously over the last year or so, and while the extent of the rise varies from place to place, AMP says Aussie house prices are running about 35% above their long term average. So for an investor, the question becomes: will this continue, and make me money? Or are we in a bubble that must burst? To answer that, you need a view on the following questions.

3. Do you think there’s a bubble? Yes/No

To answer this question, look around you. If you notice neighbours’ houses being listed for a lot more than they used to, you might think price rises are out of control. But, come auction day, are they selling? Is the auction packed with people who look worried they might miss out? Actually, auction clearance rates in both Sydney and Melbourne are falling, which is not what you normally see in a bubble.

4. Do you think it’s too easy to get a mortgage? Yes/No

Another bubble characteristic is too easy access to credit from the banks. That’s what started the sub-prime crisis, and subsequently the global financial crisis, back in 2007. Chances are, though, that most Australians do not feel it has got easier to get money out of banks in recent years. It’s tough to get a loan to value ratio rate of 80% these days without jumping through a lot of hoops, and that didn’t used to be the case.

5. Do you think there’s enough housing to go around? Yes/No

This is another crucial part of deciding whether we’re in a bubble or not. It’s simple supply and demand: if there’s not enough housing, there’s a good case for prices to keep going up. If there’s plenty, and still prices are soaring, it’s time to worry. This picture also varies from place to place but in the major cities it’s rare for people to feel there is a major residential oversupply.

6. Do you carry too much debt – and do you think everyone else does? Yes/No

Australians do tend to carry quite a lot of debt, in a variety of different forms from the mortgage to the credit card. One of the toughest lessons of the financial crisis was not to over-extend yourself: you only need a modest knock to your circumstances to find yourself unable to service a loan if you have too much debt on your hands. More broadly, if you think Aussies in general have too much debt, that’s something to worry about at a time of high house prices, as a reversal in values is likely to hit people such as property investors who rely on rental income to service their loans.

7. Do you think interest rates are going to climb quickly? Yes/No

We tend to forget that interest rates have been in double digits not too far back in Australia’s history. How many of us could cope with our mortgages, both on home and investment properties, if that happened again? Nobody is forecasting levels like that in the near future but rates are likely to rise before they fall – steep hikes could prompt a fall in property values as buyers pull back.

8. Do you think shares are a better bet than property? Yes/No

This isn’t a cause for worry, more an investment decision – for a budding property buyer, it’s worth considering if other investments look more promising. Planners tend to see better value in Aussie shares than Aussie residential property right now, but there’s plenty of opinion on both sides.

9. Do you expect unemployment to rise sharply? Yes/No

This is something else that prompts property prices to fall. At the moment, there’s little obvious reason for alarm about the Australian economy: it’s doing vastly better than most others in the developed world, although it is perhaps troubling how heavily reliant the economy is on China and general emerging markets demand for commodities.

10. Do you think there are too many property investors, as opposed to home owners? Yes/No

A final spur for a property bubble is speculators piling in. In contrast, when most home purchases are going to families who hope to live in them, that’s considered a sign of stability. AMP says the proportion of housing finance going to investors has actually dropped, from 50% seven years ago to 39% today.

Mostly yes: Aussie property is due for a fall and you’re worried about exposure. Deleverage yourself and sell at the top.

Mostly no: Just because the market is highly valued doesn’t mean there’s not a good reason for it. No cause for alarm.

The idea of using the equity in your home to start a property portfolio has a lot of appeal. You don’t have to use a lot of savings; you don’t have to sell anything; you just use something you already own to anchor a new investment.

Here’s how it works. Your equity in your home means the amount of it you own – the value of your home, minus whatever’s outstanding on your mortgage. If you have a home worth $500,000, and your outstanding debt is $200,000, then you have $300,000 of equity in your home.

You can use that equity to make other investments, such as buying another property. There are two ways to do this: you draw on your existing home loan (sometimes known as a redraw), or get a new line of credit, whether from your existing lender or a new financial institution. You use that money as a deposit on an investment property, and get a new loan for the balance of the acquisition price.

