By Milton Kotler

Scores of Chinese cities are being rebuilt. Entirely new cities have been built. Industrial parks dot the landscape. They are mini-cities in themselves. China is in a development frenzy that the world has never before seen. Some fear a bubble. But this burgeoning landscape will not implode. It is only the beginning of a full new decade of development. The reasons are twofold. First, rapid middle class growth demands a vast new supply of upgraded housing. Second, demand for housing, office building and commercial space for retail, hospitality and entertainment has barely been meet in hundreds of second and third tier cities. The vast supply of Western capital for real estate development has barely begun to flow into China.

According to the Ministry of Construction (MOC) by 2010 China will need to build 8 billion square meters of housing space to meet demand. If the floor space of one unit is 100 sq.m, 11.4 million residential units will be needed every year. Moreover, with China’s accession to the WTO and the approach of the Olympic Games in 2008, large-scale projects including infrastructure, urban renewal and high-tech developments, as well as environment-friendly schemes should stimulate tremendous grade A offices and high-end residences.

The first tier cites are still “growing markets”. In these markets, the competition is fierce, and development is outpacing occupancy. Many local real estate companies and foreign companies have invested there for many years. Second tier cities like Tianjin, Nanjing, Chengdu, Chongqing, Dalian, and scores more are developing real estate markets, with higher yields that the primary cities. As the primary cities mature, they will be the growing markets of tomorrow.

The policy of the Chinese government is to attract greater foreign investment for Chinese urban development. It is important for local officials in primary and secondary cities to understand the trends and sources of foreign investment for their attraction strategies. It is important for foreign investors to understand the opportunities that await them.

An Amazing Growth

The companies in China’s real estate market have reason to be optimistic.
In the first half of 2003, total investment in Chinese real estate was RMB 381.6 billion Yuan, up 34.0% from the year-earlier period. Residential development amounted to RMB 258.6 billion, 67.8% of the total investment. By geographic location, the growth rates in East, Middle and West China are 29.2%, 55.9% and 45.6% respectively. In 2002, the total investment in the Chinese real estate market was RMB 773.64 billion, an increase of 21.9% over 2001.

In China, the real estate market is often divided into residence, villa and high-scale apartments, office buildings, and commercial housing, which retail shopping, hotels, restaurant and entertainment. The investment and the sale space in China’s commercial housing real estate kept the steady increase in recent years. Especially in the half of 2003, the investment in commercial housing real estate rose 50% from a year earlier, according to the China National Statistics Bureau.

Recently a ranking official from the China Ministry of Construction predicted that in the next five years, the real estate industry would be relatively stable. "The phenomenon of major fluctuations will no longer occur as in the previous years, and there will be ample space for development.'' According to a survey reported in the China Construction magazine, about 21.9% of the residents surveyed indicated they would like to purchase new houses with a size of 70-150 square meters within 5 years. Also some anticipated big opportunities will come with Beijing Olympics 2008, Shanghai World Expo 2010 and real estate financing and banking reform.
The selection of Beijing as the host city for the 2008 Olympics had an almost immediate and significant impact on the Beijing real estate market. Analysts now anticipate another six to seven years of double-digit GDP growth in the city as a result of massive Olympics-related urban investment. Beijing forecasts for 2002-08, there will be a floor space of between 10 and 12 million sq.m. needed per year in Beijing. In December 2002 the Paris-based Bureau of International Exhibition’s (BIE) voted in favor of Shanghai hosting the World Expo in 2010. A huge US$40 billion wave of infrastructure construction will wash up onto the banks of Shanghai’s Huangpu River in the run-up to the event, which will drive its property market, and further reinforce Shanghai as an ideal investment destination.
Economic development requires that the real estate industry maintain a definite rate of growth. According to the goal set in the Outline of the Ninth Five-Year Plan for China's National Economic and Social Development and the Long-Range Objective through the Year 2010, China's annual economic growth rate will be maintained at 8 percent, and the rate of fixed asset investment at 30 percent.

