SURREAL ESTATE
Property has destroyed billions of dollars for Asian companies. It's high time they turned their backs on real estate - if they can
By Justin Wood

To any casual observer, the Paragon center in the heart of Singapore's Orchard Road shopping district is the epitome of refined retailing. Ranged around the mall's vast central lobby are six floors of jewellers, watch companies and fashion boutiques selling illustrious brands such as Gucci, Prada and Mont Blanc. Well-heeled shoppers stroll past the elegant shopfronts clutching luxury purchases from Lanvin and Alfred Dunhill and everything seems the perfect picture of elegant wealth.

But appearances can be deceptive. While the glitzy mall may look the part, behind the scenes it's giving its owner a serious headache. Singapore Press Holdings, a S$904 million-a-year (US$516 million) media group, bought Paragon - and another mall next door called Promenade - back in 1997. Costing a cool billion Singapore dollars, the idea was that the two shopping centers would provide SPH with a steady rental income to balance out its more cyclical media business.

Five years on, though, and the top brass at SPH could be forgiven for never wanting to set foot in a mall again, for property and rental values across Asia have nose-dived by as much as 60 percent during that time. Needless to say, SPH's results have taken a beating. In 2002, property accounted for almost a third of the publisher's assets, yet contributed just 6 percent of its revenues and none of its profits. Worse still, when SPH tried to get rid of its real estate last year, it found that "unfavorable market conditions" stopped it from doing so, leaving the company lumbered with these poorly performing assets.

Sadly, SPH's plight is far from unusual in Asia. From Manila to Mumbai, companies across the region have massively over-invested in property during the past 15 years and are suffering enormous pain as a result. They now face a bleak choice: sell out today and take the loss on the chin, or hold on and endure crippling returns in the hope that the property markets will recover soon.

As Ho Tian Lam, chief executive of DTZ Debenham Tie Leung, a firm of property consultants in Singapore, concedes: "It's a tough move deciding whether to take a haircut or not." And that's doubly true when what's required in many cases is more like bloody amputation. Nonetheless, companies are starting to make these tough choices, particularly in the face of the structural changes sweeping across Asian property markets that threaten to change them forever."

Property Pain

To help cast some light on the state of real estate investment in the region, CFO Asia teamed up with two accounting professors from Singapore Management University - Andrew Lee and Kevin Ow Yong - in January to look at what sort of financial returns property investments have yielded. In doing so, we took the major stockmarket indices of Hong Kong, Singapore, Malaysia and the Philippines and divided the companies on those indices into three groups. The first group was made up of firms whose primary business was property development and investment. The second group included all those companies which had no property interests at all, other than the factories and offices they use every day. Finally, the third group was made up of diversified conglomerates with many activities, including both property and non-property businesses, like SPH in Singapore.

The results show clearly just how pervasive property has become in corporate Asia. On all four indices, around half of the listed companies operate some form of property development or investment business. And while you would expect to see a certain number of pure property companies, what stands out is the large number of diversified conglomerates that engage in both real estate and other types of business.

As Rob Hart, executive director at Morgan Stanley in Hong Kong and head of property research at the bank, notes: "If you compare Asia to anywhere else in the world, you have to conclude that Asian companies are far more heavily involved with real estate."

Following on from this initial observation, we then looked at the relative returns of the three groups of companies on each index - although here we excluded the Philippines due to a lack of reliable data - and we used several different performance measures. First, we calculated market value added, or MVA, to see whether the companies in each group were generating shareholder value (see "Behind the Numbers," below). We also worked out the return on capital employed (ROCE) for each group of companies, and then looked at earnings multiples - calculated by dividing a firm's enterprise value (EV) by its earnings before interest, tax, depreciation and amortization (EBITDA).

The results were dramatic. Since 1997, the start date for our study, non-property companies have strongly outperformed both pure-play property firms, and diversified conglomerates. In Hong Kong, for example, the five-year average ROCE for non-property companies was 17.3 percent. In contrast, the other two groups only managed a ROCE of around 6.5 percent. And in Singapore, the five-year average ROCE was 15 percent for non-property businesses, but just 7.6 percent for diversified conglomerates and 3.7 percent for pure property businesses.

