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THINK: China
An overseas investor’s guide to China
Data generating art
Using data from Fig.5 in this report, the
graphic represents the trend in prime office
capital values CNY per sq m from 2004-2014.
This document is solely for the use of professionals and is not for general public distribution.
Introduction
This report aims to provide a flavour of the real estate investment climate in China, and to highlight the leap in risk appetite required by
overseas institutional investors seeking to penetrate the market. Those seeking to participate are advised to do so with their eyes wide
open. We explain the hurdles and consider the risks of investing relative to competing global markets. However, the potential rewards of
establishing an operational presence could be great, given the prolific social and demographic megatrends that are currently shaping
China’s future.
China is arguably the epicentre of mass urbanisation, experiencing relentless growth in its middle classes, and symbolising the shift
in economic power from the West to the East. It has transformed itself over the past two decades into the world’s largest exporter,
characterised by major industrialisation. As the economy progresses along the value chain, from production to consumer and service
industries, immense opportunities will open up for real estate investors. According to projections by Oxford Economics, more office jobs
will be created in Chinese cities over the next 15 years than in all the metro areas of the rest of the G20 countries combined. As China
becomes richer, growing financial security should lower precautionary saving and underpin further rapid expansion in consumer markets.
Following an overview of risks and rewards, the second half of this report will provide brief portraits of the Tier 1 cities of Beijing, Shanghai,
Guangzhou and Shenzhen. This is partly to emphasise the importance of local knowledge to real estate investors, since China is by no
means a homogeneous market and its cities are driven by different dynamics. These snapshots focus on Tier 1 markets because their
improving real estate transparency makes them a likely first draw for cross-border investors.
2
THINK: China
An economy walking the tightrope
Following the global financial crisis in 2008, the Chinese
authorities injected a major stimulus to offset the effect of
deepening recession in the industrialised world. The price was
rising inflation, soaring asset prices, and burgeoning levels of
debt across local government and the corporate sector. Behind
this growing pile of debt, a rapid expansion in household
income boosted retail sales and helped to restore the economy
to buoyant growth. Monetary policy was promptly tightened,
inflicting pain on the over-stretched balance sheets of firms,
while the banking sector experienced a rise in non-performing
loans. Fears of a housing market correction emerged as sales
slumped and regulations were introduced to encourage more
first time buyers into the housing market; they were offered
an additional 10% discount to the benchmark borrowing rate.
Aside from the short-term policy challenges that dominate our
financial headlines, the medium-term test for the government
is to restructure local government and corporate debt, and
rebalance the economy from investment to consumption.
Success will require both financial and social reform, not least
the liberalisation of deposit rates and introduction of more
varied savings instruments, capital account convertibility,
exchange rate reform, and an overhaul of the Hukou System of
registration. Household savings are currently assumed to be
in the region of 25—30% of income, although some estimates
are as high as 40%. This high degree of precautionary saving
reflects low government spending on health, education and
pensions. Reforms are evolving to rectify the problem. The
government is implementing policies to boost rural incomes
and to spend more on health and the provision of insurance.
The aim is to increase the minimum wage to 40% of the urban
average by 2015, suggesting the government is concerned by
the social impact of rising inequality. Reform or even outright
abolition of the Hukou System would also free up income,
and lead to higher levels of retail spending. At present, only
the affluent benefit from mobility, since they can fund the
cost of social services from their own pockets. The continued
programme of mass urbanisation demands migrant workers,
who move to the cities to find work, can access a social
infrastructure.
All in all, the current backdrop remains one of economic
imbalances, mounting environmental concerns, rising economic
inequality and an aging population. We need to remain mindful
of these issues as we assess the real estate investment risks
and opportunities facing the cross-border investor.
Fig.1: GDP growth, average % change per year
12
10
8
6
4
2
0
1980’s
1990’s
2000-14
2015-30*
Key
US
China
EU
World
Source: NIPA, Haver Analytics, China National Bureau of Statistics,
Office of European Communities, Oxford Economics
*Forecasts by Oxford Economics, June 2015
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THINK: China
Breaking through the entry barriers
Joint ventures are the preferred route
The transaction statistics are telling: according to Real Capital Analytics, nearly $250bn of
capital has been invested into China by overseas sources over the past decade. Development
sites accounted for 75% of the total, with office and retail investment accounting for less than
20%. The majority of investors were from culturally-aligned countries, with 70% of the overall
capital from Hong Kong, and 15% from Singapore. The rest of the world represented less than
16% of inflows over the decade, highlighting the resistance of China to foreign ownership of its
assets. The US is the world’s third largest overseas investor, accounting for 7% of total inflows.
Equity funds such as Blackstone and Carlyle Group have been prominent players, whereas
institutional investors comprised just over one-third of US inflows. A small number of US players
have had considerable success in penetrating China, eg New York-based developer, Silverstein
Properties, announced a joint venture with Qianhai International Energy Financial Center Co. in
early 2014, to acquire a mixed-use development site in Shenzhen from the Chinese government,
for a price exceeding $2.2bn. Meanwhile, European investment amounted to a mere 3.2% of
total inflows over the decade, with Shanghai and Beijing being the major focus. HSBC Holdings
was the biggest investor by far, but a few other institutions have made modest inroads, among
these Grosvenor, Deutsche Bank, SEG Group and TH Real Estate.