There are a few considerations before you try this, starting with working out how much capital you will be able to get. If you are looking for a line of credit, banks will be having a look at how much equity you have in your home and deciding what proportion of that they are prepared to lend you. Typically, these days the maximum is 70 to 80% of that equity. Banks used to lend much more before the financial crisis, but those days are gone, and with good reason: being too highly geared can get you into a world of trouble if circumstances turn against you, such as losing your job, losing your tenant in an investment property, or interest rates rising quickly.

The rate of interest on a secured line of credit is usually slightly higher than a home loan, and naturally you need to be comfortable that you can meet the additional repayments to service this facility. Keep in mind that this line of credit will be secured against your own home.

Then, there’s the new investment loan. Again, the bank will be looking at a few things in deciding how much to lend to you: the size of the deposit you’re able to put down; and what your income and assets say about your ability to make repayments. The key measurement banks use here is the loan to value ratio: again, banks these days are unlikely to go far beyond lending you 75% of the value of the property.

Doing these sums allows you to work out how much money you have to play with, and therefore how expensive a home you can afford. Next, you need to work out what rental income you can reasonably expect from that property, and how it relates to the repayment costs on your new investment loan.

This is where you get into questions of negative and positive gearing. If your rental income is less than your loan repayment, you are negatively geared. If it’s more, you are positively geared.

Australians have a habit of actively seeking out negative gearing, because it comes with a tax advantage. The shortfall between your rental income and the interest you repay on your loan can be used as an offset against tax, and you can see this tax refund as an additional source of income from the investment property. That’s fine – but some people get so fixated with the tax implications that they forget about the point of being in the investment and the first place, and find themselves getting into a debt hole where they can’t find the money to make repayments. It’s worth sitting down with tax and financial advisors to discuss your own circumstances.

If you have more money coming in from rent than is going out on repayments, that presents another question: what to do with it. Advisors suggest repaying your home loan. “The interest on the debt on your family home is not tax deductible, while the interest on your investment loan is tax deductible and will reduce your liability to tax,” says Kevin Sudlow at Multiport. So it’s better to pay down non-deductible debt on your home than deductible debt on an investment property.

What are the cons of using home equity to buy a new property? “You are now servicing two loans, which isn’t a problem if you can service both loans,” says Sudlow. “However if the rental payments you receive don’t cover your loan repayments, you will need to contribute that extra money to fund the investment loan repayments.” And if interest rates rise, that will become tougher.

BOX: An example

Kevin Sudlow at Multiport maps out the following example of using equity to build an investment portfolio.

Steve and his family live in a property worth $700,000, with an outstanding debt of $300,000, meaning he has amassed $400,000 of equity in his family home.

Steve has found a $500,000 unit he would like to buy as an investment. His financial institution agrees to establish a $280,000 line of credit for him – that is, 70% of the value of the equity he has in his family home. He draws $150,000 from this line of credit, and uses it as a deposit on the unit, and pays the balance, $350,000, with a new loan.

So what’s happened? Steve’s got an investment property without having to use any cash savings, or sell any other assets – he’s just used the equity in his family home. He uses the rental income from the new property to repay the loan on that property.

But let’s say the rental income doesn’t cover the interest on that loan. This is what’s known as negative gearing, and it has two impacts: he needs to come up with the cash to cover the shortfall; but he also has a tax benefit. Let’s say his rental income is $10,000 per year and the interest on the investment loan is $15,000, creating a deficiency of $5,000 that he will have to come up with from elsewhere. That deficiency is deductible from other income for tax purposes, so if Steve is paying tax at 31.5%, he will have a saving of $1,575, adding to his investment return.

What if it’s the other way around, and his rental income is greater than his interest costs? If he receives $15,000 a year in rent and the loan repayments are $9,000, he is better off diverting the extra $6,000 to paying down the outstanding debt on his family home, as that is not tax deductible, whereas interest on investment loans is deductible.

While Steve has acquired a new property, he has also acquired risk: he is now servicing two loans, and if he should find himself without a tenant in his investment property for any length of time that is likely to become a major financial strain. Steve, like anyone in this position, should work out just how stretched he would be if that were to happen or if interest rates were to rise sharply, and ensure he is comfortable with the answer.

