Virtual Realty
by Gregory J. Karns

     The financial turmoil in Asia has had a broad and dramatic effect on all economic sectors, but perhaps most severely on real estate. Although Asian governments were quick to enact laws and programs designed to spur foreign investment, Asian real estate values continued to fall. The severe capital crisis, exacerbated by a dizzying level of short-term, dollar-based debt, has led to an extraordinary number of defaults and bankruptcies, even among some of Asia's largest and most respected companies. Many of these companies tried to sell their real estate to raise desperately needed capital, and yet, more than two years after the outbreak of "contagion," almost no real estate transactions have been completed.

     Initially, the lack of activity in the Asian real estate market could be traced to an unwillingness to accept the circumstances. This almost universal denial is understandable, given the prior 30 to 40 years of unprecedented success. For example, Korea's annual growth rate of 6.6 percent, sustained over the last 40 years, makes it one of the best performing emerging markets in the world. Similar accomplishments abound in the region. It is not surprising then that Asian nations did not immediately abandon decades of proven business techniques at the outbreak of the crisis. However, even now that the problems are more fully recognized, real estate transactions still are not occurring.

     One major impediment to "transactioning" stems from the general lack of reliable data concerning Asian real estate assets. Surprisingly, this has less to do with so-called "market transparency" (the current buzzword in Asian circles), and more to do with the consequence of what could be called a "market vacuum." The problem is a veritable paucity of real estate transactions in any major Asian commercial district during the decades preceding the crisis. In a culture where land represents power and wealth, the disposition of real estate assets could be considered a sign of weakness. The few transactions which did occur often were not arms' length, and so not useful as an indicator of value. Over the years, this lack of reliable market data fostered and nurtured largely speculative assumptions of value, and in the Asian market vacuum, with speculation serving as the basis for valuation, prices always increased.

     Another less apparent obstacle lies at the heart of Asian real estate finance principles. For many years, Asian banks lent freely to businesses using real estate as collateral, and then lent again (and again) against its expected increase in value. Over time, the amount of this "real estate" debt far exceeded any income-based valuation of the real estate collateral. In essence, Asian banks were loaning on real estate, but with an eye on the owner's corporate earnings. In a lending arena where speculative real estate values, and not the actual income generated by the real estate, secured debt, the speculators could continue to push Asian real estate values higher and provide a basis for additional lending, so long as Asia economy continued to expand and Asia's corporate earnings continued to grow.

     Thus, it is appropriate that the miracle economies of Asia were referred to as "bubbles." Quite simply, once corporate liquidity shifted and currencies fell, corporate earnings dropped. As a consequence, speculation could no longer fuel the real estate markets, the banks stopped lending and the bubbles burst.

     One might assume that in the Asian real estate market foreclosures would be rampant, producing significant buying opportunities for investors with cash. However, before Western investors pack their bags, they should know that despite a broad liberalization of laws governing foreclosure, in many parts of Asia, foreclosure has been difficult and sometimes impossible to accomplish. Again, an understanding of the dilemma provides a clue to the problem. Given that most Asian banks loaned on real estate without any expectation that it could support the debt it collateralized, they have been unwilling to write down their loans (which the banks always underwrote on the basis of corporate earnings) to match the deflated value of the real estate. For foreign investors utilizing income-based approaches to valuation in an environment focused upon land premiums, the challenge is to structure a deal which makes (enough) economic sense to the investor without causing too great of an economic (indeed, even cultural) upheaval for Asian property owners.

     Fortunately, key events are now occurring in Asia that should improve the odds. First and foremost, one must recognize the relatively short supply of institutional grade real estate assets in Asia. The lack of investment grade assets, coupled with the general improvement in Asian economies over the last year, should provide encouragement for investors to pursue these top quality buildings, even at what is still perceived to be a premium over the prevailing market. From the seller's standpoint, the stabilization of most Asian currencies should improve investors' offers, which often included a pricing hedge against currency volatility. From the buyer's standpoint, several key bank mergers which have been completed or are in the process of completion should bring about more significant write downs of non-performing assets, which in turn will generate a wave of buying activity. Of course, the competitive advantage will belong to investors who understand and can be sensitive to the issues facing Asian property owners, and who can come up with more creative structures to soften the valuation and other hurdles which they face.

     Ultimately, the key to sustained and comprehensive recovery remains a continued commitment to market liberalization and institutional reform. When the Asian crisis peaked in 1998, government and business leaders stood in agreement on the need for fundamental economic and political reforms to spur recovery and withstand future downturns. However, as Asian nations grow stronger and move away from their economic precipice, some government and business leaders now believe that they have little to gain and much to lose from radical change. More than just a temporary repricing of assets, the challenge for Asia will be to find a way to carry through with the economic, political and social reforms needed to propel the Asian miracle into the 21st century.

     As Confucius once wisely observed, the movement towards (new) order cannot be achieved without some chaos. And as every good real estate investor knows, out of chaos comes real opportunity.