Since foreign investment is not necessarily encouraged, teaming up with a credible local partner
can provide a more effective entry route. Overseas investors need to have a high level of
confidence in their partner, and choosing a partner with reputational integrity is critical. Chinese
private property companies have been turning to foreign institutional investors for financial and
operational expertise for some time. A recent example is China Vanke’s venture with US private
equity firm, Carlyle Group, in 2014. Carlyle acquired and will manage nine of China Vanke’s malls
until these assets are eventually securitised. Carlyle Asia Investment Advisors Ltd holds 80%
of the asset platform company, and both parties cooperate on the management via a separate
venture. The deal effectively enables China Vanke to diversify its residential business with
investments in the commercial sector. Prior to this deal, China Vanke had announced a tie-up
with Blackstone to pursue opportunities in logistics. Meanwhile, Blackstone acquired a 40% stake
in Shenzhen-based SCP in 2013, one of the biggest shopping mall companies in China. SCP has
nineteen malls in first and second tier cities, where international retailers are present and cater
for the growing number of upper middle classes. In the logistics space, Prologis partnered with
HIP China Logistics Investments Limited, a subsidiary of Abu Dhabi Investment Authority, with the
aim of building, acquiring and managing logistics properties. $500m of equity was committed by
HIP China Logistics Investment and $88m by Prologis. In 2012, TH Real Estate entered into a joint
venture with experienced developers RDM Asia and Waitex group to develop and manage outlet
malls in China.
Fig.2: Cross-border investor flows into China by source over last decade*
7.0% 0.7%
3.2%
Generally speaking, domestic developers tend to be more at home with residential than
commercial development, since cash is realised quickly after sale and can be used to fund
expansion and land purchases. Entering into a JV with a residential developer, who has been
forced into mixed-use/retail schemes because of land sale requirements, represents a potential
opportunity for an experienced mall operator looking to break into China.
4.9%
14.7%
69.5%
Key
Hong Kong
Singapore
Source: Real Capital Analytics, May 2015
*
Decade to 5 May 2015
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THINK: China
Rest of Asia-Pacific
Europe
US
Other
Tax and corporate structures
Foreigners cannot buy assets directly, so prospective purchasers need to set up a WFOE (Wholly Foreign Owned Enterprise): a liability company established within mainland China, to act as a vehicle for
foreign investors to buy real estate. This process can take up to six months. Asset sales are subjected to capital gains tax of between 35-60%, so selling the entity rather than the asset is more efficient.
An offshore holding company is the preferred tax efficient route, since it avoids payment of land appreciation tax, which would wipe out a significant element of the profit when the asset is sold.
Competing for stock
According to DTZ research, Shanghai has the highest degree of foreign ownership, with around half of the Grade A stock in the hands of overseas buyers. Nearly 40% is owned by listed developers,
mainly from Hong Kong or Singapore, who tend to be reluctant sellers of their prized core assets. Beijing’s Grade A office space is around 25% foreign owned, and private developers are more
prevalent. According to DTZ, foreign ownership falls to c.15% in Shenzhen and is almost negligible in Guangzhou, although ownership for a large proportion of the stock in these cities could not be
readily identified. Accessing core stock can be something of a headache, not least because much of the Grade A office space falls short of international build standards. Domestic investors tend
to hold assets over the long term, with apparently little regard for physical or locational depreciation. Owner occupiers also tend to stay long term, occupying part of their building and leasing
the remaining space. When core stock does become available, the competition can be fierce. Domestic state owned enterprises have access to easy credit, and overpay to prevent assets going
offshore, particularly in prestigious districts such as Financial Street in Beijing. Nor is there a level playing field when competing with insurance firms, who enjoy low financing costs. Insurance
firms have sizeable funds to allocate and many are still in the initial stages of building up their real estate teams. They target trophy assets in core cities. Big developers and conglomerates, such
as Vanke, Fosun International, Dalian Wanda and HNA Group, also compete for product, normally displaying a more diverse appetite across regions and sectors. Domestic debt can be expensive,
but developers can issue bonds to finance acquisitions. Elsewhere, billionaire funds and global pension funds actively compete for big ticket assets at the core end of the spectrum, although their
appetite for China has waned recently, relative to other Asia-Pacific markets.
Land use rights
Shenzhen was the first province to grant 50-year leases in 1987, when the seeds of capitalism were sown. To this day, it remains unclear whether local governments will guarantee consent to
renewals when the first tranche of leases expire in 2037. Land is effectively owned by the state and rights are granted depending on use; normally 40 years for commercial development and
50 years for mixed-use schemes. It seems doubtful the government would take too onerous a position with respect to extension, or indeed deny an extension to an existing landlord, as the
consequences would seriously undermine the real estate investment industry. Despite the low probability, however, such uncertainty is difficult to overcome for an institutional overseas investor.
Anecdotal evidence suggests investors are demonstrating resistance to schemes with less than 30 years of the lease remaining, although the lack of pricing transparency makes it difficult to
determine whether discounts are conceded on the sale of affected assets.
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THINK: China
Real estate market risk
TH Real Estate Research analyses real estate market risk globally. Four broad building blocks
of risk are considered: transparency, liquidity, volatility and income security. The scores on
these individual components are combined and translated into a market risk premium and, by
adding the country risk free rate, or 10-year bond yield, a required return can be established
for each city or country. This has been derived for all broad property sectors, because
investor attitudes to risk are assumed to differ by property type. For instance, shopping malls
tend to be held very long term and, as such, liquidity and volatility risk scores are considered
to have a lower weighting relative to the scores for offices. In addition, the risk scores reflect
the perspective of a cross-border investor, since domestic investors will take a different
view of transparency in their home market. The required returns are intended to assist in
understanding risk relativities between countries and markets, and should not necessarily be
taken as absolute targets.