Foreign Investment

Foreign capital in China's real estate sector grew rapidly, with the encouragement of the Chinese government to promote the commercialization of the property market. Actual foreign investment in the real estate sector was $700 million in 1992, and rose to $6.22 billion in 1994. However, the Southeast Asian financial crisis of 1997 reduced the volume of utilized foreign capital to $5.27 billion in 1997 and $4.39 billion in 1998. The upward trend has now resumed, and remained stable over the last two years. In China today, about 5,000 real estate companies gained funds from outside of Mainland China (including joint venture, foreign-owned and other types of investment in Chinese real estate companies), and this number accounts for 20% of real estate companies in China. According to some authorities’ predictions, investment in China’s real estate will obtain an annual growth of 7% in the next 5 years, and more foreign funds will be pulled into this market.

The percentage of foreign direct investment in the total capital source in Chinese Real Estate Market ( RMB billion Yuan).

(Other Sources include pre-sale earnest money, bond, etc..)
Data: China National Statistics Bureau

In the next five to ten years, foreign business people face promising prospects. According to Ministry of Construction statistics, the average level of profits from real estate investment in China is not lower than 30 percent. This is higher than the profit level of some other industries and certainly higher than profit levels in real estate both in the U.S. and Europe. According to an official from the Real Estate Department of the Ministry of Construction, foreign investment in China's real estate sector is very profitable. With barely tapped and vast sources of investment in Chinese real estate, Western investors should be the big new winners in China’s real estate market, following the earlier success of Hong Kong and Taiwan investment.

It is useful to segment foreign investment in three parts: 1) Greater China FDI, which includes Hong Kong, Taiwan and Macao; 2) Asian investment ranges from Japan and Korea southward to Singapore, Thailand, Indonesia, Malaysia, Australia and New Zealand; and 3) Western investment, includes America and Europe.

Foreign companies began to share the big market pie about 10 years ago. Investment from Hong Kong, Taiwan and Macao dominated the whole capital from outside mainland of China in real estate industry during this period.
Hong Kong’s real estate tycoons began to enter the mainland market in 1992. Those names include Cheung Kong Limited, Hutchison Whampoa, Henderson Land, Sun Hung Kai Properties, Hang Lung Properties and Kerry Properties. They are the major investors from outside of Mainland China, and have strong bases there. For example, Hutchison Whampoa reserved 4 million-square-meter lands in mainland of China.

Director Sung Chun Wah (MOC) stated recently that more than 1,200 foreign enterprises and 3,800 enterprises from Hong Kong, Taiwan and Macao have been established in China’s real estate industry. Over 1,000 are wholly foreign-owned. More than 5,000 foreign and off-mainland enterprises accounted 20% of overall China real estate enterprises. For example, in Beijing, the number of real estate items invested by Hong Kong –owned companies is 411, and the contract investment is US $ 8.87 billion, respectively accounting for 72.2% and 72.3% of the total foreign investment in this city. Hong has taken a leadership position in mortgage financing, as well. Bank of East Asia, a Hong Kong-based bank agreed in early September 2003 began to offer mortgage to homes buyers of projects developed by Beijing-based Soho China Co Ltd. The 2.5 % interest rate offered is lower than the 5.04 % interest rate offered by domestic banks to homes buyers.

The reasons why Hong Kong real estate companies could succeed in China market lay on three reasons: 1. Hong Kong has a common culture with mainland of China, and has much geographic edge. 2. Many companies in Hong Kong switched their directions to Mainland China, while the local real estate market began to slump several years ago. 3. Hong Kong real estate tycoons keep very good relationship with China’s central and local governments. They are always the biggest donation sources of the non-government projects, e.g. education, natural calamities and accidents, and sports events. Sometimes they are able to break thorough policy restrictions and local criticism. Cheung Kong Limited is an example. When this company began to develop the Dongfang Plaza near Tiananmen Square in the early 1990s, many people including some famous architects and governors opposed it intensively because the potential buildings were too huge and not consistent with the atmosphere there. But at last, the project was supported by some top governors and finished successfully.