In November, Sabana REIT achieved a number of landmarks: the largest ever Islamic real estate investment trust (REIT); the first one to be listed in Singapore; and perhaps the transaction that demonstrates beyond argument that Islamic securities can be attractive to investors who couldn’t care less about religion.

Sabana was, on the face of it, a curious deal. Singapore’s REIT market has made its name through listings from big developers like CapitaLand or Mapletree, choosing collections of quality assets and listing them with a view to careful management and expansion under their own brand name. This, on the other hand, seems a looser affiliation of 15 industrial properties, and the closest thing to sponsorship comes from Freight Links Express, which injected five of them. Management of the assets will not be contributed by a big property developer but will be through independent management controlled by the shareholders themselves.

But if that seemed rudderless, it didn’t show in the deal’s reception. It raised S$636.1 million (US$500 million) and brought in four cornerstones: Al-Salam Bank of Bahrain, Capital Investment & Brokerage of Jordan, Fidelity’s FIL Investment Management (Hong Kong), and a subsidiary of Metro Holdings called Meren.

“I think it’s a landmark deal from a number of perspectives,” says Jason Kern, managing director and head of real estate advisory for Asia Pacific at HSBC, sole financial advisor and one of the lead managers on the deal alongside UOB and Daiwa. Partly that’s because it’s a big deal by any measure; partly because of its scale as a Shariah deal; and partly because of its contribution to Singapore’s overall REIT market, cementing its place as the regional hub. But chiefly, it’s about investors. “We have truly brought a brand new set of global investors to the Singapore market through this deal,” he says. “30% of the shares went to Shariah-compliant investors who had never invested in a REIT before, much less in Singapore.” And the bulk, 70% went to non-Shariah buyers.

Perhaps the most significant name in the investor roster is Fidelity. It’s rare for Fidelity to come in as a cornerstone investor in any circumstances, but to do so in an Islamic deal is particularly striking. Fidelity declined to comment, saying it never comments on individual stock holdings or IPOs. But Kern says: “Non-Shariah investors like Fidelity saw the underlying attractiveness of the deal in terms of the size and the yield and the high quality of the assets. Those fundamental aspects were attractive enough to get them on board; for them, the Shariah-compliant nature was neutral.”

This is exactly what Islamic bankers have been saying for years, but have lacked an obvious example to point to for evidence. In Malaysia in particular, it is commonplace to claim that Islamic finance works primarily as a solid financial system producing attractive assets, regardless of whether you embrace the faith or you don’t. “In Malaysia, some of the largest providers of Islamic financial services will tell you that more than 50% of their clients are non-Muslims, some up to 70%,” says Dr Zeti Akhtar Aziz, governor of Bank Negara Malaysia. “In our sukuk market, we see many issues from non-Muslim countries, and many investors. They look at whether products or services meet their financial requirements, and whether they are competitive. So long as you can offer those two elements, Islamic finance offers tremendous benefits,” including for investors who are not drawn to it for reasons of religion.

Still, for a deal that mainly went to non-Muslims, it was interesting to note that Sabana went for a level of Shariah compliance far higher than that typically required in neighbouring Malaysia. In fact, of the Shariah book, most were from the Middle East, including Kuwait, Jordan, Bahrain, the UAE – and Saudi Arabia, by far the toughest market of them all on Shariah compliance.

This is an interesting decision. Until now, Malaysia has been the main centre for Islamic REITs. Malaysia’s Securities Commission issued its guidelines for Islamic REITs back in November 2005, and the first three REITs in the region are here. They are based on interesting assets: the first, Al-Aqar KPJ REIT, established in June 2006, is underpinned by hospitals; the next, Al-Hadharah Boustead REIT, was the first plantation REIT in the world; and the third, Axis REIT, was distinctive for having started life as a conventional REIT in 2005 before begin converted to an Islamic structure in December 2008. (Another REIT, Cambridge, began a similar conversion but abandoned it.)