20
15
10
5
0
Malaysia
China
Hungary
Income security
Singapore
Poland
Portugal
Hong Kong
South Korea
Spain
Volatility
Norway
Italy
Czech Republic
Luxembourg
Ireland
THINK: China
Denmark
Liquidity
Source: TH Real Estate Global Risk Model, Q1 2015
6
Austria
Finland
Belgium
Transparency
Australia
Switzerland
Sweden
Netherlands
United States
Japan
Key
Bond yield
United Kingdom
France
Germany
Forecasts for expected returns can be compared to the required return, to ascertain which
locations are best placed to cover investment risk. The risk facing institutional overseas
investors into China makes for a sobering prospect. Fig.3 illustrates the required returns in
selected global office markets. China has the second highest real estate risk premium of
28 countries (Fig.3 excludes Greece).
Fig.3: Real estate prime office market risk, %
Real estate market risk
Transparency
Volatility
Market transparency is clearly a major issue for overseas
investors, and China is deemed to have the second highest
transparency risk globally, ranked 27th of 28 countries in the
Global Risk Model. Only Malaysia is classed as less transparent.
The scores are underpinned by JLL’s Transparency Index, on
which China’s Tier 1 cities are classed as “semi-transparent”,
sharing the same classification as some European countries,
notably Turkey and Greece. According to JLL, China scores
relatively well on the measurement of investment performance
and market fundamentals, but has some way to go regarding
the transparency of its transaction process. This said, future
improvements to the regulatory and legal environment are
anticipated, given plans to introduce a national property
registry. Transparency is also likely to improve in the listed real
estate sector, where exchange-traded REITs are now trading.
China’s Tier 1 cities should therefore experience further
improvements in transparency over time.
Volatility tends to be high, as office cycles are prone to boom
and bust. Based on the standard deviation of the prime rent
series, China ranks as the highest risk country in terms of
volatility. China malls are less volatile, however, ranking 9th
out of 18 countries.
Liquidity
China’s liquidity score is reasonably good relative to other
countries, although the cross-border share of overall
transactions is low. The score is based on five-year rolling
annual average of investment transactions as a share of global
office investment volumes. China ranks eighth-lowest risk out
of 28 countries for offices (land sales are excluded). Shopping
mall liquidity is poor by comparison, with China ranking 17th
out of 18 countries. However, city scores differ; Shanghai and
Beijing offices account for the lion’s share of China investment,
and rank 26th and 29th of 56 cities globally. In terms of recent
liquidity drivers, REITs generated a big increase in transaction
activity in 2013, but this reduced considerably in 2014. Private
developers are expected to be the main net sellers in the near
term focused on assets sales in Shanghai and Beijing.
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THINK: China
Income security
Income security is a major issue for investors. As previously
discussed, the land rights issue in China and assumed goodwill
by the government, requires a leap of faith for any investor.
Additionally, relatively short lease lengths for occupiers
compromise income security. Standard leases tend to be for
three years, although some tenants do agree longer terms in
return for incentives. According to local sources, the majority
of tenants do not exercise their break option. Void risks can
rise substantially, however, when over supply of new space
provides occupiers with a greater range of options. The risk
model calculates relative country income security risk partly
on the basis of standard lease lengths. In the case of offices,
international corporate representation is taken into account
to reflect the availability of strong tenant covenants. In the
retail sector, the model considers the number of international
retailers in the market. China ranks 18th lowest risk of 28
global office markets, and 9th out of 18 for shopping malls.
Fig.4: China’s real estate market global risk rankings
Office
Mall
Transparency
27
17
Liquidity
8
17
Volatility
28
9
Income security
18
9
28
18
Total countries in ranking
Source: TH Real Estate Research Global Risk Model, Q1 2015
Reward vs risk
Given the relatively high structural real estate market risk, acquiring prime offices in Tier 1
cities at today’s record low net yields, requires a positive expectation of rental growth. Although
vacancy rates across China’s Tier 1 office markets are relatively benign at present, this situation
is about to deteriorate due to a significant expansion of stock over the next five years. While
prestigious CBDs with a tight occupier balance should still benefit from modest rental growth,
Pudong district in Shanghai being a good example, a softening in the rental tone is more than
possible in more exposed markets, particularly if the economy slows by more than anticipated.
30,000
0
2014
2013
2012
Source: Property Market Analysis, Spring 2015
2011
Guangzhou
2010
Shanghai
2009
Key
Beijing
2008
THINK: China
60,000
2007
8
90,000
2006
For a risk-averse investor, China’s office market undoubtedly calls for a “wait and see” strategy,
pending a correction in pricing, although this is unlikely to be imminent as Chinese bond yields
are not correlated with those in the US. Rising US interest rates should have more impact on
Hong Kong, Singapore, Melbourne and Sydney, where strong positive correlations are evident
between their respective country bond yields and the US bond yield.
120,000
2005
Notwithstanding the structural market risk already discussed, locational depreciation can also
be mispriced, particularly in areas where new sub-markets are emerging. Over-development
is encouraged by local governments, who use land as collateral for loans raised through local
government financing vehicles. This is effectively an off-balance sheet means to raise money
to build infrastructure, and meet other spending requirements set by the central government.
