How higher inflation and rising interest rates will test Asia’s buoyant property market

Asia’s real-estate sector benefits from relatively strong fundamentals and reliable demand that should limit any fall in prices
Given huge demand for home ownership and the large amount of capital waiting to be deployed, Asian property should continue to perform well

Nicholas Spiro

Published: 6:45am, 19 Jul 2022

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At the start of this year, most parts of Asia’s property sector were performing well. Even some of the more vulnerable segments of the market were still growing. In Australia, whose overheated housing market was starting to cool, home values in Sydney and Melbourne continued to rise on a year-on-year basis in January, underpinned by rock-bottom interest rates.

In the commercial sector, transaction volumes in the first quarter of this year were higher in annualised terms in most major markets in the region. Moreover, rental yields in the popular industrial and logistics sector continued to decline.

Yet, as the second half of the year gets under way, the picture is markedly different. The sudden and sharp rise in borrowing costs triggered by the ultra-hawkish pivot by the US Federal Reserve has driven up mortgage rates, increased companies’ cost of capital and prompted a repricing and reappraisal of assets that are steering Asia’s property market into uncharted waters.

Several Asian central banks are behind the curve in battling inflation and are being forced to raise rates more aggressively than expected. Not only is it unclear how high rates will go, there is uncertainty over the severity of a policy-induced economic downturn. “Right now, the cost of debt is top of mind. We’re past peak pricing,” said Greg Hyland, head of capital markets Asia-Pacific at CBRE.

The residential market is repricing the fastest. A report by Standard & Poor’s published on June 16 singled out New Zealand, Australia and South Korea as the most exposed because of developed economies’ greater sensitivity to moves in rates and excessively high household debt.

Average rates on long-term fixed-rate mortgages for new owner-occupiers and investors in Australia have jumped to between 4.1 and 4.5 per cent, a full percentage point higher than at the start of this year.

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According to calculations by CoreLogic, this month’s rate increase of 50 basis points by Australia’s central bank to 1.35 per cent means that a new owner-occupier borrower in Sydney – with a 20 per cent deposit and a 30-year variable rate mortgage – is already facing an additional A$600 (US$400) increase in monthly repayments.

In the commercial sector, investment activity is slowing as buyers turn more cautious. While there was a drop in transaction volumes last quarter compared with the first quarter, according to preliminary data, the impact of higher rates is likely to be more discernible in the coming months.

It is not just the higher cost of debt that is dampening investment activity. Higher construction costs and concerns about the security of income in a much weaker economic environment are also having an adverse impact on sentiment.

As was the case when the pandemic erupted, resilient and defensive sectors in Asia’s most mature and liquid markets are better placed. Japan, which was in favour with investors before rates began to rise sharply and continues to pursue its decade-long ultra-loose monetary policy, is more insulated.

Yet, even more resilient markets are not immune to the fallout from the rapidly rising cost of money. Higher rates are focusing attention on long-standing vulnerabilities and challenges in Asian commercial property.

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Last year, rental yields on prime logistics assets in Melbourne and Sydney fell by a further 75 to 125 basis points, to close to 3.5 per cent, according to data from JLL. This is near the level at which Australia’s 10-year bond yield now stands, showing the extent to which the yield advantage has eroded.

The end to super-cheap money will also accelerate the divergence between prime and secondary properties. JLL estimates that there is more than US$40 billion worth of unrealised value in ageing and underperforming real estate in Asia. As rates move up, prices of lower-quality buildings, especially ones that do not meet sustainability standards, will fall more sharply.

Still, with the notable exception of China’s hard-hit housing market, Asia’s real estate sector benefits from relatively strong fundamentals. Although they are more vulnerable, residential markets are supported by strong demand and persistently constrained supply, limiting the fall in prices.

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Moreover, the level of financial distress in the commercial sector is negligible. Many owners have strong holding power, while the investor base has changed significantly as markets have matured. “There are many more ‘core’ buyers that have limits on leverage,” said Stuart Crow, chief executive of Asia-Pacific capital markets, at JLL.

Crucially, the medium-to-long-term prospects for Asia’s property markets remain attractive. With Europe’s economies at the sharp end of the commodity shock stemming from Russia’s invasion of Ukraine, and increasing anxiety about a recession in the United States, the growth outlook for Asia is more favourable.

Some of the biggest investors in the region are high-conviction thematic buyers who are focused on sectors that benefit from structural shifts in consumer behaviour and demographics. “Mega trends such as urbanisation, infrastructure and digitalisation have served us well,” said Danny Phuan, head of Asia-Pacific acquisitions and head of China at Allianz Real Estate.

To be sure, the end of the era of low rates and low inflation poses big challenges for Asia’s property industry, with a strong likelihood that risks are being underpriced in some markets. But, given the huge demand for home ownership and the large amount of capital waiting to be deployed into commercial real estate, Asian property should continue to perform well.

Nicholas Spiro is a partner at Lauressa Advisory

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