Malaysia is unusual in having published guidelines for Shariah compliance in REITs, but that’s no surprise: Malaysia stands out for the clarity of its regulation and practice in Islamic finance across the board. But the part of these guidelines that leaps out is that in Malaysia, a REIT can get up to 20% of its total turnover from what it calls non-permissible activities. So, for example, if you own a shopping mall, the fact that it includes a supermarket that sells alcohol, or a newsagent selling lottery tickets, does not count you out of Shariah compliance in Malaysia provided no more than 20% of the rental income to the trust comes from those sources. Likewise if your office tenant mix includes a conventional insurer, or a bank, or a broker who deals in non-compliant shares, the same 20% rule applies. (Crucially, this has to be from mixed compliant and non-compliant activities; if your property has tenants in which everyone conducts non-permissible activities, such as a cluster of bars, then that’s not Islamic even if the rental from those activities is less than 20%.)

That’s considered rather liberal in Shariah terms, and it certainly won’t wash in the Middle East. “There are varying degrees of Shariah compliance,” says Kern. “We have gone for the most strict interpretation.” The Shariah committee Sabana put together included Mohammed Elgari, a Saudi scholar (profiled in Asiamoney in September 2006) who brought a more strict interpretation of compliance than would be common among Malaysian scholars. Doing so opened the investor base to the Middle East.

Making a REIT Islamically compliant is not particularly complicated. Chiefly, it’s about avoiding tenants or sources of income from no-no areas like defence, alcohol, gambling, porn or conventional financial services. In practice, this makes industrial portfolios easier to consider than, say, retail or office property which is always going to have a wide range of contributory tenant mixes. “Generally, industrial property would be a lot easier than commercial assets,” says Tan Jeh Wuan, managing director of the Islamic Bank of Asia in Singapore, although he does point out that defence assets – like military barracks – can be trickier to handle.

In many cases it’s unavoidable to have some income that is indirectly non-compliant, so the practice is simply to cleanse that income – generally by giving it to charity so it never features in the income stream. “The work required is nothing other than getting that respected Shariah board put in place, having scholars do due diligence on the rent, and then looking at individual tenants to make sure the leases are not for businesses that constitute a violation like alcohol or tobacco.” Retaining the Shariah board represents something of a compliance cost, but Kern puts it at about US$100,000 a year.

Leverage is also an issue, and this is a continuously grey area in Islamic finance. Naturally, the Quran did not get into precise percentages of acceptable leverage, so it has been left to scholars and the market to decide what degree of (compliant) borrowing would represent undue risk to the point of becoming speculation, which is prohibited.

“The purest view of an Islamic REIT would be that 100% of the financing is done in an Islamic way, in which case the ratio is not an issue,” says Tan at IBA. “At the other extreme, the Dow Jones Islamic Index has created some accepted minimum standards of leverage for Islamic investors to buy equities. In between this and pure REITs come a whole range of standards, and it depends how Islamic investors look at these standards relative to their internal requirements.” As a rule of thumb, indices like the Dow Jones Islamic index consider 30% leverage a ceiling for any stock to be considered; in Sabana’s case, it starts out with leverage of 26.5%, compared to an average for the REIT sector generally in Singapore of over 30%.

The fact that industrial REITs are an obvious area for further Islamic growth stands Singapore in good stead, because it is already a haven for industrial REITs – in fact, they are the largest cluster. Moreover, they tend to be backed by very big names: Mapletree, which has a logistics REIT, is backed by one of Singapore’s sovereign wealth funds, Temasek; and Global Logistics Properties, the industrial property company which came within a whisker of being Singapore’s largest ever IPO earlier this year, is backed by the other, Government of Singapore Investment Corporation. GLP is not a REIT but is considered likely to spin one off in due course. CapitaLand, the biggest of all REIT developers, is better known for its retail REITs but is also a candidate.

Asiamoney asked all three groups, who responded with varying degrees of practised ambiguity. “We are always exploring and seeking new opportunities in the market,” says Jonathan Kuah at CapitaLand. “However, at this juncture we do not have any immediate plans.” At Mapletree, Lily Ler, who speaks for the MapletreeLog logistics REIT, was less open to the idea. “To be in compliance with the Shariah investment principles will mean imposition of restrictions and conditions on the logistics players, which would not be welcomed unless they are able to impose similar conditions on their principals,” she says. “Until our customers are ready to accept such terms, we do not think it is practical to make MapletreeLog Shariah compliant in the immediate foreseeable future” – although that’s not the same as saying that new REITs might not consider the approach.