The rapacious appetite for development has produced huge pressure on land prices as
developers compete for plots. Vast amounts of new office supply is completing or planned
in decentralised areas. The need for reform of local government financing has long been
acknowledged. A framework to regulate and supervise local government budgets is needed
to ensure financial resources from the sale of land use rights are more sustainable. Local
government will potentially be able to develop alternative sources of finance via municipal
bond markets.
150,000
2004
Due to the general lack of transparency, domestic investors tend to employ capital values per
sq m as their benchmark, unlike overseas institutional investors who focus on the relationship
between net income and price. Capital values for Beijing prime offices have soared relative to
values in the other Tier 1 cities, largely due to a major uplift in rents between 2010 and 2012.
Fig.5 illustrates the degree of catch up with Shanghai, in particular where rents have barely
recovered their pre-GFC peak. Only a modest uplift in prime office capital values is anticipated
over the medium term. Combined with low current net income yields, estimated to be in the
range of 4.8-5.5% across the Tier 1 cities, expected returns are unlikely to compensate investors
for the market risk.
Fig.5: Trend in prime office capital values CNY per sq m
Adaptability is key to managing retail risk
In the retail sector, pricing challenges are just as prolific, and the environment for accessing
super returns from rapidly accelerating rental growth is no longer evident. A spike in mall
development is unfolding and lower returns should produce greater consolidation among
developers. China is diverse, so being successful in one city does not guarantee success
elsewhere. Local knowledge is invaluable in positioning schemes for their best market niche.
Retailers often seek to establish links with experienced developers, particularly in over-supplied
markets, to ensure the scheme is attractive and relevant to local consumers. New centres
can take up to a few years to stabilise, often experiencing high vacancy rates in the early
period after launch. Over time, however, footfall tends to improve and reach critical mass, and
tenant turnover slows. Developers are learning that customer experience and active asset
management are required to avoid the onset of early obsolescence.
Online sales are a rising threat, having witnessed exponential growth in recent years. Clothing
accounts for 20% of online sales, and is supported by rapid shipping processes and same
day delivery in Tier 1 cities. Payment systems, such as Alibaba’s Alipay, have led to growing
confidence in online shopping. Mall owners have embraced experience shopping to combat
the threat, and have extended their offer to include leisure, health (eg. dentistry), and education
(eg. early learning centres and language schools). The K11 Mall in the Puxi district of Shanghai
provides the most impressive example when it staged an exhibition of Monet, the French
impressionist. Food and beverage is also important in generating repeat custom. Food and
beverage tenants pay lower base rents, however, and press landlords for turnover rents. Some
malls have found success by shifting the focus to mid-range fashions by international retailers
such as Zara or H&M, which appeal to a younger demographic and increase dwell times. In fact,
youth fashion brands are increasingly establishing themselves as key tenants
and even playing the role of anchor tenant.
China retail market
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THINK: China
China through a long lens
There are seismic demographic and social shifts underway in China, reflecting the shift of economic power from the West to East. According to estimates from Oxford Economics, China’s GDP now
matches the level of the United States, if measured in real terms in US dollars and adjusted for purchasing power. Fig.6 illustrates China’s rapid growth, especially since the turn of the millennium,
during which its share of the world economy (in purchasing power, US$ exchange rates) increased from 7.4% to 16.5% by 2014.
Fig.6: Share of world GDP
Fig.7: GDP per capita
25
% pa
% pa
Level change in $
Level change in $
2005-2015
2016-2030
2005-2015
2016-2030
China
8.8
5.8
6,178
14,355
Hong Kong,
China
2.8
2.2
12,840
21,318
India
5.5
4.8
1,784
4,427
Indonesia
4.5
4.3
1,954
4,911
Japan
0.6
1.1
2,265
7,016
Malaysia
3.0
2.4
4,682
8,049
Philippines
3.7
3.2
1,513
2,970
Singapore
2.5
1.7
14,698
19,072
South
Korea
3.1
2.6
9,211
16,607
Taiwan
3.2
2.6
11,117
19,703
Thailand
2.9
3.6
2,580
7,286
Country
20
15
10
5
0
Source: NIPA/Haver Analytics, China National Bureau of Statistics, Oxford Economics projections from 2015,
June 2015
2030
China
2028
2026
2024
2022
2020
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
Key
US
Source: Oxford Economics Global Cities Database, June 2015
According to Oxford Economics, China’s GDP per head is set to reach $10,830 this year, compared with just $4,600 a decade ago. While the growth in GDP per head might be slowing, China
is nevertheless predicted to expand more rapidly than the other emerging economies in Asia over the next fifteen years, as Fig.7 highlights. GDP per head is projected to exceed $25,000 by
2030, after adjusting for purchasing power. The forecasts in Fig.7 highlight how China will go on widening the prosperity gap with most of emerging Asia, and closing the gap with the advanced
economies of Hong Kong, Japan and Singapore.
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THINK: China
Urban sprawl on a mass scale
In the weeks before the Chinese New Year, 700 million people cram onto trains, buses, planes and boats to leave the cities and return home to the countryside. This mass migration is the largest
annual movement of humans in the world. In 2012, half of the population of China lived in a city, a figure projected to rise to 60% by 2020. China’s 10 most inhabited cities expanded their combined
population by 35 million people in the decade to 2012. The combination of mass urbanisation and growth in China’s middle class has led to a phenomenal expansion of residential housing stock, as
well as new office markets and an explosion in shopping mall development. The growth in households has almost matched the growth in population over the past decade, and household growth is
expected to outpace population growth between 2016 and 2030. This will ensure that large-scale residential development continues apace.