Bricks on the Brain

Clearly, property investments are not only widespread, but they have served as a serious drag on financial performance. So why are so many companies in Asia obsessed with owning and developing real estate? One reason, says Ho at DTZ Debenham, is that "it's written into the Asian psyche, especially the Chinese, that property is the best and safest asset to hold".

Another reason lies in the phenomenal profits that many companies made from property during the 1980s and early to mid-1990s. Those were boom times in Asia. Regional economies were growing at breakneck speed and called for shiny new offices, shopping malls and giant residential complexes to house Asia's newly affluent workers. Foreign investment poured into the region and anybody who wanted to could become a property developer.

Thousands of companies did, and for a while they made fantastic returns. Peter Barge, Asia Pacific chief executive of property consultancy Jones Lang LaSalle in Singapore, notes: "At times, it was difficult to know what the core activity of a company was. Their property division was making far more money than their original line of business."

But by the time Asia's financial crisis struck in 1997 it was obvious that the supply of property was seriously outstripping demand. A real estate bubble had formed and it's been deflating ever since. Figures from Jones Lang LaSalle show that property prices across the region - both rental values and capital values - are down by as much as 60 percent in some cities, and are trading at levels last seen in 1990.

Not that everyone has suffered equally. The region's pure-play property firms, and many of its large conglomerates, like Hutchison Whampoa in Hong Kong and Malaysia's Genting have been involved in property for many years. And while they've suffered in the recent slump, overall they've done well from the business of bricks and mortar. But for those companies that diversified into real estate more recently, particularly during the 1990s, property has been a one-way passage to pain.

Many of these firms were previously involved in manufacturing, plantations, transportation and other businesses and piled into property with little expertise or understanding. As Piers Brunner, managing director in Hong Kong for Colliers International, a property consultancy, points out: "A lot of property investments were made without the correct due diligence, feasibility studies or risk analysis. Decisions were made on gut feel and in the belief that property prices only ever went up."

Unfortunately, that wasn't the case, and as the research carried out by CFO Asia and Singapore Management University shows, such decisions have come back to haunt the companies that made them. For Andrew Lee, co-author of the research, our results highlight the folly of non-property companies venturing into real estate. After all, he points out, "with well-developed equity markets in Asia, and plenty of listed real estate firms, investors can easily diversify their portfolio to gain exposure to property. They don't need corporate managers to do it on their behalf."

A Bitter Pill

Given these findings, isn't it time that companies in Asia got out of property? For real estate firms, with no other business lines, that's not so easy. But for diversified conglomerates, many observers reckon the time is ripe to leave the carnage of the real estate markets behind and move on.

The problem is that many managers are reluctant to sell their property investments today because it would mean booking serious losses, particularly in cases where they haven't depreciated their real estate assets in line with the market. But waiting for the markets to turn could prove to be a futile exercise.

That's because the way in which the market values property is maturing, says Jeremy Lake, executive director in Singapore for CB Richard Ellis, a property consultancy. "In the past, valuations were a bit haphazard," he recalls, "but today it's all about cash flow. Companies aren't looking so much at capital appreciation. Instead they're making valuations based on underlying rental income."

This new maturity has attracted a number of foreign investors such as Ergo, a German insurance giant, and Prudential, a pension provider from the UK, both of which have snapped up several properties in the past 12 months. In general, such firms are looking for returns of between 6 and 8 percent on property investments, which is bad news for those hoping to wait out the market, says Lake. "Given current rental values it will be many years before capital values reach the levels of the mid 1990s."

What's Done is Done

Still, while some companies are reluctant to accept the new realities of real estate in Asia, others are not. As Hart at Morgan Stanley notes: "There's a perception among many conglomerates that property has shifted structurally to become a lower-returning type of asset."

