This article first appeared in City & Country, The Edge Malaysia Weekly on May 15, 2023 - May 21, 2023

Rising interest rates and the corresponding change in property values are the major criteria influencing investment decisions in the current market or economic climate, according to CBRE Research’s Intelligent Investment report titled “Analysing the funding gap: A bird’s-eye view of the Asia Pacific commercial real estate debt market” published this month.

Using investment volumes as a proxy and a stabilised loan-to-value (LTV) ratio across asset classes, the report suggests there were US$177 billion (RM785 billion) of outstanding commercial real estate senior loans across Asia-­Pacific as at 1Q2023.

The funding gap is expected to reach US$5.8 billion in the next 36 months (between 2023 and 2025), with the office sector most exposed to refinancing risk due to weakening capital values and yield decompression, especially in Australia and South Korea.

The report highlights that by total volume, Australia will be facing the biggest funding gap between 2023 and 2025, followed by Japan, South Korea and mainland China.

In Australia, while cap rate expansion and debt maturity in 2024 are of concern, many Australian real estate investment trusts ­(REITs) used the 2021/22 period as an opportunity to extend their loan maturities and offset any refinance risk in the interim, according to the report.

South Korea is anticipated to face more immediate pressure, with 73% of the total funding gap in this market due to emerge in 2023.

The report indicates that the markets will witness different periods of funding gap stress, with the office sector the most affected. However, it notes that while the loss of their original equity investment will trigger investors to ­offload assets, a fire sale is unlikely.

The bulk of the debt-funding gap has come through declining capital values as LTVs in Asia-Pacific remain mostly unchanged, it adds.

It reveals that in 2023 and 2024, the Hong Kong and Australia office sectors along with the South Korean industrial sector will see the largest funding gap compared with the original equity amount.

According to the CBRE report, office properties are likely to face the greatest funding gap out of all sectors owing to projected declines in capital values, with most markets set to experience a fall of 5% to 20% between 2023 and 2025. It anticipates an indicative gap of US$5.4 billion in the office sector in the next three years.

It also states that Asia-­Pacific office yields are expected to ­soften by 75 basis points to 150bps due to weakening investment and the higher cost of debt, which are the primary contributors to anticipated weakening capital values.

Meanwhile, Japan is largely unaffected by the current economic climate with its cap rates for office assets. Nonetheless, the weakening office rental outlook over the next 24 to 36 months will see the country’s office capital values fall by 14% between 2022 and 2025, says the report.

Across other sectors, industrial and retail are expected to see a minimal funding gap in the next 36 months, as the former had undergone a correction at the onset of the pandemic, while the latter’s magnitude of cap rate compression in the last few years is still greater than the anticipated softening.

The report highlights several factors that are causing the funding gap in the region, one of which is rising interest rates.

Although interest rates in Japan and mainland China have remained largely unchanged, those in the major markets in Asia-Pacific “have increased significantly in response to global inflationary pressures”.

“As at the end of March, interest rate pressures within Asia-Pacific were most pronounced in Australia, [South] Korea and Singapore, with borrowing rates for these markets having increased by at least 300bps. However, [South] Korea and Hong Kong have shown signs of easing, registering a decline in reference rates in 1Q2023.”

The report cites that interest rates in markets outside of Japan and mainland China are expected to remain elevated until the end of the year, with some easing of central policy rates expected to commence in 4Q2023.

As a result of the increase in rates, investment volumes in most markets have been pulled down. “The significant hike in interest rates combined with worries of a global economic slowdown have widened the gap between buyer and seller expectations. Except for Singapore, all markets in Asia-Pacific registered a sharp slowdown in commercial real estate transaction activity year on year (y-o-y) between 2021 and 2022,” states the report.

Nonetheless, while investment is anticipated to be muted in 1H2023, cap rate expansion, elevated dry powder levels and overall improving market conditions are expected to underpin a rise in investment in the second half of 2023, reveals the report.

LTV ratios in the Asia-Pacific real estate market have remained steady since government initiatives were undertaken to restrict lending for real estate investment.

“The only markets to see some movement in LTV ratios over the past 24 months were [South] Korea (60% to 55%) and Australia (55% to 50%). However, the magnitude was significantly below the 72% to 57% drop observed in the US, as reported by CBRE Econometric Advisors in December last year,” notes the report.

Meanwhile, corporate bond issuance in 2023 and 2024 is poised to be lower than in previous years as developers are looking to issue new corporate bonds at higher coupon rates to offset rising debt costs.

The report adds that interest expenses are also slated to increase significantly across some markets. Developers and fund managers with refinancing risk in those markets are expected to be net sellers in 2023. “This cumulative funding gap will likely create challenges for some investors who are unable or unwilling to invest additional cash, forcing them to return keys to lenders as falling values and rising financing costs make it challenging to justify original underwriting assumptions.”

For example, the report cites that mezzanine and junior loan providers will experience losses in some cases due to falling property values and illiquid markets, and among bearish lenders, non-performing loans (NPLs) may be packaged together and sold on the secondary market at a discount.

Still, there are likely to be better opportunities for equity investors to acquire assets on more attractive valuations. There will also be solid prospects for alternative lenders, as returns for debt strategies are likely to outperform equity investments during this period, according to the report.

It forecasts that the funding gap will create opportunities for investors to provide mezzanine or bridge loans for new asset valuations, with continuous scarcity of senior loan providers in some markets, especially for development projects.

“However, demand for mezzanine debt to fill in the gap will not guarantee its availability, meaning that opportunities for mezzanine and junior debt could shrink significantly as lenders and equity partners have become more stringent,” reiterates the report.

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