The investment from Thailand and Singapore is another big strength. For instance, in September 2002, Chia Tai declared its intention to invest RMB 10B to develop a 1 million-square-meter commercial residence. Prior to this project, the company invested US$400M to develop the first shopping mall in Shanghai, Chia Tai Plaza. Keppel Land Ltd in Singapore also said it's setting up a joint venture with the Singapore government's housing development arm to build homes in China. The venture will start in "promising cities" in China and expand to other parts of the country as demand picks up, Keppel Land said. Last month a Shanghai project and other developments boosted overseas contributions to 27 percent of its profits in the first quarter. Another Singapore company, Ascott Group inked a contract with the Beijing Foreign Investment Center to launch the Ascott Property Management Co Ltd in Beijing in Jan 2003. So far, Ascott has set up a world-class Ascott Beijing Hotel and a luxurious apartment building in the capital city, and is to further expand its business in Beijing for huge opportunities brought about by the 2008 Olympic games.

Macquarie Bank from Australia is one of few companies from western countries, which had operations in China’s real estate industry for more than five years. Since starting its China business in 1995, it has developed around 3,000 apartments in Tianjin and Shanghai. Now Macquarie is developing and managing Waratah Gardens in conjunction with AMP Henderson Global Investors and a local partner. Strong returns have been achieved from Waratah Gardens, a 773-apartment complex in the Pudong New Area aimed at Shanghai’s rising middle class. Furthermore, In January 2002, Macquarie and Schroders Asian Properties LP created a joint venture with a Shanghai residential property development and funds management business. With a pool of up to $US40 million ($A79 million) from partners, the joint venture had the capacity to develop residential projects in and around Shanghai with a total end value approaching $US400 million ($A790 million).

Only recently have companies from America and Europe began to pay attention to China market in recent years. The lure of higher return on investment has attracted investors from familiar U.S. shores of 15% IRR to new Chinese shores in the range of 25%-70% IRR. What was thought to be a high-risk place to invest in real estate a decade ago has become a verified and compelling destination today.

Compared with players from Hong Kong, investment funds from American and Europe very cautious in the last decade about China’s real estate market because of uncertain regulations and bureaucratic routines. Until now there have been few big accomplished Western projects. Cultural and language differences create difficulties in understanding local markets. This slows business procedures and increases costs.

But, starting from 2001, many foreign fund organizations from America and Europe have entered into China’s real estate market. They were inclined to cooperate with local real estate companies or fund organizations, and their investments in the new projects were often up to 70%. China has begun to understand Western real estate investment tools, like REITS, and plans to open the market more smoothly to these ways of doing business. Notably, China authorized the first REIY just one month ago.

In September 2003, Rockefeller decided to invest US$1.5B in the Waitan (The Bund) project in Shanghai, which will include Rockefeller Center, where the group’s Southeast Asian headquarter will be located. Morgan Stanley also declared In July 2003,to invest US$ 90M in a luxurious commercial residence project in Shanghai with Yongye Group, a local company. Lowes Enterprises of L.A. is developing villas and high rises in Shanghai and Beijing. The Hines Company of Houston is another success case. It invested US$ 200M in a commercial residence in Beijing in 2000, and this project, aiming at the middle-class residents, was sold out when it was finished in early 2003. In addition, in October 2001, it bought Shengshi Building in Beijing from Hyundai with US$95 million.

Golden opportunities in this market, a decade long record of Hong Kong and the affirmations of Chinese foreign investment policy have overweighed past concerns. We are on the threshold of a Western investment deluge. But all markets have risk, - even Golden Markets. Newcomers from the West will try to unravel the complexities and risks of the Chinese market and find the keys to superior profitability.

A Golden Opportunity

The increasingly flexible financing system is another driving force for Western investment in China’s real estate industry in the future. The developers and buyers will have more types of financing sources with the relaxation of some constraints on foreign banks’ involvement in China real estate industry. DBS Bank, as an example, has closed syndication for a $180 million dual tranche facility for Shanghai Hua Qing Real Estate Development. Bank of China (Hong Kong). Commerz East Asia and Maybank have joined as underwriters with commitments of between $30-$40 million. Countless offshore sources of construction financing have been established.