Bankers are certainly talking to groups like this. “We are seeing a lot of interest following the Sabana REIT,” says Tan at IBA. Interestingly, he says that many of these inquiries come from companies in the GCC considering an Islamic REIT in Singapore. “The advantage is, it opens up the investor base. In a normal REIT conventional investors can of course participate, but in an Islamic REIT both conventional and Islamic can do so.”

Raja Teh Maimunah, head of Islamic market development at Bursa Malaysia, also suggests we may see REITs from the GCC appear in Asia – though naturally, she’s expecting them to come to Kuala Lumpur. “Companies in the Middle East are not as familiar with what the REIT structure does, but real estate is close to their heart,” she says. “The Asian REIT market could possibly address some of the challenges with the regard to the returns investors are seeking in the GCC from their real estate investments. Some listed REITs in Malaysia start out with a yield of 7 to 8% at IPO. That’s virtually unheard of in the GCC.”

Another sign of interest in the GCC is that prior to the financial crisis, the Islamic International Financial Market – a Bahrain-based multilateral backed chiefly by Middle Eastern countries, which seeks to standardise markets and products in Islamic finance – was looking at issuing guidelines and templates for Islamic REITs. Changes in the market through the financial crisis caused it to look at other things instead, and the bulk of its work since then has been on standard templates for hedging mechanisms in order to bring that element of Islamic finance into line with International Swaps and Derivatives Association (ISDA) structures. “But it’s possible we will return to Islamic REITS if the industry requires it,” says Ijlal Alvi, CEO, in Bahrain.

If GCC property developers are considering REIT listings in Asia, then Singapore may be able to make a useful point of distinction. Malaysia is clearly the regional centre for Islamic finance, and has a track record going back the better part of 20 years in its capital markets now. But if Singapore can use the Sabana example to suggest that levels of Islamic stringency are typically higher there, it’s possible it could steal a march. “It is essential for the Islamic REITs that are coming up in Singapore to be able to set a relatively high level of Shariah compliance standards so that they meet GCC requirements,” says Tan. “We want to maintain those high standards so that investors can look at an Islamic REIT listing in Singapore as, by general consensus, meeting the GCC standards.”

Still, the fact that there are REITs with more liberal interpretations of compliance in Malaysia does not mean it would not provide a willing audience for stricter structures too. In the end, these deals will stand or fall on what they offer to investors, and more than anything, that’s just about providing a decent deal. “Sabana REIT offered very good commercial returns,” says Tan. “That is what attracted conventional investors: if it makes sense, they come in.”

Later this month the Government of Singapore Investment Corporation, one of Singapore’s sovereign wealth funds, will being a global roadshow for a new IPO. The listing will be for a cluster of overseas assets held by its real estate arm, and is expected to raise about US$3billion.

The float – expected to include a group of logistics property assets in Japan and China purchased from ProLogis in 2008 – is an example of how momentum has returned to Asian real estate markets in the wake of the global financial crisis. If the IPO raises as much as expected, it will be the largest in Singapore since 1993.

And GIC is not alone in being able to find opportunity post-crisis. Last year, CapitaLand, the Singapore-based developer, astounded markets by raising US$2.02 billion in the listing of its CapitaMalls Asia real estate investment trust (REIT) while most developers were still recovering. Elsewhere, movement is gathering pace: in the space of one month in August, LaSalle Investment Management announced three separate transactions worth a combined US$345 million in Japan, Singapore and Australia. Ian Mackie, who runs the LaSalle Asia Opportunity Fund Asia, caught the popular mood when he said: “After two tough years following the global financial crisis, it is really exciting to have so much good news to announce within a week. We see strong growth potential in Asia Pacific where the markets are recovering much more rapidly than other parts of the world and we continue to seek more opportunities in this region.”