The population of China is projected to top 1.45 billion by 2030, during which time ageing and dependency will become growing issues. The working age population is set to shrink from 72.3% in
2015 to 67.9% by 2030, a consequence of China’s one-child policy. This is broadly in line with other major Asia-Pacific economies, yet nothing approaching the scale of the problem facing Japan,
where the working age population is predicted to plummet to just 57.1%. Ageing and social security provision will be a challenge for policymakers, but could open up significant opportunities for
real estate players in the form of public/private partnerships in the healthcare sector.
The white collar revolution
Urbanisation and the shift to higher economic value sectors will be accompanied by a growing demand for office space. The biggest cities have already experienced massive job growth over the
past decade, with 24.3 million net jobs created in financial and business services alone from 2005-2014. The number of office jobs in Beijing and Shanghai more than doubled, underpinning the
development of major new office areas. By 2030, the share of office jobs in the workforce is set to rise further, as the economy continues its transformation from production to services. The
resulting growth will have great impact; Beijing’s office employment, as a share of total employment, already dwarfs that of London and Paris, and is set to exceed 40% by 2030. This is equivalent
to an additional 2.7 million jobs, more than all of the financial and business jobs currently in the metro area of London. Furthermore, according to projections by Oxford Economics, Chinese metros
are predicted to add more office jobs between 2016 and 2030 than the entire rest of the G20 economies combined.
11
THINK: China
Rise of the consuming class
China is getting richer and has been gaining considerable ground on the US. GDP per head
(expressed in US$ and reflecting purchasing power) has almost doubled in the last decade and
was equivalent to just over 23% of GDP per head in the United States in 2014. Oxford Economics
project the upwards trend to continue over the next fifteen years, when China’s GDP per head
will rise to the equivalent of 40% of that in the United States.
Growth in China’s middle classes is supporting buoyant retail demand. Oxford Economics
estimate real personal disposable income per head of $6,700 in 2015, reflecting average growth
of 9.4% a year since 2005. By 2030, this figure is projected to exceed $16,000. In 2012, there
were 36.6 million households with an income of between $35,000 and $70,000, and this is
predicted to quadruple by 2030. According to a 2013 report by consultants Kinsey, ‘Mapping
China’s Middle Class’, the upper middle class share of urban households is expected to rise to
54% by 2022, largely at the expense of a decline in mass middle class households. This means
sophisticated shoppers, who are able to pay a premium for quality and purchase discretionary
goods, will emerge as a dominant force. The same report highlights the different generations
within the middle class, the younger often raised in a period of relative abundance, unlike their
parents who were primarily focused on economic security.
30,000
40
35
25,000
30
20,000
25
15,000
20
15
10,000
10
5,000
5
0
0
Source: NIPA, Haver Analytics, United Nations, projections by 2015 from Oxford Economics June 2015
12
THINK: China
2030
% of US
2028
2026
2024
2022
2020
2018
2016
Key
China GDP per capita, PPP exchange rate, constant 2012 prices, $
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
China’s transition to a consumer economy is slowly taking shape. According to the World
Bank, household spending averaged around one-third of China’s GDP between 2010 and 2014,
compared with 68% in the US, 61% in Japan and 50% in the EU. Urbanisation rates are much
higher in the US (83%), Japan (92%) and the EU (74%), so China should increase its overall
share of consumption as urbanisation continues. Oxford Economics project the share of
consumption in GDP will rise by 8 percentage points by 2030.
Fig.8: China’s GDP per head $ (LHS) and % of US GDP per head (RHS)
Spotlight on Tier 1 cities
The remaining sections of this report provide brief
investment and occupier highlights for each Tier 1
city. The aim is to provide a flavour of the risks and
opportunities for a potential overseas investor.
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THINK: China
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Beijing
14
THINK: China
Offices
The pace of development of Beijing’s office stock has
been staggering since the turn of the century. Rapid
urbanisation got underway soon after China was admitted
into the World Trade Organisation in 2001. Practically all
government functions and state owned enterprises (SOEs) are
headquartered in Beijing, the undisputed centre of political
power. As a result, the majority of multi-national firms also
located their headquarters in the city.
The office market is located within a system of ring roads, and
office sub-markets tend to be defined by these radials. The
CBD and Finance Street sub-markets comprise two-thirds of
the total stock. Most of the remaining stock is either located
at Zhongguancun, which is popular with smaller technology
occupiers, or in the decentralised Wangjing or fringe CBD
(Lufthansa).
The CBD skyline is dominated by high rise towers, with
the 81-storey Tower 3 of the World Trade Centre its most
prestigious building. The Grade A stock in Beijing amounts
to c.8.5 million sq m, equivalent to 60% of Central London’s
total office stock. The CBD accounts for nearly half of Beijing’s
Grade A office space and is home to a well-diversified base of
professional services occupiers. Overseas firms account for
around half of tenancies, but this is changing as MNC demand
for space has waned in recent years, with a growing number
downsizing and opting not to renew their leases. Foreign
investment banks have a highly visible presence.
Finance Street has 1 million sq m of stock and the occupiers are
mainly SOEs, regulators, insurance companies and domestic
banks, many of which have self-financed the construction of
their building. Therefore, there is a high proportion of owner
occupation and rents are among the highest in Beijing. New
stock is emerging constantly at Wangjing where rental levels
reflect a 40% discount to the CBD, albeit a discount that has
been shrinking in recent years.