Just consider China Resources Enterprise, a HK$24.2 billion-a-year (US$3 billion) conglomerate with interests that stretch from brewing beer to weaving cloth to importing petrochemicals. Traditionally, the company has also owned a broad portfolio of property investments, but last year it announced plans to divest its real estate and focus on supermarket and fashion retailing in China.

Then there's Hong Kong's Swire Pacific, a HK$15.2 billion-a-year (US$2 billion) conglomerate that owns Cathay Pacific Airways as well as a host of other businesses. The company has a giant real estate division - Swire Properties - but in recent years senior managers have been trimming it down and moving funds into higher-yielding areas of the group such as its beverages division, where Swire has the franchise to produce and sell Coca-Cola products in Hong Kong, Taiwan and other territories.

It's the same story elsewhere in Asia. In Singapore, SembCorp Industries, an engineering giant, has announced plans to shed all of its property assets. The country's three largest banks, DBS, OCBC, and UOB, have also stripped out property development and investment activities. And back in 2000, PSA Corporation, a port operator, transferred all of its property assets to Temasek, a Singapore government investment vehicle which owns PSA.

All of these moves away from property acknowledge the fact that real estate no longer earns healthy returns - largely because the property business is so capital-intensive. While the industry often produces respectable profit margins of 50 percent or more, it also locks away huge sums of cash for long periods of time so that overall returns are low.

Asset Assault

It's for that reason that even some property companies are trying to divest as much of their property portfolios as they can. Singapore-based Keppel Corporation, a S$5.5 billion-a-year conglomerate with interests in offshore marine, infrastructure and property is a good example. For some time now, the group's real estate arm has pursued an "asset-light" strategy that sees it concentrating on developing property and on providing property services, but no longer holding real estate investments. Investment "requires heavy capital and produces low returns" says Lim Chee Onn, chairman of Keppel.

The firm's results for 2002 are illustrative: while the company earned an overall return on equity (ROE) of 13.4 percent, the property business posted a ROE of only 7.3 percent. Still, at least that's up on the 5.4 percent it earned in 2001. Much of that improvement is thanks to the drive towards asset-lightness which saw Keppel divest S$343 million of office buildings during the year, and monetize S$353 million of future sales from a residential development still under construction.

In fact, it seems that many businesses are going even further than this. While property firms are concentrating on development rather than investment, and while many conglomerates are moving out of the property business altogether, some companies are deciding to strip their balance sheets clean even of the buildings that they use every day. That means choosing to lease offices and factories rather than own them, and crafting clever property outsourcing deals, all in the name of deploying cash as efficiently as possible. In February this year, for example, Siemens, a German electrical engineering group, set the property world abuzz with an innovative deal in Singapore (see "Siemens' Property Coup," below).

So with all these properties being divested and disposed of, who's buying them? The answer is a new breed of property investor. Unlike Asian conglomerates of the past, real estate investors of the future aren't looking for huge speculative gains. Instead, they want to see steady, predictable returns with low risk. That means pension funds and insurance companies - especially from Europe and the US where investors are looking for global diversification. Another growing force in the market is the recent arrival of real estate investment trusts (REITs) in Asia which again aim to provide a steady stream of rental income rather than dramatic capital gains (see "Is Now the REIT Time?" below).

It all points to a more sophisticated and balanced future for real estate in Asia, and one where far fewer companies are involved compared to today. That said, it's also true that history repeats itself, and commentators have raised warning flags over the property market in China, which appears to be copying the rest of Asia but with a 10-year time lag. Shanghai, in particular, is starting to look dangerously bubble-like, and the temptations of making a quick buck are all too present.

In December 2001, for instance, Want Want Holdings of Taiwan acquired a plot of land in Shanghai in order to build a block of serviced apartments and commercial units. The problem is, Want Want's core business is the manufacture of rice crackers. Perhaps Asia hasn't learnt its lesson after all.

Justin Wood is executive editor, south-east Asia, for CFO Asia