Notably, in many cases the biggest and strongest players in Asian real estate appear to have come out of the crisis even bigger and stronger than they entered it. CapitaLand is a classic example: in January, as others were still refinancing or regrouping, it bought Orient Overseas Development Limited (OODL), a Chinese property business, for US$2.2 billion. It is understood that CapitaLand beat off other bidders, including impeccably connected Chinese state-owned enterprises, because it was the only one that was able to demonstrate it could finance the acquisition without relying on bank lending. It was an illustration of how financial prudence has served it well. “Before the crisis, people were complaining we were undergeared and had too much cash,” says Olivier Lim, group chief financial officer at CapitaLand. “But people don’t know how to value optionality, flexibility.” He adds: “The principle is to raise money when we don’t need it. That’s the best time to raise money: the cheapest rates.” Even after the acquisition, CapitaLand has a low gearing of just 0.28 times and cash reserves of S$4.9 billion.

Others show the same strength. Mapletree Logistics, a REIT owned by Mapletree Investment, part of the Temasek sovereign fund in Singapore, has acquired consistently since the financial crisis began to ease, most recently on August 18 when it purchased a Singapore property, National Cool Lifestyle Hub, for S$53 million, bringing its total portfolio to 87 properties across Asia worth over S$3 billion. “I need financial capability to support my product offerings,” says Richard Lai, CEO. “Without money it’s a tough ask to build anything. But our financials came through the crisis quite intact, and that has enabled us to be the first mover in the market during the recovery.”

It may be that the financial crisis has weeded out some of the less sustainable practices in listing real estate too. The development of the REIT market in Asia, while steady, has sometimes been undermined by structures that are heavy on financial engineering and light on decent assets – a charge that has particularly frequently been aimed at Hong Kong.

In launching the CapitaMalls Asia REIT so soon after the financial crisis, and in such scale, CapitaLand brought to bear the lessons it had learned in its previous five REITs, making it comfortably the most prolific issuer of the structure in the region. For a start, it did things properly: CapitaMalls Asia is one of the biggest listed mall owners, developers and managers in Asia with interests in 88 properties, 49 cities and give countries; its last stated total property value was about S$21.8 billion. There was no question of this REIT lacking critical mass.

This reflects a long-standing policy of putting high quality assets into REITs, and treating them as closely-linked businesses rather than straightforward capital-raising divestments. “When we did our first REIT, I was asked by a big Hong Kong company: why are you putting your best assets into the REIT? We said we wanted it to be able to generate returns for investors, and so we can earn fees. It’s not just a divestment model.”

It’s interesting that, as markets revive, the range of locations in which REITs are appearing is increasing. Only four new REITs were listed in Asia in the second half of 2009 (not counting a number of non-listed trust vehicles formed in South Korea), and all of them were in Thailand: Sala@Sathorn Property Fund, MFC-Strategic Storage Fund, 101 Montri Storage Property Fund and TPARK Logistics Property Fund. These were small deals, with a combined market cap barely over US$100 million between them, but the idea of Thailand as the sole source of issuance for a period of six months would have been unthinkable a few years ago.

This year, much attention has been focused on Malaysia, which has been a disappointing market for new issuance in previous years. Sunway REIT, which owns hotels and shopping malls spun off by its Sunway City parent, raised M$1.48 billion in July, the largest REIT IPO in southeast Asia this year, swiftly followed by CapitaMalls Malaysia Trust – yet another Capitaland vehicle – which raised MR786.5 million.

REITs are popular again because their defensive, yield-heavy characteristics are in vogue at a time of volatile market performance and uncertain economic prospects. One only has to look at the cornerstone investors in the two Malaysia deals to see the appeal REITs clearly hold for institutions: GIC, Malaysia’s Employee Provident Fund, Permodalan Nasional (another key Malaysian institution) and Great Eastern Life Assurance (Malaysia) took anchor positions in the Sunway float, while the EPF and Great Eastern Life were also cornerstones in the CapitaMalls Malaysia deal.

Others are likely to follow. China has talked for many years about launching REIT structures, and a pilot project is expected to be developed later this year, although market talk suggests that at first only institutional buyers will be permitted to participate. And the next hotbed of issuance is likely to be the Philippines, once some final issues around taxation and implementing rules, delayed with the change of administration, are cleared. Among the many likely issuers when those hurdles are surmounted are SM Prime, Ayala Land, Robinsons Land Corp and Metro Pacific Investments.