On the other hand, some foreign banks have been permitted to provide the mortgage to homes buyers. After four years of preparation, a Sino-German housing savings bank got a green light from China's central bank in October 2003 and will open in north China's Tianjin municipality. A spokesman for the China Construction Bank (CCB), the Chinese side of the joint venture, said on December 2003 that the Sino-German Housing Savings Bank Co. Ltd. has a registered capital of 150 million Yuan, with the CCB owning 75.1 percent of the stake and the Bausparkasse Schwaebische Hall of Germany owning 24.9 percent. HSBC has entered the mortgage financing market.

The ongoing reformation in China's big banks will give foreign investors additional asset opportunities. The big banks in China have many distressed real estate holdings available to foreign buyers. Chinese state asset management companies have recently held auctions to release vast amount of default property to Morgan Stanley, Goldman Sachs and other global bidders.

First Tier Cities vs. Second Tier Cities

In China, first tier cites include Beijing. Shanghai, Shenzhen and Guangzhou. The second tier cites are large coastal cites and capitals of affluent provinces. These include Tianjin, Nanjing, Hangzhou, Dalian, Qindao, Ningbo, Chongqing and Chengdu,

In the first half of 2003, the Development Research Center of State Council (DRC) in China ranked Chinese cities by their potential to attract the investment in real estate. The cities are ranked as follows: Shanghai, Beijing, Shenzhen, Guangzhou, Xiamen, Ningbo, Hangzhou, Nanjing, Chengdu, Tianjin.

Until now, major western investors have clustered in first tier cities, and make at least 25 percent return on investment (ROI). However, they are facing fierce competition from their Hong Kong and Chinese counterparts. Currently, no statistics for rate of ROI in the second tier cities’ real estate market is available, and the estimated rate is close to 25%. Moreover, most of the second tier cities are hungry for FDI in the real estate market, and they may offer more incentives and therefore a higher ROI, than those first tier cities do.

The net income in real estate in Chinese major regions in China in 2001

Data: China National Statistics Bureau

Even though the first-tier cities attracted a large part of the investment, returns didn’t follow investment. For example, in Beijing, net income in 2001 was negative. Also the vacancy ratios in the first-tire cities are comparably high than that in the second tire cities. There is little data available about the vacancy ratio from the Chinese government in recent years. Until July 2002, vacant space in China real estate (including residential, office building, and commercial housing) was about 0.12 billion sq.m. with related financing of RMB 25 billion. Floor space that had been vacant for more than one year was about 50 million sq.m,, which accounts for more than 50% of total vacancy, an increase of 11.5% than the same period of 2001. Some expects believe that the vacancy level at that time was about 26%, far higher than the alert level of 10%. Remarkably, Vacancy is mainly distributed in Beijing, Guangdong province, and Shanghai. It was obvious in Guangdong, Shanghai, Zhejiang and Beijing. The total vacant space in these four districts amounted to 49.6% of total vacant space in China in 2002.

Some foreign investors have begun to exploit the new market in inner China. For example, Kempinski Hotels & Resorts, the oldest luxurious hotel group in Europe, recently signed a contract with Sichuan Xiang-yang Real Estate (Group) Co., LTD for Kempinski’s hotel management and inner decoration contract. Kempinski Hotel will be the only Five-star Hotel in the south part of Chengdu, and it is expected to go into operation by the end of 2003.

Moreover, because of some big reconstructions projects, the second tire cities can provide more opportunities and incentives to foreign investors. Tianjin, for instance, launched a RMB 100 billion project in early 2003, Haihe Project. Haihe River is the seventh biggest river in China. The river, across the city of Tianjin, is the symbol of this city. In order to renew the former fame of Haihe, the government of Tianjin has invested nearly 16 billion RMB for infrastructure improvements, as the foundation for a vast master plan for river front redevelopment. The Haihe project has begun to promote the real estate market in Tianjin. According to the statistics data from Tianjin Housing Management Bureau, the sale of real estate in January 2003 increased by 91.9% than the same period of last year, and broke the record in the history.
Nanjing is planning 34 kilometers of redevelopment along the Qinghuai River to fortify the cities tourism strategy as a great cultural destination for foreign as well as domestic visitors. Many second tier city riverfronts are following suit with different industry strategies.