The vacancy rate in Beijing is around 4.5%, but there are
substantial schemes either planned or under construction,
seven of which exceed 100,000 sq m and one exceeding
245,000 sq m. Rent levels have soared since 2009, but growth
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is almost certain to slow as supply rises and the economy
settles on a slower profile of growth. Prime rents are very
expensive compared with Shanghai, and forecasters predict
they will be double their pre-crisis peak by 2018.
In terms of investment, office volumes account for 75% of
Beijing’s market, with approximately 30% of acquisitions made
by domestic occupiers for part self-occupation. International
landlords struggle to access the market since demand from
domestic buyers is prolific. Beijing gross office yields fell from
8.0% in 2009 to 5.0% by end-2014. Combined with rapid
rental growth, returns to the investor during this period were
spectacular, compensating for market risk. Rental growth
expectations are currently underpinning frothy capital values,
but this situation is unlikely to persist indefinitely. A potential
correction in capital values over the medium term remains a
significant risk.
Retail
CBRE’s 2014 study ‘How Global is the Business of Retail?’
identified Beijing as the world’s leading market in terms
of retailer penetration. Its growing population of wealthy
young shoppers is driving sales in malls, while high-end
consumption is supported by its affluent population and
resident political classes. With rising real disposable incomes,
demand has been buoyant, and retail sales growth has kept
pace with stock growth.
The relative maturity of the market is reflected in the
decentralisation of its stock, which is more evident in
Beijing than in any other Tier 1 city. Beijing has seen a major
expansion of stock over the last seven years, and core
submarkets account for just one-third of space. In these
saturated core markets, urban malls make up around twothirds of the floor space. Although new schemes are scheduled
for core areas over the next few years, most of the new supply
is focused on decentralised areas where newly completing
projects face intense competition. This decentralisation trend
is expected to continue, in line with the government’s recently
announced intention to restrict new commercial property
development in the central area (defined by 4th Ring Road).
In terms of opportunities, medium-sized (50,000-80,000 sq m)
and larger malls (80,000-120,000 sq m), tend to achieve
the strongest rental growth, as they can better agglomerate
shopping with a dining and leisure experience, a key
determinant of success. Malls with good connectivity to the
subway also tend to outperform and remain defensive over the
longer term. Schemes with poor connectivity are more at risk of
physical obsolescence as new stock is delivered to the market.
Almost all of the retail stock in Beijing is modern, having been
delivered since the turn of the millennium. This compares
with 50% for the Asia-Pacific average. The stock is set to
grow by 20% between 2014 and 2018, and could increase by
a further 20% between 2019 and 2023. Some schemes will
require expensive injections of capital to remain competitive.
Another area of risk involves malls that are specialised in the
luxury offer as the government’s anti-corruption campaign,
introduced in 2013, has had a detrimental impact on the sale
of luxury goods. Beijing’s affluent population continues to
support the sector, but overseas tourism numbers have fallen
and luxury retailers are not expanding.
Shanghai
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Offices
Shanghai’s office core CBD is located within a 5km radius,
bounded by the inner ring road. Its Pudong sub-market is
home to half of the city’s Grade A stock, and to a concentration
of prestigious tower buildings, headquarters of many major
financial firms. Pudong has almost no vacancy while the
neighbouring Puxi sub-market, located just across the river,
has vacancy closer to 10%. Puxi boasts its own trophy office
schemes and attracts a more diversified tenant base with good
representation from multi-national firms. The current Puxi
stock amounts to 5.4 million sq m, and is set to grow by 40%
over the next three years due to the infilling between the inner
and outer ring roads. In addition, a master plan exists to create
a further 4.5 million sq m of office and retail space, in close
proximity to Hongqiao airport.
Shanghai rents are volatile compared with Beijing and rental
levels halved after the GFC, as foreign occupiers in particular
consolidated their space requirements. Shanghai rents are
considerably more affordable than Beijing, and Puxi rents
could fall by a further 15-20% as new supply is delivered.
The investment market can no longer ignore softening rents,
and capital values should reflect this reality. Analysis by JLL
suggests the CBD needs to expand over the medium term
in order to accommodate the growth in demand for space,
suggesting Puxi rents will eventually recover. By 2020, fringe
CBD markets are likely to become contiguous with the Puxi CBD
especially those located just outside the ring road, a process
assisted by significant improvements in transport connectivity.
Shanghai is perhaps the most comfortable destination for
overseas investors into China and has a distinctly international
feel. Overseas developers from Hong Kong and Singapore have
been very active since the 1990s. Opportunities are limited
with relatively few transactions involving assets in the core
CBD. Most opportunities are confined to the emerging fringe
where potential investors must navigate excess supply risk.
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Retail
Fringe areas in close proximity to the CBD, with good transport
connectivity, arguably offer the safest choice. Newer markets
are more risky, as tenants do not always find it easy to relocate
from their existing district council areas due to tax registration;
in practice, incentives or discounts can be used by the local tax
bureau to dissuade businesses from leaving.
Over the long run, Shanghai will develop further as an
international financial centre and improve its competitiveness
relative to Singapore and Hong Kong. Compared with the other
major regional Asian financial centres, Shanghai is presently
immature and has drawbacks to overcome. The city is the
government’s main testing ground for its Free Trade Zone (FTZ)
initiative, in part an experiment to advance reform and open
up China’s service industries to the rest of the world. Within
these zones, capital flows will be freer, and it is hoped that
foreign investment will be encouraged by greater exchange
rate flexibility, easier to transact cross-border payments, and
preferable tax treatment. Shanghai will effectively become an
offshore RMB hub located on the mainland.