It will be interesting to see if the wealth of gaming and entertainment-related construction in Asia leads to new listed vehicles. Singapore and Macau have both seen transformative new developments which combine casinos with entertainment and business reach completion in the course of this year: Singapore with its Las Vegas Sands-led Marina Bay Sands development and the Resorts World development in Sentosa led by Malaysia’s Genting; and Macau with the opening of Melco’s City of Dreams development and Venetian Macao, also backed by Las Vegas Sands.

Properties like these have sought to revamp the traditional form of the casino, particularly in Macau, as being purely for gaming. The Marina Bay Sands development, for example, includes a theatre, exhibition hall, museum shopping mall and an iconic three tower hotel; Resorts World combines the casino with a Universal Studios, an oceanarium, shops and six hotels; and City of Dreams includes one of the most ambitious water-based performances ever attempted in a specially-built auditorium. The idea is to take the Vegas approach to the gaming industry, in which the actual gambling does not produce the majority of earnings.

Backers like Las Vegas Sands, Genting and Melco Crown Entertainment are all listed in their own right, but it’s possible that the resort and gaming-based high end property that comes with projects like these could find themselves into separate listed vehicles in Asia in due course.

If gaming and entertainment prove not to be the source of new assets, there will be others; there is renewed vigor to find ways to put real estate assets in publicly traded vehicles, and plenty of investor appetite to buy them.  “With concerns over the financial condition of Asian REITs largely alleviated, investors will renew their focus on portfolio expansion and growth in distributable income,” notes research group CB Richard Ellis. “Further acquisitions are likely as Asian REITs look to enhance their portfolio quality ahead of the full recovery of the real estate market.” After some tough years, activity has returned to Asian real estate.

BOX: The China bubble?

Earlier this year, word started to spread about the idea of asset bubbles in Asia. Had the stock market recovery been too much, too soon?

Closer analysis showed that at the heart of the concern about Asia was the Chinese property market. For example, in June Nomura called a 20% fall in some Chinese property over the next 18 months, with analyst Sun Mingchun pointing to housing prices 13 or 14 times higher than disposable income in Beijing and Shanghai. By then, prices in 35 major Chinese cities had more than doubled in real terms in the previous decade, with prices up an extraordinary 41% year-on-year in the first quarter of 2010.

Since then, though, China has sought to cool things down, apparently with some success. For example, it restricted third home mortgages in heated primary cities. “This announcement has immediately cooled down market sentiment, particularly in Beijing,” says Macquarie analyst Eugene Cheung. Macquarie says that average weekly sales in August were down 39% from their peak in April, and that price growth is slowing, though it is still very high – 10.3% year on year in July.

Catherine Yeung, investment director at Fidelity Investments, is not concerned. “If we look at the Chinese property market a lot of people are saying that there’s been a bubble, but the government’s been very proactive in ensuring that you’re not going to see a massive bubble in the property market itself and hence harsh policies have been implemented,” she says. “Also when you compare the loan or debt level in China versus the US it’s very different. In fact Chinese cities have one of the highest levels of home ownership at about 86% across the world.”

Nevertheless, the cooling of the property market, and then the gradual removal of tightening measures thereafter, is one of the most closely watched issues in Asian macroeconomics at the moment. A bursting of a property bubble in China would lead to major problems for the country’s banks, already heavily weighed down by their lending to projects during China’s stimulus measures last year; and if China’s banks run into trouble, that would have global consequences.

For years Chinese property developers have had it easy. When China sought to spend its way through the financial crisis, developers benefited from the abundance of bank liquidity. More recently, they have benefited too from the vibrancy of the high yield bond markets and their thirst for China exposure. But are these markets drying up?

A host of Chinese developers have found success in the high yield bond markets this year. For example, in April 2010 two developers launched in considerable size in the same week: Yanlord Land, rated Ba2/BB, raised US$300 million in a deal through HSBC, RBS and Standard Chartered, and Agile Property, rated Ba3/BB, raised US$650 million through Stanchart, Bank of America Merrill Lynch, Deutsche and Morgan Stanley. Other PRC property developers to have raised funds have included Kaisa, Renhe Commercial Holdings and (on the equity side) Shimao Property.