Risks ahead

Even though many foreign investors are very optimistic with China’s real estate market now, the risks of operating in China need to be realistically assessed.

1. Overheated Market. From 1998 to 2002, the average growth rate of investment in China's real estate industry was around 20 percent. Currently, the ratio between China's housing price in most cities and residents' average income is about six times higher than the international average; in Beijing and Shanghai the ratio is 10 times higher. In 2002, 26 percent of China's commercial houses were unsold, breaking the international alert level of 10 percent. And in the first half of 2003, the percentage of unsold houses had increased 8.6 percent year-to-year.

On the other hand, in the first six months of 2003, the loans provided by banks across the country totaled RMB1.8 trillion (about 217.5 billion US dollars) -- nearly the total for the whole of last year-- of which a great part flowed into the real estate industry. To prevent the risks of bubbles arising in the real estate industry, China's banking sector has taken measures to control the loan levels among developers and house brokers

Some Chinese experts think China’s real estate is overheated, while others have different opinions. Some experts thought the 26% vacancy ratio was not a horrible number, since the urban population percentage in China was 35% in 2002, and it would increase to 46% in 2010. The annual population increase is 18.5 million, which means that the floor space of 3.8 billion sq.m. would be needed to accommodate them over the next 8 years, an average annual demand of 0.42 billion sq.m..

The Ministry of Construction (MOC) will also issue a series of adjustment measures for a rational and healthy development of the real estate industry. Tong Yuezhong, Deputy Director of the MOC Housing Industrialization Promotion Center, said the control measures, which will be taken, are not to halt the fast growth of the real estate industry, but to readjust the housing structure and build more houses for low- and middle-income people.

2. Government intervention. The Chinese government has reduced its ad hoc comments to the market in the past five or six years, but the practice continues, which might cause concern among investors. Early 2003, the Chinese government said it would tighten grip on real estate development.

3. Inefficient and Ineffective System for Operation. There are still too few real estate laws developed so far, making foreign investors unsure of how to evaluate business opportunities in China, and creating uncertainties for foreign funds in real estate.

4. Low Purchasing Power. The purchasing power of ordinary Chinese is still low. Many wage-earning people do not have the ability to purchase a high-end residence, which represents a risk for foreign investors focusing only on the high-end market.

5. Land Ownership. All land in China belongs to the state. Leases for residential property last 70 years, and 50 years for commercial property. Foreign investors may only obtain a land use right, rather than land ownership. At the same time, the new constitution provides for the protection of private property.

6. Local Policy. Some local real estate companies have close relationships with local governments, and win special favors that can put other investments at a comparative disadvantage.

Yet with all of these risks, the inflow of Western investment will be a mighty force in shaping China’s real estate industry in the coming decade. It is important for local authorities to develop competitive strategies to attract this capital. Several elements are essential to a successful strategy.
1. Master Plans. Many second tier cities have a “brush stroke” approach to planning. They offer opportunistic parcels to investors without a strategic direction for development. This is dangerous for cities and unappealing to Western investors. Chinese cities need detailed distinctive goals and master plans to accomplish these goals.

2. Infrastructure investment. There is nothing as attractive to western investment as to see the local authority’s budget for infrastructure improvement.

3. Outside Expertise. Great mandates for urban development rest upon the shoulders of talented professionals who are often relatively new to the game of large scale market based investment and development. They can use outside help to link them more effectively to the foreign developer and investment communities.

4. Strategic Plans. While it is anecdotally averred that Chinese developers do not need research and market planning to build successful projects, this is not the case with foreign developers and investors. These distant sources require the solid research and reasoning of local strategic marketing plans that research, target and position potential properties for validated customer markets. They will gravitate to those cities that have these plans.