Although currently operating in the shadows of Hong Kong
and Singapore, the Chinese government makes little secret of
its desire for Shanghai to become the pre-eminent financial
centre of Asia. There is growing confidence that Shanghai
can attract a greater share of the region’s headquarters
of international companies, particularly as transparency
improves and business becomes easier to transact. However,
Singapore is also on the front foot with its own dramatic plans
to shift the industrial dock area and expand the CBD, creating
affordable housing on the peninsula and permitting a huge
expansion in the population. The battle for future dominance
is taking shape.
Shanghai is one of the most sought-after markets for both
domestic and international retailers. In fact, the city has the
largest number of fast fashion brands, and matches Beijing
in the number of available luxury brands. The heart of the
retail core lies along the Nanjing Road. Currently, Shanghai
is struggling with an over supply of new schemes, and asset
management is often a key differentiator in determining
success or failure. Experience shopping, the food and beverage
offer, marketing promotions and campaigns, are all considered
important weapons in the landlord’s armoury. However, the
food and beverage offer appears to have reached saturation,
and many are now pondering what the next big idea will be in
the quest to attract footfall and increase dwell times.
Shanghai has always been the most active retail investment
market, accounting for around one-third of all China retail
transactions between 2005 and 2013. From an investor
perspective, destination malls are insulated against future
supply shocks because enough of the population will always
opt to shop in venues in city centres. Many of the better malls
are owned and leased by developers from Hong Kong or
Singapore, and rarely transact in the open market.
Investors should remain cautious to decentralised locations,
where trading conditions are challenging, and in centres
where retailers do not always pay base rents. However,
there are potential opportunities in suburban areas that are
experiencing rapid population growth. Fast fashion retailers
have been expanding into selected decentralised areas, and
this is generating an upwards pressure on rents. According
to CBRE, some secondary locations have outperformed the
core in terms of rental growth. The decentralisation trend is
expected to continue as infrastructure improvements facilitate
the continued movement to the suburbs by growing numbers
of middle class families.
Guangzhou
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Offices
Guangzhou is China’s third biggest city by population and
constitutes the main manufacturing hub of the New Pearl
River Delta, sometimes referred to as the workshop of the
world. Guangzhou has a distinctly local feel compared with
the internationalism of Shanghai. It is the biggest conurbation
in the New Pearl River Delta, a region which the World Bank
reported had displaced Tokyo as the world’s largest urban
area in size and population. As a result, mass urbanisation is
underpinning rapid progress to a service-based economy, and
the office stock has more than doubled since 2006.
A new CBD has emerged at Zhujiang New Town (ZJNT),
located to the south of the established office core at Tianhe.
Despite the relentless number of schemes completing,
demand has broadly kept pace with supply due to ever
rising take-up by domestic firms. According to JLL, 87%
of take-up came from foreign firms in 2007, but by 2013
domestic firms accounted for more than half. Much of
current demand is driven by relocations to new areas of the
city and by corporate expansions. Vacancy is tight in the
old CBD at just 3%, but rises sharply to around 20% in the
ZJNT. ZNJT is home to Guangzhou International Finance
Centre, a 438.6m high tower containing over 250,000 sq m
of space in 103 above-ground level floors. The elevators
reach a speed of 8 m per second. The supply pipeline is still
booming and numerous additional projects will be delivered
in ZJNT, including Yuexiu Financial Tower and Guangzhou
CTF Financial Centre. In addition, with land supply becoming
limited in ZJNT, development has shifted eastwards to
Guangzhou’s International Financial City, where a huge
number of schemes is currently being built. The supply
overhang should exert downwards pressure on rents in the
short term and underpin a softening in capital values. In
terms of occupier demand, MNCs have centrally-controlled
budgets and are no longer expanding, while central
government is taking a more restrictive approach; SOEs
typically seek requirements for 40,000-80,000 sq m, so the
future is going to be challenging at a time when these new
schemes hit the market.
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THINK: China
As a result, developers and landlords are becoming more
sophisticated at arranging pre-lets and understanding the role
of incentives.
According to JLL, capital values grew strongly in 2011 and
2012 (by 28.4% and 15.1% respectively), slowing to c.3% pa in
2013. Grade A capital values are currently 80% higher than
their post-crisis trough, and gross yields are c.5%, and even
lower in ZJNT. Recent investment activity has been dominated
by owner occupiers, and local investors have serious doubts
about future income growth. Many large schemes could be
sold floor-by-floor as strata titles, as landlords try to de-risk
their exposure.
Retail
Guangzhou’s retail offer is notably less flashy than Shanghai
and Beijing, and fast fashion tends to prevail. Competition for
retail space is fairly intense in the CBD area, and there is much
refurbishment underway.
Malls tend to be youth focused, and incorporate a wide food
and beverage offer, which can be a problem for landlords
as fashion retailers pay higher rents. International brands
targeting Guangzhou can find it difficult to access the best
schemes because domestic retailers are willing to pay high
rents. However, international brands are attractive and tend to
improve the reputation of a mall. They increase footfall, which
is critical as a significant component of mall rents tend to be
on a turnover basis. In line with other Tier 1 Chinese cities,
investors struggle to find assets in core areas and need to
consider the emerging affluent suburbs. Some developers with
residential portfolios may be more willing to trade their retail
assets, given the residential slowdown.