Many considered these bond deals to be a sign of borrowers looking for alternative sources of funds following a tightening of bank liquidity in China, as the state has sought to rein in bank lending as part of broader austerity measures to curb potential overheating. In fact, that may not be the case.

“To be frank we haven’t seen much evidence that there’s a tightening of liquidity for developer companies,” says Jason Kern, managing director and head of real estate advisory for Asia Pacific at HSBC. “They still appear to have good access to relationship-type lending both from a domestic base and from international banks.

“I suppose the fear out there would be that at some point liquidity dries up, but we haven’t seen any sign of it thus far.”

HSBC is working on a number of high yield bond deals for Chinese developer clients, and an absence of bank liquidity is not being cited as a rationale by any of them. Instead, developers are using bond markets to diversify sources of funds and build new investor bases. “A lot of the issues we are working on are debut bond issues,” Kern says. “If you are a publicly traded PRC developer listed in Hong Kong, in the long term you want to make sure there is appetite for your bonds as well as access to banks in order to diversify your funding sources.”

There is, though, a sense that the easy money from the bond markets may be gone, for the moment at least. Surely before the Yanlord Land deal, Glorious Property postponed its own planned global bond. Issuance appears to have stopped post-Yandlord as the markets have become more volatile: a combination of the effect of the European sovereign debt problems, uncertainty about how China will handle austerity measures, and the amount of funds already taken from the market by the likes of Yanlord and Agile. Pricing on existing bonds has backed up, and bookrunners mandated to handle further high yield deals are simply preparing them to hit the market, not actively launching them, instead waiting for better conditions.

“You had a window of two weeks that saw US$2.4 billion coming out in one sector,” says William Pang, head of Credit Trading, Asia, at Deutsche Bank. “You have also had a very specific change in government policy that has negative implications on the business model of these real estate companies,” he adds, referring to measures such as limited access to second or third buyers of the same household, and potential city-wide limitations. “Together with that is the overhang of the European situation. All of this clearly has an impact and has created some headwinds.”

“But real money continues to have interest in this space, and given that this is a critical part of Asian high yield, I don’t see a dramatic adjustment to that medium term trend.”

Despite worries about overheating in Chinese property generally, investors do not appear especially worried about the credit quality of individual names. “For PRC developers as a whole, balance sheets are in fantastic shape,” says Kern. “There are probably only a couple of names where you could make an argument they have an overleveraged balance sheet. For the most part they have less than 100% net debt to equity, and many are self-financing with cashflow from actual projects.” They are, though, vulnerable to a drop off in sales volumes if they are protracted, though so far the yields on offer -  an 8.875% coupon on Agile, 9.5% on Yanlord, 11.5% on Renhe – have more than compensated investors for that risk.

In the loan markets, extremely large deals are being completed in the Hong Kong markets, including for developers with considerable China presence. Examples include Chengdu IFC Development, owned by Wharf Holdings (HK$8 billion five-year bullet); Sun Hung Kai (HK$10 billion, five-year); Sino Land (HK$8.8 billion); China Overseas Land and Investment (HK$5 billion); and Yanlord Land (US$400 million, three year).

However, while liquidity for big, listed names appears strong, it’s a different story for those Chinese developers who are pre-IPO. “Two years ago the trend was that everyone was looking for net asset value based on the land bank, so pre-IPO companies would borrow money to increase their land bank to get a better valuation in their IPO,” says Ruoyu Jiang, Managing Director, Credit Structuring at Deutsche Bank. “Now, although land bank is important, people are more focused on the ability of a company to generate cashflow and repay their funding. It’s fair to say the Chinese banks have basically closed. There still may be people looking at the property sector pre-IPO, but they are very selective.”

Finally, Shimao Property’s HK$1.96 billion follow-on offering in April – raised, through JP Morgan and Morgan Stanley, despite a profit warning – suggests a third option for developers: more equity.