As ever, the best performing malls are interconnected with
the metro system, where a huge expansion to sixteen lines
is underway and set to complete by 2020. The new lines will
connect the city centre with suburban areas and even
neighbouring second Tier cities, such as Foshan. Department
stores, such as the Friendship Store, provide luxury goods for
the local middle-aged affluent population. However, with Hong
Kong around two hours away by train, luxury shoppers tend to
make their purchases over the border to take advantages of
lower prices.
Development has been relatively stable in recent years, but
a boom in malls is now underway. Half the space completing
is in suburban areas that are experiencing rapid population
growth. Such areas include Panyu, Baiyun and Haizhu, and
are home to CBD commuters who require affordable family
homes and have been priced out of the city centre. These
consumers do not necessarily want to head back into the CBD
to shop at the weekends, and this presents an opportunity
for mall developers. Near-term completions include Wanda
Group’s 154,000 sq m Panyu Wanda Plaza. In the city centre,
new schemes include Sun Hung Kai Properties’ 100,000 sq m
Parc Central in Tianhe, and GT Land Group’s 33,000 sq m
Seasons Mall IV in Zhujiang New Town. The IFC area in the
CBD currently lacks a decent retail offer, however, despite its
many wealthy residents and a huge influx of daily workers with
high disposable incomes.
Shenzhen
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Offices
Shenzhen embodies the spirit of modern China and its bold
experiment with capitalism. Also located in the Guangdong
province, Shenzhen was the first of five Special Economic Zones
established in 1979, owing much to its proximity to Hong Kong.
From a simple fishing village in 1978, with a population of a few
thousand, the city today has a population of 10 million, almost
exclusively comprised of migrants. The financial centre is home
to the Stock Exchange and the headquarters of numerous hightech companies. Shenzhen is also one of the busiest container
ports in the world.
Shenzhen’s office stock is catching up with Guangzhou in
terms of size and is set to overtake its neighbour by 2016.
The current CBD is located at Futian and has 4 million sq m
of floor space with plans for a further 2.7 million sq m. Future
development will also focus on Nanshan, a small sub-market
of just 0.6 million sq m, and in Qian Hai Central District, where
planned schemes will add a further 1.6 million sq m, more
than tripling its size. The new district in Qian Hai enjoys tax
discounts and incentives and has been growing in importance.
Potential investors face significant control challenges, since
more than half of the Grade A office ownership is strata titled.
There are single ownership buildings of considerable size, such
as the 130,000 sq m NEO Tower A at Futian and the 135,000
sq m KK10 at Luohu. While rents have soared in recent years,
capital values have risen by less, according to JLL suggesting
investor caution. Because new supply is booming, the vacancy
rate is set to rise sharply by 2016, potentially to 25%. In terms
of the new head quarter schemes, around 40% are set for
owner occupation, while half will be leased and the remainder
strata titled.
In the long run, there will be a high speed train connection
with Hong Kong Kowloon, the airport and potentially a road
bridge. Qian Hai therefore has a bright future and represents
the final development phase in Shenzhen, given the physical
constraints of the bay in the south and the airport to the north.
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THINK: China
Qian Hai will share similar legal and tax structures to Hong
Kong and, as an office centre, will challenge the traditional
CBD, forcing it to adapt in order to regain competitiveness.
municipal government changed the visa rules to combat
parallel trading by limiting trips to Hong Kong by permanent
residents to just one visit a week.
Retail
The Shenzhen investment market is relatively illiquid and
deals involving big lot sizes are rare. The strata title market
is more active, as are deals for single units within malls. Malls
affected by diluted ownership struggle to implement effective
operating strategies and this lack of control presents a risk for
potential investors.
Shenzhen’s retail core is centred on the districts of Futian,
Nanshan and Luohu, where much of the stock emerged
between 2002 and 1994. Luohu has mature, high end schemes
including MixC, KK Mall and the King Glory Plaza. Non-core
areas include Longgang and Longua, but over supply has
become a problem in recent years. A further 2 million sq m
is expected to complete in the next three years, and vacancy
could exceed 15%.
The consumer base is affluent and boasts the highest real
household disposable income per head of any Tier 1 city. The
city population continues to rise with ever more residential
schemes completing in the suburbs. The relative youth of the
population is striking; Shenzhen is the youngest city in China
with an average age of 34. As a result, the city has become a
major testing ground for fast fashion retailers.
The better performing malls provide nursery and educational
facilities to cater for the city’s growing number of young
middle class families. As with Guangzhou, luxury shoppers
tend to head to the tax free zone of Hong Kong, so the luxury
offer in Shenzhen is relatively limited. Cross-border shopping
may become more restrictive in the future if Hong Kong
representatives are successful in their calls for restrictions on
mainland Chinese tourists.
Street demonstrations in Hong Kong reflect the locals’
impatience over having their daily lives disrupted, as Chinese
tourists frequently empty shops of baby formula, cosmetics,
luxury goods and medicine, with the high demand leading to
increased prices. As Hong Kong does not impose a sales tax on
certain goods, they are very attractive to mainland shoppers
and parallel traders alike. In early April 2015, the Shenzhen
Contact us
Andy Schofield
Director of Research
T: +442037278203
E: [email protected]
www.threalestate.com
[email protected]
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